Should I Pay Off My Mortgage Early?

I have heard this question three times in the past month, so I thought it must be on the minds of at least a few more of you. The answer isn't as easy as you might think. There is no denying that it feels great to get any debt paid off early, especially one that could be taking up 20% to 40% of your monthly budget. When a client comes to me wanting to put a little extra money toward getting rid of her mortgage, I am happy to support the effort. But I do ask clients to consider this list of questions. Depending on your answers, you might want to leave the mortgage alone and focus on something else.

1. Do you have a good, fixed-rate mortgage at a low interest rate?

The home buying process is confusing enough that a lot of people walk out of it not sure what sort of mortgage they actually have. If that's you, go check your documents right now. A fixed rate mortgage means that your required monthly payments will stay exactly as they are throughout the life of the loan, and that's great. Any sort of variable rate mortgage, on the other hand, could bring some nasty surprises. Your variable rate mortgage payments will go up if interest rates go up (and they probably will). If that happens just at the moment when you are trying to get costs under control, your mortgage could become a very painful thorn in your side.

By all means, pay off a variable rate mortgage as soon as you can. But if you've got a nice, predictable, fixed-rate mortgage, ask a few more questions...

2. Do you have other debts?

Your mortgage is what we call a "secured loan," meaning that if you don't make your payments, the lender can claim something of value (your home, in this case) to pay off that debt. When lenders write a secured loan, they don't mind charging you a lower interest rate. A car loan is also secured, but let's face it—it's a lot harder to collect value from a used car than a house. And that is why your mortgage is probably the best interest rate you are ever going to get on a loan that isn't from your mother.

This means that your other debts—credit cards and car loans, for instance—are likely to have higher interest rates than whatever you are paying on that mortgage. Mathematically speaking, you want to pay those down first. As you get the loan with the highest interest rate paid off, shift that payment to the next highest and so on. The mortgage will probably be last on this list. [One caveat: student loans are often secured by the federal government and may not follow this pattern, so check your interest rates first!]

3. Do you need to be putting more money away for the long-term?

This one is not always obvious, but think about it—if you are investing money for a child's college tuition or your retirement or anything else that might be more than 10 years out, you are probably planning to get an average return of at least 5% to 8% per year on the money you are investing. If your mortgage is at 3%, then putting the extra $100 a moth toward paying off the mortgage will save you money at a rate of  3%. But if your investment plans go reasonably, you might be giving up 6% or 8% in returns in order to get that 3%.

As you've probably figured by now, the comparison isn't perfect. You are just about guaranteed to save that 3%, whereas investment returns are never, ever guaranteed (no matter how great your investment strategy). But if your targets and strategy are reasonable and you are investing for the long-term, it's a very good bet that your investments will out-perform the savings you got from paying down that mortgage.

4. How much is your tax deduction doing for you?

You probably know that if you live in the home you own you are getting a tax deduction. What fewer people know is that the deduction is actually for the interest you are paying on that mortgage. In fact, in the early years of your mortgage what you are paying is almost entirely interest. To help you visualize that, I found the handy image below from a website called "Financial Tips":

Mortgage-Amortization

In fact, mortgages work through "amortization," which means that the bank builds in the interest payments in a particular way. Specifically, your payments go mostly toward interest (in yellow) throughout the first years of your loan repayment. As you can see from this chart, the balance of your payments does not shift toward the actual principal (in red) until you are more than half-way through paying off the loans. (By the way, this is why you want to make absolutely sure your lender applies any early or extra payments to principal!)

Alright, so you are only getting the homeowner's tax deduction on that yellow stuff. Why do you care? Because tax planning is a strategy game. Being able to take the mortgage deduction during a period when your income is higher (especially if it is just over the line of one of the tax brackets) can mean a significant tax savings. So, in getting rid of your mortgage payments faster, you might be getting rid of a key part of your tax savings strategy.

So, should I pay off my mortgage early?

After you've gone through list, you might find that paying off your mortgage doesn't make sense from a mathematical point of view. But there is still one more question to ask. The fact is that, just as we perform better on exams when we feel confident, we tend to handle all of our financial decisions better when we feel good about the steps we're taking. As I've said to more than one client recently, if paying off that mortgage means that you feel more "on top of" everything else, that might be reason enough.

So You Want To Buy A House

As I've mentioned before, most of the topics I write about in this blog come from the casual (and sometimes not so casual) questions people ask me every day. One of the big topics lately has been buying a home. You'd think that with all of the pressure on Americans to buy their own homes, we would feel a little more comfortable with the mechanics of it. But most of us end up confused or frustrated at some point in the process. To help prevent that, here are a few things to think about if you are considering a new home.

It's your life

Let's start with the obvious. Some of us buy because we are dreaming of that home. Some of us, though, are just feeling like buying is something we are supposed to do. Yes, a home can be a great investment, but like all investments it can go really badly. Before you buy for investment purposes read this post.

Likewise, buying can make you feel more grown up if your idea of dinner at home is a take out carton and a coffee table you picked up on Craiglist. But homeownership is a pretty expensive way to impersonate a grown up. If you are thinking of spending hundreds of thousands dollars to buy a new place, make sure it's a decision that works for you. Put aside any and all advice from well-meaning family, friends and real estate agents and really weigh whether at this particular point in your life (whenever that is) you actually want to be a homeowner. If the thrills of home decorating don't make up for the frustrations of home maintenance for you, maybe you'd be better off getting a real kitchen table and throwing the extra money in your retirement account. If you do want to be a homeowner...

Do the math

There are a thousand and one mortgage calculators on the web to help you figure out how much you would pay per month and in down payment for the house of your dreams (or a smaller replica of the house of your dreams). I've already posted a basic explanation of how banks calculate your mortgage qualifications.

But it isn't just about what you can afford. Be sure to think about the what you actually want to pay given your other monthly expenses and opportunities. Mortgage payments, like rent payments, fit into the category of "fixed expenses," the things that you can't negotiate if you have a difficult month. It's one thing to cut out the fine dining, put off a trip or cut down on your retirement contributions for a bit; it's a whole other thing to be tied to a high mortgage payment if your income suddenly goes down. Which means you want to do some real soul searching about how much of a mortgage payment you are ready to carry, no matter what happens.

Not So Hidden Costs

We all know there are extra expenses to buying a home, but they look pretty inconsequential next to the home prices themselves. They seem a lot less inconsequential on closing day when you actually start to pay them. From the beginning of your search, keep this list in mind and be ready with cash on hand. And of course, bargain with everyone from banks to sellers for the best deal.

The first of the "extra" costs is the real estate agent's commission  (typically 6% split between the seller and the buyer agents). If you are smart, you'll also pony up for a home inspector whom you trust—you will feel pretty stupid if you scrimp on the few hundred bucks here and find yourself with thousands of dollars in surprise repairs later.

And then there are the famous "closing costs" that come due on the day you get the keys for your new house. In total closing costs generally range from about 2% to 5% of the value of the property, though it's not unheard of to see that percentage go all the way up toward 8% (ouch).

• Bank Fees (the bank giving you the mortgage may charge an origination fee, "discount points", credit report or loan application fees, title search and title insurance fees, a charge for the appraisal, and the initial interest payment)
• Initial property tax payment
• Charge for a survey of the property
• Homeowners Insurance
• Attorney fees (for your attorney)
• Recording fee (to your local government records office when you file your new title)

Your closing costs will be lower if you get tough with your lender from the start (be sure to ask the bank for a Good Faith Estimate—they are required to give it to you by law!). Costs can be shared with the seller if you and your agent negotiate well, and if you've got a little extra room in your mortgage limits, some of these costs can be rolled into your mortgage. This is the place where having a good agent and communicating well with your bank can make a huge difference.

Don't Rush the Process

In all likelihood, you won't end up buying the first home you think you want. Plan to spend at least 3-4 months becoming familiar with the market and just as importantly, focusing in on what you really want. Real estate agents are notorious for bringing clients to homes that only loosely fit the client's "wish list." It's not that your agent wasn't listening to you; it's just that agents have learned from experience that most people only realize what matters to them most by looking at a lot of different properties and changing their minds over time.

Patience can save you money on your home price. And it can save you money after closing. The adrenaline rush of buying a house tends to send new owners into a follow-up frenzy of furniture shopping and DIY projects. This is all made worse by the fact that the $6,000 dining table no longer looks as expensive when compared with the $600,000 condo. By all means, pick up a new couch if you don't have one from your old place. But you'll save money and be happier with your home in the long run if fill in the gaps slowly (or at least wait until $6,000 looks like a big number again).

Ask Around

At this point it might look like I am trying to dissuade anyone from buying a home. I'm not. Buying a home is an exciting process. If this is the next big purchase for you, start by asking people you know about their own experiences. How was their lender? Who was their agent? Their home inspector? Which areas of town did they search? Why did they buy where they did? What would they have done differently, if anything?

The home hunting season starts up in late February. Good luck!

Is Your House A Home Or An Investment?

Ask this question of just about any American and they will happily tell you that it is both. And why not? From home improvement centers and real estate agents to government programs and tax breaks, the clear message is that it is always better in the U.S. to own a home. The reality is a little trickier, though. And if you plan to use your home as an investment—that is, to actually get additional value out of it at some point in the future—you need to think more clearly about the limitations of living in one of your biggest savings accounts. Here are a few key points to consider:

1. You don't buy a house for the land.

We have a tendency to think that buying a house is somehow a more "stable" investment, as if the fact that we can still touch and see the land means that it's value is not going anywhere. Sure, you can probably still grow potatoes on the land  even if the economy tanks. But let's face it, you didn't pay a quarter of a million dollars so you could grow veggies and no one else is going to either. The value of property, like the value of any other investment, comes from only one factor—what someone else will pay for it at the moment you want to sell;

2. Home values can be just as unstable as stock markets.

Our most recent U.S. Census data shows that median household net worth went up by about 30% between 2000 and 2005 (an increase from $81,821 to $106,585)! This was great news, and it was almost entirely due to the fact that people's home values went up during those years. But when home prices dropped in the 2008 crash, Americans' net value also went down...by about 35% as of 2011. That crash wiped out almost a decade worth of gains, and it left many homeowners with mortgages that were more than the home's value. We haven't all recovered, yet. According to Zillow's 2014 report, 16.9% of U.S. homes were still "underwater" (worth less than their home loans) as of the end of October, 2014. Which brings me to my next point—

3. You can't live in a mutual fund.

Generally speaking, this is a point in favor of buying a home as an investment. Since you were going to pay housing costs anyway, why not put it toward an asset of your own? But if your stock prices crash, you can usually leave them be and wait it out until the market recovers. If your home price crashes and you can't afford your mortgage or you have to move for a new job, you just don't have that luxury. That means you may be forced to "cash in" at the worst possible time, making you a lot more vulnerable to losing all of that money you've put in and possibly more;

4. Your mortgage is someone else's investment.

In our rush to celebrate the great American home-buying dream, we often forget that the reason economists love home buyers is because home owners borrow so much money. Home owners not only tend to take out large mortgages (which can be bundled and sold off into all sorts of investments by financiers), they also borrow more through auto loans, education loans and credit cards because of the sense of safety provided by their home values. It's great for the economy, but it might not be so great for you. If we assume that the average U.S. mortgage is a 30-year fixed rate at about 4.5% interest on a $222,000 loan, then the average home owner is paying a total of about $183,000 in interest for the privilege of being rent-free. This, of course, does not include any of the closing costs, maintenance, taxes and upgrades you choose to do on your home (not to mention the added temptation of new sofa cushions, shelving, curtains, etc...);

5. There's no profit until you sell.

All of us are happy when we get word that our home price has gone up. And thanks to refinancing, we can access some of that money (for a price) by borrowing against the new value. But nothing will change the fact that investments don't make you any money until you sell them, and this applies to your home, as well. If you are counting on the value of your home to help you in retirement, keep in mind that without some creative help from family members, this will mean a reverse mortgage or a sale. And if you choose the latter, you are going to have to find somewhere else (somewhere less expensive) to live.

All of this is not to say that your home in not a good investment. It may very well be! The mortgage tax deduction can offset some of those interest payments, and if you buy in the right time and place you could make a lot of money when it is time to sell. What all of this does mean is that averages will do you no good in determining whether you should by a home. You need to do the calculations based on things like how long you plan to stay in the area, what other resources you have in case of a downturn, what the rental market looks like in your area and what other financial and familial obligations you have.

Most importantly, though, you need to account for the fact that what you are buying is not a house...it's a home. If flexibility, adventure, ease or mobility are what you need at this point in your life, there are probably better investment options for you. If, on the other hand, buying a house ensures that you can keep the kids in school with their friends or that you can finally set down roots in a community, well, that is another kind of investment—one that doesn't come with a calculator but makes a world of difference.

Getting A Mortgage 101

We've had a number of clients in the office lately asking about qualifying for mortgages. Despite the fact that just about everyone and everything in U.S. policy is trying to get us to buy homes, we Americans are often confused about how our mortgage system works. So here are the basics to know before you go shopping for a mortgage:

Down Payment Realities

Before the 2008 housing market crash, banks had all sorts of inventive programs to get people in new homes. It turns out some of them were too inventive, and banks are back to some more familiar requirements. If you can do it, your best bet is to put at least 20% of the total price you are paying down on the house. Why? A 20% down payment will almost always get you a better interest rate. And since your large down payment is considered less risky for the bank, you won't be required to pay private mortgage insurance (PMI). Folding the PMI into a higher interest rate might help, but there is no way around the much higher cost, in loan terms and PMI if you dip below that 20% down payment.

But....

If you are going to have trouble coming up with a larger down payment, you might qualify for a special loan through the USDA's zero-down payment for rural low-income buyers, VA loans for veterans, Fannie Mae's Homepath Program or a first-time home buyer program in your area. Start with the link to HUD's website at the bottom of this post if you think you might qualify for home buying assistance.

Know Your Ratios

For obvious reasons, most people figure that they can afford a mortgage if the monthly payments are comparable to their current rent payments. But banks takes a completely different approach to whether you can afford a mortgage—they use very specific income-to-debt ratios. Here's how the math works:

The first number the bank will calculate (the "front" ratio) is the percentage of your income that will need to go to housing costs. In this case, your income is everything you earn before taxes*, and the housings costs include mortgage payments, taxes, insurance and even homeowners or condo association fees. Let's say you gross monthly income is $5,400, and your monthly housing costs are $1,800. That give you a front end ratio of 33% (1800÷5400=.333).

Now for the "back" ratio—use the same numbers as above but add your consumer debt (car loans, student loans, credit card debt payment, etc...) to your housing cost. If the consumer debts were another $500 per month, you would add that to the $1,800 for a total of $2,300. Now divide that $2,300 by the same $5,400 income as before and you get about 43% (2300÷5400).

Your ratios will be written: 33/43 ...and you will probably have trouble with your bank. Why? Because while a 33% front ratio is just fine, banks are usually looking for a lower back ratio—something closer to 38. Some of the subsidized loan programs I mentioned above might let you go up to 41 on that back ratio.

Know Your Terms

In addition to interest rates, down payments and mortgage insurance, the way that you repay your mortgage loan can vary. A 10-year mortgage means lower monthly payments but less interest paid over time; a 30-year mortgage can lower your monthly costs, but means you will pay substantially more interest over the course of the loan.

You also need to watch out for the difference between fixed rate mortgages (your interest rate & payments stay the same until the mortgage is paid off) and Adjustable-Rate Mortgages (ARM's). Most banks will offer you a lower initial interest rate if you are willing to sign on to an ARM, but there's a big down side. ARM's mean that you (and not the bank) are taking the risk that rates might go up. In that case, you could end up paying much more per month or having all of your payments go to interest (which means that your loan could actually be getting larger!). Because of this unpredictability, we usually recommend fixed-rate loans if you are buying a home.

Be Prepared

Now that you know how the calculations work, you should have an idea of what you can do before you go to the bank to put yourself in a position to get the best terms on your mortgage:

1. Save up for a healthy down payment of 20% if at all possible (that will not only get you a better interest rate but also reduce your monthly payments, which means better ratios);
2. Lose the consumer debt payments. As you can see, paying off some of those consumer debts can make all of the difference in qualifying for a mortgage. Even if you qualify, waiting until you have debts under control can improve the interest rate you get;
3. Rehabilitate your credit score. This one gets lots of press, and for good reason. The interest rate you will get and often, you ability to qualify for a loan at all depend on your credit rating. Fortunately, you can improve your rating if it has fallen over the years.

Find A Good Bank

Mortgages work just like any other product—you need to shop around. If you belong to a credit union, start there, but be sure to talk to a few different lenders before you make a final choice. You might also consider a mortgage broker, who will scout around for you to find the best offer (be aware, though, her fee is paid by the bank that secures the deal so she is not working entirely for you).

Don't be tempted to skip this step! Banks can offer wildly different terms and rates for the same home purchase, which means you could end up paying thousands more for your home loan.

Check Out Resources

The U.S. Department of Housing and Urban Development (HUD) provides step by step information for home buyers, including links to home buyer programs in your area. Check them out on HUD's site.

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*Note that you have to be able to document your income, usually through tax returns. Self-employed buyers can still qualify, but the process may be slightly more complicated.

Money. The Person Next To You Probably Isn't Doing Any Better

A client walks into my office for a first meeting, puts down an envelope of assorted papers and takes a deep breath. I know exactly what is going to come next. I don't know yet what state her finances are in, of course. But what I do know is that she is already feeling embarrassed—embarrassed because she doesn't have enough money, embarrassed because she should have more, or just embarrassed that she has so much and still doesn't entirely understand what the heck she's doing with it. And don't let the "she" confuse you—all of this embarrassment around personal finances applies equally to men.

One of the most fascinating things about advising people on their finances is that you are often the only person who gets to hear what they are actually thinking about their financial situations. To me, their situations are almost never shocking—I've seen people with a lot more assets than you'd expect and plenty with a lot less than you'd think. What is shocking is how many people think their situations are unusual.

So here are a few bits of random information to make you feel better before the weekend—

Americans owe a total of about $8.17 trillion on their mortgages. Yours is just a drop in the bucket. And if you haven't bought a house, well, this is a good time to look at all those mortgage-bound borrowers and feel a little bit smug about your freedom.

Student loan debt stands at about $1.19 trillion, up about $78 billion from last year, which means that student loans are about as American as apple pie. In fact, more American than apple pie—how many Americans do you know who can make an apple pie?

The National Financial Educators Council tested over 8,000 people from 50 states on very basic financial literacy. The average score for adults 25 to 50 years old was a C-. Our oldest Americans (aged 50+) had the best grade with a resounding 75 out of 100. If you feel badly about the grade for your age group, at least you aren't in the 19 to 24 crowd. They got a cringe-inspiring 67% of their answers right. But then, again, mostly they're just trying to figure out the student loan apps right now.

The whole point of emergency savings is to spend it in emergencies. Also, emergencies—medical, employment, legal, etc...—happen all of the time.

Maybe that last point was not what you were expecting on a financial blog. But I find myself reminding people all too often that making ourselves (or anyone else) feel embarrassed about the ups and downs of life just doesn't make sense. And maybe, just maybe, if we talked about money more as a society, we might see that the person sitting next to us is trying to figure out all of the same stuff.

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Stats are from the New York Federal Reserve's May Report on American consumer finance, available online for anyone looking for some laughs.

One of the best (free!) places to get good information on financial basics is the Practical Money Skills For Life video series—and my blog, of course.