## Ask an Ex-Banker: Mortgages Part II – Should I Pay My Mortgage Early?

Dear Banker,

Most months we manage to cover our costs and have a little extra left over.  Sometimes I send the bank an extra \$500 or \$1,000 toward paying down our mortgage balance, which has another 21 years to go.  Once I sent close to \$5,000.  Does this make sense?  — Manny T., Chicago, IL

Dear Manny,

Congratulations on doing the first-order hardest thing in personal finance – produce a monthly surplus in your household.  Wealth for you – while not inevitable – is made possible by this monthly surplus.

I appreciate your question whether you should – or anyone should — pay off a mortgage early with small interim payments of principal.

This perennial question generates as many strongly held opinions as there are mortgage holders.  There’s a thoughtful discussion to a similar question prompted on this personal finance site.

Like most interesting personal finance questions, the answer depends on a combination of personal psychology and finance math.[1]  Your own personal relative weighting of this combination may lead you to a different ‘correct’ answer than that of someone else.[2]

My own short answer is that while paying off your mortgage principal in small early increments does not make much sense from a pure financial math perspective, it can be the totally correct thing for certain psychological reasons.

Therefore, while I don’t advocate paying off a mortgage this way, I fully acknowledge that for people with a different psychological approach than me, the incremental payments make plenty of sense.

The math side of things – forward rates

First, it’s helpful to understand mechanically what happens when you make an extra, partial, principal payment on your mortgage.

After making your regular monthly payment, let’s say you send an additional \$1,000 to the bank for principal.  The bank – actually the mortgage servicing company, but let’s not nitpick – applies that principal to the furthest-away-in-time mortgage payment.  In Manny’s case, his \$1,000 payment gets applied toward a payment due 21 years from now.

In other words, Manny’s total mortgage principal gets reduced by \$1,000, but not in any way that affects his current monthly mortgage costs.  He’s still obligated to make regular mortgage payments next month.[3]

You may have read, not entirely incorrectly, that when you pay debt principal early you get a guaranteed return on your money equal to your interest rate.  If you have a 6% mortgage, the conventional wisdom goes, you get a 6% “return on investment” when you pay off your mortgage.

But this is not entirely correct either, in purely financial math terms.

I’m going to assume Manny’s mortgage (obtained 9 years ago) has a 6% interest rate.  Since he’s eliminated by early payment the obligation to pay 6% interest on his borrowed money 21 years from now, we could more precisely say he’s invested the equivalent of \$1,000 at “6% interest rate, 21 years forward.”

That may seem like an odd turn of phrase, except that the bond markets operate precisely this way – on today’s interest rate (you might call this the ‘spot’ rate) as well as tomorrow’s forward rates (incorporating the idea for example, of 1 year interest rates, one year from now, stated as “1 year rates, 1 year forward.”)

We don’t all have to be bond geeks to make good decisions about early mortgage payments, nor do we need to know exactly what I mean with this clarification, except you should understand the following:  We don’t know with very much precision what prevailing interest rates will be 21 years from now.  As a result, it’s not as obviously a ‘good trade’ to pay off your mortgage at 6%, precisely because it’s not actually true that you’re locking in a “6% return” on your money today.

21 years from now a 6% mortgage interest rate may be extraordinarily high or it may be extraordinarily low (I’m agnostic on the issue) but the imprecision around the question of forward rates makes it less obvious what your effective ‘return on investment’ really is, or what you should reasonably expect to earn on your money 21 years from now.

One major and obvious exception to my clarification on “forward rates” is that if you pay off your full mortgage balance early – entirely eliminating the need to make future monthly payments – then indeed you did lock in a 6% ‘return’ on your money.[4]

Inflation scenario as an illustration of forward rates

To return to the problem of unknown forward rates for a moment, it may be helpful to think of specific, possibly extreme, scenarios.  I’ve written before that the combination of home ownership with a mortgage can be a very powerful inflation hedge.  One way of seeing that is through the concept of forward rates.

A future high inflation rate can illustrate the ‘forward rates’ problem.  If future inflation, say 10 years from now, runs at an annual 15% rate, with prevailing mortgage interest rates around 18%, then it becomes obvious that locking in a 6% return on your money in the final years of your mortgage was not a good idea, from a personal financial math perspective.  In my example you might have earned 18% just leaving your money parked in a money market account.  That kind of future interest rate can show us why we should be less sure of ourselves that earning a 6% return by paying of a mortgage early is the right decision, from a purely mathematical perspective.

More on the math side of things – comparative rates of return

I have not yet addressed the most common financial math reason why people claim you should not pay off your mortgage in small early chunks of principal payment.

Specifically, many argue that you may be able to earn a higher return on your money “in the market” than you can by eliminating personal debt and locking in the rate of return of your mortgage’s interest rate.

This is possibly true, although it depends on specific scenarios, like the following:

·         If you are talking about credit card debt – with interest rates between 9% and 29.99% – it’s clear to me that paying off your debt offers a better return than you could reasonably expect from another investment “in the market.”

·         If instead you are talking about current prevailing mortgage rates – like my newly refinanced 15-year mortgage at 2.75%! – then I heartily agree that a better return is quite likely available “in the market” rather than through paying down personal debt.

·         If you are able to invest in a tax-advantaged 401K or IRA vehicle, and you have a sufficiently long time horizon to invest in risky assets, then you can stack the odds mightily in your favor to earn a better return “in the market” rather than paying down debt.[5]

The Psychological approach – Arguing against myself

So I’ve made the case that locking in a specific return on your money – by paying down mortgage debt – is not as clear-cut as it first appears, from a purely finance-math perspective.

However, I do think the psychological aspect of making early mortgage payments should not be forgotten.  We are all humans,[6] responding irrationally to myriad inputs.  For many of us, money left on a monthly basis in the checking account gets spent, so the key to not spending is to not leave extra money lying around.

If Manny’s realistic choice every month is between sending \$1,000 to the bank to pay his mortgage early or instead – like many of us – to spend \$150 more on Amazon Prime downloads, \$300 on jewels in Farmville and \$273 on One Direction concert tickets, leaving just a \$277 surplus at the end of the month, then the choice is clearer.

All the possible market returns in the world cannot undo the simple fact that paying off debt guarantees an incremental increase in net worth.  If you can’t stop yourself from spending your surplus – and this really comes down to the psychological imperative: “know thyself” – then paying off the mortgage in small extra increments makes total, perfect, unassailable sense.

And then there’s risk tolerance

In addition, there’s the “know thyself” imperative applied to risk tolerance.

Investing money in the market – instead of paying down debt – makes an increase in net worth possible, even likely, but has no guarantee.  If you hate losing any amount of money ever, then by all means pay down all of your debts before investing in anything risky.

Earning a 6% return by paying off your mortgage[7] early may sound much better than shooting for a possible 10% compound annual return but with a possibility of a 25% sudden loss in any given year.

Few investments in the long run are worth 3AM insomnia.  A fully paid-off mortgage may do more for encouraging restful sleep than all the Posturepedic  mattresses in the world.

On Mortgages Part I – I Am a Golden God

Part III – 15 yr vs. 30 yr mortgages

Part IV – What are Mortgage Points?  Are they good, bad or indifferent?

Part V – Is mortgage debt ‘good debt’ A dangerous drug?  Or Both?

Part VI – What happens at the Wall Street level to my mortgage?

[1] My bond sales mentor memorably told me once that bond sales consists of 5% bond math and 95% child psychology.  Personal finance strikes me as a similar deal, although probably even more weighted toward the psychology part of the spectrum.

[2] And since I’m always looking for an excuse to quote Jack Handey, let’s review this gem: “Instead of having ‘answers’ on a math test, they should just call them ‘impressions,’ and it you got a different ‘impression,’ so what, can’t we all be brothers?”

[3] I’m assuming for the purposes of this example that Manny has sent the money to the bank to be applied to principal since that’s how his question is phrased, rather than specifying something like ”I’m paying the next 3 months early.”  Presumably that’s also possible, but non germane to the question.

[4] At this point further math geeks will point out that the tax-deductibility of mortgage interest means that your effective interest rate is probably closer to the 4% than 6% rate, making your effective ‘return on investment’ lower than it seems.

[5] As always, if you can get an employer match for 401K contributions then that use of money trumps everything except paying off high interest-rate credit card debt.

[6] All of us, that is, except for my Rihanna-bot, who takes care of me in my old age, on my hovercraft.  She’s not human, just human-like.

[7] Yes, closer to 4% after taxes, and yes, actually “6% 21 years forward.”

## Ask an Ex-Banker: Home Loans and Home Equity Lines of Credit

Q. Dear Banker, My wife and I are planning an addition to our house. We need the additional space, but I do not want this project to stretch our overall budget. Since I have a specific idea of how much I want to pay, a rise in interest rates would cause us to make different decisions on the project details. Unfortunately, we need to make those decisions now but will not need the money for another 8-12 months. I don’t care if interest rates go down, I like where they are now, but borrowing money before you need it sounds foolish. How does your average Main Streeter hedge against interest rate swings?

A. I understand your question to be whether you should borrow money now, before you need it, because rates are ‘low enough,’ and because you worry rates will not be this low in another 9 months when you actually need the money for the home renovation.

My short answer is: “Maybe, although I personally would not” as to whether you should borrow now and lock in today’s low fixed rates, in anticipation of needing money 9 months from now.  I’ll explain what I mean by that in a moment.  The longer answer, which I’ll detail more fully below that, is that you really need a home equity line of credit, not a fixed-rate home equity loan.

Should you lock in a loan 9 months early because rates are ‘low enough?’  I’ll make a bunch of assumptions to be able to answer the question specifically, and I hope you can adjust the answer to your own particular situation.

I’ll assume you can get a Prime[1] rate home equity loan for a pretty major \$100,000 home renovation at 5%.  That means you’ll pay \$5,000 per year in interest, or an extra \$3,700 for borrowing 9 months early.

\$3,700 is not the end of the world for peace of mind, and so I’ll answer “maybe” borrow this way to lock in an attractive low rate like 5% today.

There are a few reasons, however, why I would not borrow money early myself.  Foremost, we really have no idea which way interest rates will go in the future.

As a former bond guy,[2] I pay quite a bit of attention to interest rates.  Had you asked me at almost any time in the last 10 years whether interest rates were likely to go higher or lower in the next 18 months, I would have said ‘higher’ approximately nine out of ten years, and I would have been wrong approximately nine out of ten years.  That’s not because I’m ill-informed, it’s just because it’s much harder to forecast the future direction of interest rates than it seems.

Because of my own deep uncertainty about the future direction of interest rates, I would argue your choice to borrow 9 months early ‘locks-in’ a loan interest ‘loss’ of \$3,700, whereas the rate available to you has a 50-50 chance of being higher or lower 9 months from now.  If you accept my view, then your interest cost for the next 9 months, by not borrowing, is \$0, which is much more attractive than losing a guaranteed \$3,700.

But what if, 9 months from now, your fixed rate jumps to 7% from today’s 5%, and you’re locking in a 10 year \$100,000 loan at \$7,000 a year, rather than the more attractive \$5,000 a year interest cost?  Well, in that case, if you carry the full sized loan for 10 years, you’ll pay a total of \$20,000 more in interest over the life of the loan.  In that stark (probably-worst-case-scenario) example you will have lost out, and you will curse my advice, as well as my children’s children.[3]

Given that the starting position of borrowing early is that you’re \$3,700 poorer, however, I see many more scenarios in which you come out ahead by not borrowing early.

If you plan to pay down the loan principal faster than 10 years, for example, or rates shoot up less than 2% over 9 months, or rates stay the same, or rates go down even further, you will have broken even or ended up better off by not borrowing early.  So that’s why I wouldn’t take today’s rates.

Instead of a home equity loan locking in today’s good fixed rates, what you actually need is a home equity line of credit (HELOC) from which you can borrow money and pay down at any time.[4],[5]

When I started a business in 2004, I met with an elderly entrepreneur who gave me great advice: Obtain the largest possible home equity line I could, not because I needed it now, but, because as an entrepreneur I needed to be ready to take advantage of opportunities whenever and wherever they might arise.

He was right.  In fact, any person who is both a home owner and a business owner, needs to stop everything right now and start applying for a home equity line of credit.  Why are you still reading this blog post?  Go, do it, now.  I’ll wait.

Ok good, you’re back.  You’re welcome.

In your case, Bradley, the potentially higher rates one year from now will be more than made up by the fact that you can borrow only the amount you need, as you need it, for your home renovation.  The slower drawdown of debt principal and the faster payoff of principal via a home equity line of credit is virtually certain to save you interest costs in the long run.

I believe the fact that HELOC rates are floating – they may go up or they may go down over time – are more than made up for by the variable amount of principal you can take out only as and when you need it.  Over the course of your planned home improvement project, if you borrow for example \$33,000 for some period of time, rather than the full \$100,000 loan, you’re obviously paying 1/3 of the interest costs than you would on the full amount, during the period of the smaller borrowing.  My point is that even if you end up with the same peak amount of borrowing, \$100,000, you’re likely to have paid significantly less in interest in getting to that point.  Most of the time, those savings will outweigh the probability-weighted cost of higher future interest rates.

A special note for small business owners, new and old:  If you’re just starting out, the HELOC may be your only ticket to borrowing money cheaply and flexibly.  Banks only pretend to lend to small businesses, and they certainly do not lend to new small businesses, so it’s hardly worth trying that route.  Banks do lend, however, against houses and home equity, so you’ve got a shot there.

For experienced small business owners: You still need the largest home equity line of credit possible.  You never know when the commercial property right next to your office may become available, and when having \$50,000 in ready cash is the difference between acquiring the real estate of your dreams and paying more to lease office space for the next 30 years.  If you have to go to your bank to apply to get the loan to buy the property next door, you’re too late.  You need the home equity line so that you can credibly represent to the sellers your ability to close the transaction within 1 week, in ‘cash.’  That is how the pros do it.[6]

[1][1] Meaning, you have excellent credit, at least above a 720 FICO.  The FICO people sell their scores from all three major credit rating agencies here for about \$35.  It’s worth it to pull your score once in a while, so you can confirm you’re eligible for the best rates and there’s no weird activity on your credit reports.  Don’t let FICO trick you into paying \$14/month.  That’s stupid.

[2] No, not the Daniel Craig type of Bond guy, much to my wife’s chagrin.

[3] Which is as good a segue as I can think of for repeating Jack Handey’s Deep Thought: “I believe in making the world safe for our children, but not our children’s children, because I don’t think children should be having sex.”

[4] This entire ‘Ask an Ex-Banker’ advice column today assumes you are a responsible borrower, and that debt incurred through a home equity line of credit will go toward productive home and business improvements and not be blown on subsidizing your unsustainable consumer-driven lifestyle.  In your case, Bradley, since you live in San Antonio, that means you can’t blow the whole line of credit on Alamo Lego miniatures and bad Tex-Mex food.   But since www.bankers-anonymous.com readers are, almost by definition, extremely responsible with debt, this hardly bears mentioning.

[5] Most HELOCs give you a drawdown period of, say, 10 years, followed by a payback period of another 10 or 20 years.

[6] While I’m very much in favor of HELOCs for small business owners, I need to acknowledge in the fine print here that things can and have gone wrong for small business owners putting their houses at risk.  Of course this would be terrible.  When you get a HELOC for your small business, make sure you save it for an opportunistic can’t lose situation, not use it to keep your flailing, unsustainable, small business alive.

## Ask An Ex-Banker: Is the Finance Game Rigged Against Outsiders?

Q: A question for debate:

We all seem to get mad that the financial-industrial complex is repeatedly rigged for the Big Boys.  I’d suggest to you that the public should just give up on the wall street-banker/big bank/mutual fund industry as having any possibility of being fair to you or me.  Thus, it makes no sense to be mad at it.  Instead, people should invest the way their grandparents did: bonds, cash savings in a local bank or a hole in your backyard, real property, and (if they’re savvy enough) businesses or stocks that they understand.  –Michael G., San Antonio, TX

This is a really good question for debate, Michael, and I agree with some of the spirit of it.  I suspect millions of people have had a version of this thought, wondering if they’re the suckers at a rigged game and whether it’s time to take their marbles and go home – to bury their savings in the back yard or the local bank.  But while I’m sympathetic with the question, I disagree on the actionable consequences of your view.

I particularly like your suggestion, paralleling Michael Pollan’s food movement of the last few years,[1] to do only what your grandparents would recognize as investing.  There’s virtue in simplicity, and you could not go too far wrong that way.  Many of us have an imaginary Amish pastoral scene in mind as a balm on a particularly confusing day.  The horse-drawn buggy approach to financial life could be a good financial life.

I’m not willing to actually go along with the Amish pastoral investing life, however, either in my own life or for people who ask me my opinion on what they should do.

Mutual funds, to pick the most beautiful of the babies you’ve tossed out with the bathwater, are just like some of the other totally awesome things we love to complain about.  If you’ve got money to invest, with a few clicks or a simple phone call, you can own a piece of a wide swath of the world’s most successful companies.  At any point in your lifetime, should you choose, you can get your investment back with a similar amount of effort, with a day’s notice.  Real property investing doesn’t work that way.  CDs don’t work that way.  Private business investing doesn’t work that way.  Our grandparents had to wait for the end of their 6 months (or whatever time) period to get their cash out of CDs, or possibly years to liquidate their real estate or private businesses.

ETFs, the ADHD sufferer’s version of mutual funds, are similarly awesome, if used correctly.  You can even invest in a wider variety of instruments than mutual funds, including currencies, commodities, real estate, in addition to the opportunity to short markets and take on leverage.

As a recovering hedge fund manager, I also obviously maintain a soft spot in my heart for hedge funds as a way to access a still wider variety of investing strategies.  As a former mortgage bond salesman as well, I could similarly wax poetic about a whole universe of investment vehicles with an alphabet soup of acronyms that, like an Elizabethan sonneteer declaring his undying devotion, would make you long to  possess a super-senior CDO linked to a basket of credit default swap positions.  Ah, financial innovation…But I digress.  Where was I?

In sum, I’m actually a fan of financial technology, albeit with one important caveat that I think will link back to your original question, about whether the financial game is incorrigibly rigged for the Big Boys.

Not to be too John Kerry about it, but my answer is No, and Yes.

I infer that what you mean by “rigged” is the idea that insiders cheat in sufficient numbers to leave outsiders at a severe disadvantage when it comes to earning a fair and worthwhile return on capital.

I disagree.  In my fifteen years in the financial industry I saw no evidence of widespread cheating.  On the contrary, I can honestly say I trust “the system” in our country to treat outsiders far more fairly than any other industry I’m aware of.  I would also trust our system in the US better than any other country’s financial system, based on quite a bit of anecdotal and experiential evidence across borders.

Where I would blanket-statement agree on the rigged part for your average outside investor, however, is in costs.  The insiders depend on your ignorance of the cost of their product.

Most investment products designed in the past 50 years are compensation schemes for insiders.

Hedge funds are the most egregious example, of course, as knowledgeable insiders correctly and dismissively refer to hedge funds as ‘compensation schemes masking as investment vehicles.”

Products like retail ETFs, primary designed to encourage high-frequency day-trading, wrap up a casino-like product in an investing package, for the benefit of the house casino.

Even the mutual fund industry typically charges far more than is necessary to accomplish what are really simple tasks with minimal value-added.

Fees to insiders in all of these areas remain stubbornly high and extremely difficult to track down for the average outsider.  In no other area of life do we willingly purchase a product costing many thousands of dollars without asking about the price of the product or attempting to price-shop the product.

I can’t emphasize enough how much of the inside game is devoted to convincing outsiders of the ‘special sauce’ of a particular investment vehicle.  Contrary to what the insiders want you to believe, simple would generally be better and low cost would be best of all.

I linked to this page before, but it bears repeating.  I have no link to this investment advisor, I’ve never met him, and I just found his stuff a month ago.  Do yourself a favor, print out pages 9-12, post them on your bulletin board, and refer to them frequently when considering where and how to invest.

[1] He famously advised people to avoid eating anything your great-great-grandmother wouldn’t recognize as food.  Incidentally, my great-great-grandmother ate a lot of Nutella.  In my own mind.