Friday, November 16, 2007

Mortgage Dilemma

Recently I received an email from John detailing his mortgage dilemma. John’s financial dilemma is not new. There are conflicting thoughts on home loans and the need/desire to pay off the loan earlier than its term. I am posing this quandary to the users because in today’s environment (interest rates are low, market direction is uncertain, recession possibility is high etc.) sitting on some extra cash may not be a bad idea. Or maybe this is the time to plough $100K in the market. So here is John’s story -

John has a 30 year fixed mortgage on his house. Recently he came across some extra cash and was wondering if he should pay down the mortgage with this money, refinance or invest the money.

Details include

  • Current mortgage - $300,000

  • Rate and type – 6.5% 30yr fixed (28 years left on the loan)

  • Extra income - $100,000 to apply against the mortgage

  • Current monthly payment - $2,000

  • Other debt - $0
Options John is considering include -

Refinance: Reduces monthly payment but locks in the money for a return of around 6-7% (the loan interest rate). If you account for a tax deduction on the loan interest – the return could be 4-5%.

Accelerated payments: John wants to keep the money in a high interest saving or CD (5 - 6% interest rate) and make extra payments towards his mortgage. End result is the same as above (reduced loan duration thereby less loan interest) but monthly payment is not impacted and the return on the money is close to 4-6%. He has a financial cushion for a few years (if he pays an extra $1K/month that would be 100 extra payments or about 8 years before the money runs out) while he is reducing his mortgage liability.

Invest the money: Invest the money in an index fund (50% US market, 25% developed market and 25% emerging market). Over the next 28 years this investment could yield about 10-15% but his mortgage is not impacted by this approach and 10-15% return is obviously a projection.

So what should John do? What do the readers think about these options and are there other options that John needs to consider in today’s financial environment?

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louise said...

I would set aside some in an emergency fund if there is not one already and then pay the rest of the mortage.
Often life throws us a curve ball, that can knock us off our feet finanically, knowing the mortgage is paid ahead is a real help when trouble hits.
I would calculate how much interest John will save by paying a lump sum off the mortgage so he can compare.
( I realise mortgages are different in the US than in Aus but thats what I would do.

Bill said...

Step 1 - Fund your emergency fund (atleast 6 months of reserve)

Step 2 - Invest 50% in equities. I would stay away from emerging markets and seek a more diversified portfolio of stocks, bonds, REITS and money market.

Step 3 - Rates are going down in the US. If you can refinance for 1% point less in the next 6 months - use the 50% remainder to refinance the loan. If rates don't drop - invest the rest in the market also. You will also have a better idea about the market in 6 months.

Anonymous said...

Pay off the mortgage! No debt is the ideal situation to be in. The sooner you pay off your house the better you are.

Richard said...

Awesome post.
As we move into the last month of 2007, mortgage interest rates are continuing to decrease. They are now at the lowest point in more than two years, thus opening a bit wider the door of opportunity for home buyers. It’s now at the lowest rate since January of last year. This is a popular option for many homeowners who are now refinancing their mortgage.