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Increase your cash-flow:
Don't rush to pay off that mortgage

By Liz Pulliam Weston

You normally don't think of people who prepay their mortgages as being wasteful or careless.

But a recent study suggests these households blow more than $1.5 billion a year, or $400 per household, by accelerating their mortgage payments instead of contributing more to their retirement accounts.

The research found that at least 38% of those who were making extra payments on their mortgage were "making the wrong choice." Instead, these households would get back 11 to 17 cents more on the dollar by putting the money into a workplace retirement plan like a 401(k).

The study, titled "The Tradeoff Between Mortgage Prepayments and Tax-Deferred Retirement Savings," was conducted by Clemens Sialm of the University of Michigan's Ross School of Business, Gene Amromin of the Federal Reserve Bank of Chicago and Jennifer Huang of the University of Texas at Austin using Federal Reserve data.

If anything, I think the study underestimates how many people make a mistake by prepaying their mortgages. It didn't look at folks who were accelerating their mortgages while carrying higher-rate debt, or who failed to have an emergency fund, or who didn't have adequate life, health or disability insurance.

Most people, in short, have much better things to do with their money than to pay off a low-rate, tax-deductible loan.

The urge to be free of debt

It's not that I don't understand the impulse to speed up the day that you own your home free and clear. There's something psychologically satisfying about knowing the bank can't take your castle.

Besides, the numbers can seem pretty impressive. Let's say you have a 30-year, $250,000 mortgage at 6% interest. Your monthly payments are $1,498.88. By paying an extra:

  • $100 a month, you could save nearly $52,000 in future interest and pay the loan off 4½ years early.
  • $250 a month, you could save nearly $100,000 in future interest and pay the loan off nine years early.
  • $500 a month, you could save nearly $144,000 in future interest and pay the loan off almost 14 years early.

So who wouldn't go for that, right? Indeed, the study estimated that almost one in six U.S. households (16%) pay extra on mortgages each year.

But anyone who really understands money would realize that the savings aren't all they're cracked up to be.

For one thing, mortgages tend to be some of the cheapest money you can get and, as mentioned earlier, the interest is typically deductible. If you're in the 25% federal tax bracket, that 6% interest rate is really only costing you about 4.5% if you itemize.

Furthermore, those seemingly impressive interest savings are way in the future, where their value will be substantially eroded by inflation. For example, $50,000 in 25 years would be worth less than $24,000 in today's dollars, even at a moderate 3.1% inflation rate.

Contributions to a workplace retirement plan will get you a lot further ahead, for a variety of reasons:

  • Most workplace plans have matches, typically 50% of every dollar you put in up to 6% of your pay. If you're not contributing enough to at least get the full company match, you're leaving free money on the table (and missing out on an immediate 50% return).
     
  • You save taxes on the money going in. Federal tax brackets range from 15% to 35%; there are also federal tax credits when lower-income folks make retirement contributions. When the money comes out, you'll owe taxes, but most people's tax rates fall in retirement compared with when they're working.
     
  • Your money can earn better returns in the market compared with paying off low-rate debt. Based on historical returns, a mix of 60% stocks, 30% bonds and 10% cash would earn an average of more than 8% a year in most 20- to 30-year periods, according to market researcher Ibbotson Associates.

The study didn't mention Roth IRAs, but they're another account you should take advantage of if you possibly can. You don't get a tax break up front, but the money comes out tax free in retirement.

Even if you're contributing the max to your retirement accounts, though, your next step shouldn't be making another mortgage payment.

Establish priorities

You need to look first at all your other debt. Chances are if you have any, it's accruing at a higher interest rate than what you're paying on your home loan. That's especially true for credit card debt: It makes no sense to save less than 6% by prepaying a mortgage when you're paying 15%, 20% or even more on your plastic.

 

What if you're free of other debt, you can start to tackle that mortgage, right?

Not quite. There are other threats to your financial security you need to address, especially:

Financial inflexibility. Fewer than three in 10 households have enough savings to withstand even three months of unemployment. Half say they live paycheck to paycheck at least some of the time, according to a survey commissioned by the Consumer Federation of America. Having an emergency fund equal to at least three months' expenses (plus access to a home equity line of credit) can make the difference between a rough patch and financial disaster; that should be your priority after saving for retirement and retiring high-rate debt. Then there's the issue of:

Inadequate insurance. If you have people financially dependent on you -- a spouse who needs your paycheck to pay the mortgage, or minor children -- you need life insurance, and usually plenty of it.  In addition, you need adequate health insurance, since medical bills are a factor in half of all bankruptcies.

Also crucial: long-term disability insurance, which most Americans don't have. Fewer than 30% of all workers have long-term coverage, according to the U.S. Bureau of Labor Statistics. Yet our chances of disabling accident or injury are pretty high: At age 30, for example, you have more than a 50% chance of being disabled for three months or longer before you turn 65, according to the Council for Disability Awareness. One in seven U.S. workers are disabled for five years or more, and disabilities cause 50% of all mortgage foreclosures. Wouldn't it be ironic if you skipped disability coverage to prepay your mortgage, then wound up losing your house? The bottom line: If you have access to long-term disability coverage at work, buy it.

OK, so what if you're maxing out your 401(k) and Roth IRAs, sitting on a pile of emergency cash and insured up the ying yang? I still wouldn't necessarily attack that mortgage. If you have kids, for instance, you might want to be tucking more away into a 529 college savings plan to make sure they aren't saddled with students loans, as too many young graduates are today.

Again, assuming the money is invested prudently in a mix of stocks, bonds and cash, you should make a much better return than what you can get prepaying your mortgage, and the money is tax-free when used for college.

You've got to live a little

There's a final, much more subjective issue to address. Some of the folks I've run into who are determined to pay off their mortgages early are what I've come to consider "over savers." They're putting aside prodigious amounts for all kinds of future goals, but spending precious little today. Sometimes they're even straining family relationships by their single-minded focus on being debt-free as early as possible.

 

That might be OK if any of us were guaranteed long, healthy lives. The reality is that no one is, and we need to strike a balance between saving for tomorrow and living today. The person who's set on paying off a mortgage in as few years as possible, even if that means skipping vacations and the occasional dinner out with the spouse, is just as out of balance as the person living on credit cards.

All that said, I'm not one of those pundits who insists that no one should ever pay off a mortgage. I think retiring the home loan by the time you retire is a good goal. Just make sure it takes its proper place with all your other goals -- and that you get to live life a little along the way.

Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money.

 

 

This now leads us to which debts should be paid off first. Some people can’t wait to get rid of their mortgage says Jane Bryant Quinn (financial analyst), so they add extra money to their payment every month. The faster the loan is reduced, the less total interest is owed to the bank. But what’s the hurry? If you’re young or middle-aged, it’s far more important to put the maximum into your retirement plan at work. If you work for yourself put the maximum into a Keogh or SEP-IRA plan. With a house plus financial investments, you’re better diversified. During the past 30 years, the Standard & Poor’s 500 have earned an average of nearly 14 percent annually, according to Ibbotson Associates in Chicago. Long-term investors have a good shot at earning more money in their stock-owning mutual funds than they can save by paying their mortgages ahead of time. You might have a change of heart, however, when you retire. At that point, your monthly income will probably drop, making a mortgage harder to carry; at that point you can use some of your investment gains to pay off the bank. Merrill Lynch says increasing cash flow is a critical element of building net worth. As an example a mortgage with interest only payments may help increase your cash flow by lowering your monthly payment. Funds that would have originally been used to pay down mortgage principal can be directed to meet other financial objectives.
"It’s unrealistic for people to think they can live their lives without debt," Buie said. In fact, without ‘well-placed borrowing,’ the average person isn’t likely to increase their wealth, Berg said. "It also makes sense to borrow when your money is put to better use somewhere else", said Susan Bradley, first vice president for financial planning at Raymond James and Associates. "You can take out a bank loan to buy a car at 8 percent interest instead of dipping into your 401(k) where it’s earning 10 percent", Bradley said. "Replacement debt is another positive way to owe money", said Robert Garner, National Director Of Personal Financial Counseling at Ernst & Young. For instance, a person might take out a home equity loan at a rate of about 7 or 8 percent – and pay off credit card debts that charge 19 percent interest. Interest on a home equity loan is also tax-deductible. "Your ability to borrow will also be a safety net to carry you through lean times if you lose your job or suffer another "life crisis", Garner said. "Many people find it hard to keep three to six months’ living expenses on hand for emergencies", he said. What about the other extreme? The granddaddy of bad debt is credit-card debt. The universal advice is to pay off the cards immediately and cut up all but one for emergencies. "I see very little other sources of financial catastrophe than credit-card debt", Buie said. "That doesn’t mean you should postpone saving money", Bradley said. She advises paying off credit cards and saving money at the same time so you can build a small emergency fund. A couple could pay $300 to the credit card companies and put $100 into a savings account. Other bad debts are consumable items, such as boats, clothes, travel, and expensive meals. That includes credit for Christmas presents. Some people probably didn’t pay off 1996 presents until late summer, said Buie. Lastly, there’s another type of debt risk-adverse investors should probably avoid: so called "margin investing", where you borrow to invest in the stock market. "Under such as system, an investor seeking to buy $10,000 of stock might put up $5,000 and borrower the other half. It’s a strategy that magnifies your earnings – or your losses – so it’s not for everyone", Bradley said. "It should only be done by people who know what they’re’ doing."

 

BECOMING A MILLIONAIRE

  • Invest $4,000 per year, and you'll be a millionaire in 34 years. If you believe that becoming a millionaire is pie-in-the-sky thinking for the average American, think again. All it takes is discipline, patience and some lifestyle decisions. Look at these numbers:
     
  • An individual who can scrounge up $4,000 a year to invest can become a millionaire in 34 years if he or she earns 10 percent annually on the investment after taxes. On the surface, that may seem difficult. However, the Dow Jones Industrial Average has had an average annual return of nearly 11 percent since the 1920s.  And 34 years is not really that long. A 30-year-old who starts tomorrow can be a millionaire before age 65. The numbers are even more impressive if you can save more and get a higher return. For a married couple to save $10,000 a year is not an easy task, but it is possible if they limit the Fancy restaurants and exotic vacations. If they earn 10 percent annually, they will have $1 million in 25 years. Let's say that you can't afford to put away $4,000 but are able to save $1,000 a year. The numbers are still impressive.
  •  By investing $1,000 a year at 10 percent annually, you will amass nearly $300,000 in 35 years Not $1 million, but not a puny retirement nest egg either.
    Conventional wisdom says investors should focus on their assets and carry as little debt as possible. Many individuals are now learning that to build net worth, "Managing what you owe" is as important as "Managing what you own." Therefore, your home-financing strategy should be a key component of your financial plan to ultimately help you build your net worth.

    But what if the Market is currently high, shouldn't I wait till it drops because of the old saying" buy low, sell high"?

    The answer is "no", as it's better to be early than to be smart in investing. That's the conclusion of a study by Neuberger & Berman Management, a mutual fund firm. Neubeger & Berman calculated the results that would have been achieved by two hypothetical investors in the stock market following two different strategies.

    • One investor, Early Bird, invested $20,000 via 10 annual $2,000 purchases from 1967 to 1976. Early Bird's timing was terrible, since he invested his $2,000 every year at the market's high. In other words, his market timing was the absolute worst it could be.
    • The other investor, Late Bird, put up $40,000 in 20 annual increments of $2,000 each from 1976 to 1995. Late Bird was a much better market timer. Indeed, his annual $2,000 was invested at the market's low point ever year (perfect 20-year timing record). So which bird had the bigger nest egg at the end of 1995 (using the Standard & Poor's 500 as a yardstick)? Surprisingly, Early Bird's portfolio had a value of approximately $320,000, compared with Late Bird's $270,000.

     

    BOTTOM LINE: It's hard to overstate the importance of time in an investment program. Even with investing twice as much and having perfect timing each year for 20 years, Late Bird came out on the short end because of a later start. 

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