 |
 |
|
Main Menu |
Plans |
Asset Management |
Financial News |
Other Services |
MortgagesTHE LONG OR SHORT OF ITConsider the story of Fred and Wilma. They are both excited about becoming the owners of an elegant house. Wilma, in particular, can barely restrain her enthusiasm for the home of her dreams. However, she has the financial brain of the couple and wants to make the best possible choice for mortgage financing. She must choose between a 15 year mortgage at 6.25% and a 30 year mortgage at 6.75%. In either case, they would borrow $100,000 in December 2004, pay the same in closing costs and neither mortgage note has a prepayment penalty. A quick analysis of their situation reveals that their monthly payment on the 15 year mortgage (principal and interest only) will be $857.42. Over the course of the mortgage they will pay $54,336 in interest. Of course, that interest is deductible. Let's assume that Fred and Wilma will be in the 28% tax bracket for the next 30 years. That means, after-tax, the interest costs them $39,122. Their total after tax payments will be $139,122. The 30 year mortgage results in monthly payments of $648.60. Total interest payments will be a whopping $133,495, but thanks to the deduction Uncle Sam gives them, the after tax-cost of the interest is $96,116 making their total after tax payments equal to $196,116. The 30 year mortgage gives them payments that are lower by $209 but it costs them $56,994 more, after-tax. One answer would be to take the sure thing, borrow for 15 years and run. But, consider the flexibility of the 30 year mortgage. If they were to invest the $209 per month in common stocks that returned 7%, after tax, for 15 years they would have over $66,632. The balance due on their 30 year mortgage after 15 years is about $73,059. They will actually have more saved than their balance due 6 months later, in June 2015. The key to this strategy is Fred and Wilma must actually save the $209 each and every month. If they don't, they may have been better off with the "forced savings" imposed by the 15 year mortgage. Investing involves risk and you may incur a profit or a loss. The examples provided are hypothetical and do not suggest or guarantee particular rates of return for any investment. How about these three alternative strategies that take advantage of the inherent flexibility of a 30 year mortgage with no prepayment penalty. If Fred and Wilma make 13 payments every year, starting in December 1999, the extra $648 will reduce their after-tax interest cost to $74,412 and pay off the mortgage in January 2023, about 5 years ahead of schedule. As an alternative, they might pay the next month's principal along with each payment. For example, in December 1999 they would pay the $93.13 in principal due on their January payment. Every month they would pay a little more in extra principal. This strategy results in after-tax interest costs of $57,832 and a pay-off in May 2017, about 11 years ahead of schedule. A simpler alternative would be to send a flat amount along with each month's mortgage payment. Sending $100 per month would reduce their after-tax interest cost to $61,750 and pay off the mortgage in August 2019. Each of these alternatives do require discipline. If one does not have the discipline to actually send the additional funds then the forced savings of the 15 year mortgage might be the best bet.
Mortgage Pre-PaymentsHomeowners are often faced with the decision whether to prepay their home mortgage. This decision can be significant given the amount of interest that could be paid over 15, 30 years or more. There are several ways to shorten the life of the mortgage. Taking a shorter term is the most direct, e.g. taking a 15-year mortgage instead of a 30-year term. This is often referred to as a "forced savings" plan because you are paying less interest and building equity. Refinancing an existing mortgage at lower rates but keeping your payments the same size is another way. Or you can put extra money toward the mortgage principal periodically. Typical methods of prepayment include making an extra payment per year, paying next month's principal or sending a flat amount with each month's payment Speeding up principal payments can save thousands in interest costs over the life of the loan. Yet, it is often stated that due to the deductibility of mortgage interest and the smaller payment of a longer term, the saved monthly funds may be invested at a higher rate (assuming the increased risk is acceptable) to offset the advantages of a shorter term mortgage. Let's look at when it might make sense to pay the mortgage off early:
Here's when it might not make sense to prepay:
There are many other variables to consider including
Mortgage RefinancingMany of us are familiar with the general rule of thumb that proclaims refinancing becomes worth your while if the current interest rate on your mortgage is at least 2 percentage points higher than the prevailing market rate. However, that rule of thumb may be somewhat oversimplified. For accuracy, be sure to compare apples to apples when considering refinancing. Specifically, compare the after-tax cost of the new mortgage with the old. Since mortgage interest is deductible, the after-tax cost of the loan equals the principal and interest payment after deducting the taxes saved attributable to the deduction. Choosing to refinance is not wise for those planning to move in the near future. There is typically not enough time to save with the lower interest mortgage to make up for or to surpass the cost of refinancing. Most sources say that it takes at least three years to fully realize the savings from a lower interest rate, given the costs of the refinancing. If you take a fixed rate loan and you refinance identical loan amounts you can roughly calculate the recovery time by dividing your total refinancing costs by your monthly mortgage payment savings. This provides you with the number of months you will need to stay in your home to "break even." (Example: if you will save $110 per month by refinancing and your refinancing costs total $3,000, divide $3,000 by $110 and the break-even point is 27 months. If you plan to stay in the house longer than 27 months, then refinancing makes sense). Refinancing, is it time yet? An oft quoted rule of thumb is that a borrower should consider refinancing if interest rates fall more than two percent below the original rate. That rule of thumb is really too simplistic to have much meaning. The question really involves comparing the after-tax savings in the monthly payment to the closing costs of the refinancing. There are numerous costs in any mortgage financing. These costs may include loan origination fees, application fees, credit checks, appraisal fees, attorney fees, title insurance, transfer taxes and others. The lender may also charge discount "points" that amount to prepaid interest. These points can run 1% to 3% of the loan. Points, unlike loan origination fees, are deductible as interest. However, the points that are paid upon acquisition of a home are deductible in a lump sum. Points on refinancing are deductible over the life of the new loan. The total closing costs on a refinancing can easily run 4% to 5% of the loan amount, although you may be able to get a break by careful shopping or dealing with your current lender. To really compare apples to apples, you should compare the after-tax cost of the new mortgage with the old. Since mortgage interest is deductible, the after-tax cost of the loan equals the principal and interest payment after deducting the taxes saved attributable to the deduction. The computation is fairly simple in most cases. The number-crunching gets a little more complex if the change in mortgage interest deductions causes you to cross over into another bracket, but the theory is the same. State taxes should also be considered if your state allows a deduction for home mortgage interest. For example, Tim originally borrowed $103,000 for 30 years at 9.5% four years ago to buy his home. Today he can refinance his home for 30 years at 6.75% at a total cost of 4% of the loan amount. Tim's loan balance today is $99,981.60. He is in the 28% tax bracket. The cost to Tim to refinance is $3,999.26 (assume no deductible points). His current monthly mortgage payment is about $866 of which about $792 is interest. That makes his after-tax payment about $644 [866 - (792 x 28%)]. His new mortgage payment will be about $648 of which roughly $562 will be interest for an after-tax cost of $491. Tim will be saving, after tax, about $153 per month. At that rate, it will take about 26 months (3,999.26/153) before he breaks even. If Tim plans to stay in the house longer than that, then refinancing makes sense. Reverse MortgagesPeople over 65 control a significant portion of the wealth in this country, but much of their wealth is concentrated in the equity in their homes. If Social Security benefits are excluded, just under half of all senior citizens would fall below the poverty line based on their income. Inflation continues to drive up the cost of food, energy, and, particularly, health care. Federal budget cuts have pushed the cost of many programs down to state and local governments, driving up sales taxes and property taxes. These taxes, particularly the sales tax, tend to be regressive and really clobber retired people living on Social Security and limited resources. The problem seems intractable. Seniors no longer work and if they went back to work they probably would not return to the work force in high paying positions; so an increase in income through additional labor is unlikely. Without additional earnings from labor, additional savings will be all but impossible. Increasing the investment return on their savings may solve the problem for some seniors. However, many are unwilling to accept the risk associated with higher returns. Even if some are willing to accept the greater risk, their resources may be too meager for an increased return to make a difference. The only available asset may be their home, which most seniors own free and clear. Enter the "reverse mortgage." Reverse mortgages literally are mortgage loans that work backwards. They also seem to violate most of the traditional principals of good lending practice, but more on that later. Under a reverse mortgage instead of sending a check to the lender every month to pay interest and reduce debt, the borrower receives a check every month from the lender and has his or her debt increase. Reverse mortgages vary from lender to lender but most have several characteristics in common. First, they are generally available only to senior citizens (the definition of who is a senior may vary from 62 to 70 years of age) who own their own home with little or no debt. Next, the type of loan is usually either a term loan (with the term based on the life expectancy of the homeowner or a period certain) or a line of credit. The amount of the monthly payment depends on the term of the loan, interest rates, the value of the home, and the percentage of current equity eligible to be loaned out. With a line of credit arrangement, there is no monthly check, the senior merely taps the line of credit for cash whenever necessary. Generally the loan is not repaid until the house is sold or at death. The risks to the lender are obvious. With a loan based on life expectancy, they could loan more than they will be able to recover on sale. There is no current cash inflow. Given these and other disadvantages, its no wonder that lenders have not been flocking to offer reverse mortgages. The Federal Housing Administration has a loan guarantee program for reverse mortgages that is available, however it is subject to limitations. The risk to the homeowner is also clear. The loan will eat away, and could wipe out, the value of their home. If the senior wanted to pass the home on to the next generation, that generation may be saddled with a sizeable debt. Of course, this brief article is no substitute for a careful consideration of all of the advantages and disadvantages of this matter in light of your unique personal circumstances. Before implementing any significant tax or financial planning strategy, contact your financial planner, attorney or tax advisor as appropriate.
|
