Sunday, April 22, 2007

Prepaying Mortgage vs Investing

I've been debating on whether or not to buy points on my mortgage, and then whether I should pay extra on the principal or not.

Let's tackle the second question first. There are many issues that disappear when you properly phrase the question. So, we'll have the goal of maximizing net worth at the end of the mortgage term.

House Appreciation: No matter how much of the house you own, it will appreciate at the same rate. Paying down the principal does not affect the value of your house. The only time paying down the principal helps with regards to house appreciation is if you sell it earlier or refinance the loan. You will then get more money from the sale or have to finance less. In my case, where I'd be more likely to keep the house and rent it out after I move, this is completely irrelevant to my final net worth.

Rate of Return: The rate of return on an investment makes all the difference. If the interest rate on the loan is 6% (as mine is likely to be), then paying down principal is effectively a 6% investment. This beats CDs and high-yield savings accounts, and is a guaranteed rate of return. However, the stock market in general tends to beat an 8% rate of return. For instance, last year I made about 14%. Currently, my E*TRADE account has earned 8.88% for the year (which is not a balanced account, and so fluctuates wildly).

Tax Considerations: Money invested is subject to income tax or capital gains tax. Assuming a 25% effective tax rate, my investments must earn a (.06/.75) = 8% rate of return. Well, my investments usually do earn 8% or greater! Plus, paying down principal reduces the amount of interest you pay, which increases your tax burden (interest being deductible).

Points: Buying points is an investment in a lower interest rate and a lower monthly payment. What is its rate of return? The value of a point varies over time and over the interest rate scale. For instance, currently moving from 6.125% to 6% costs .375 points, while moving from 5.875% to 5.75% costs .75 points. At 6%, my $232,000 loan has a monthly payment of $1,390. At 6.125%, it goes up to $1,410. 0.375 points costs me $870, and saves me $20/month, or $240/year. This is effectively a 25% return on investment. Given this new outlook on the value of points, I will need to talk to my mortgage guy again and figure out what is going on in more detail. Not every company has the same point scale, so it may just be that right now E*TRADE happens to have a favorable points system.

The other issue with points is that it also reduces the interest paid, and therefore increases your tax burden. Even still, the numbers above make it seem to be a solid investment.

Psychology: Even though paying down principal is logically a fairly conservative investment, there are a number of psychological advantages. First and most importantly, it feels good to not have so much debt, and to not have so many years left on the mortgage. Second, the more equity built, the more you feel like you have flexibility to sell or refinance. We'll see what I end up doing after my cash flow stabilizes (i.e., after I finish buying appliances, televisions, and furniture).

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