For the last few years we have enjoyed some of the lowest interest rates in history. A self evident truth in economic theory is when prices are low, people tend to buy more, and it is no different with home mortgages. In an effort to keep real estate prices high, central banks throughout the world have made great efforts to keep interest rates low. In fact, an American home buyer is currently looking at 30 year mortgage rates around 4.0%. While it may seem attractive to be borrowing money so cheap, home buyers should understand how mortgages work so they can make wise financial decisions.
MILESTONE #6: Pay off Home Mortgage
Recently, I have advised several middle-aged couples with substantial cash reserves in their bank savings and checking accounts. When I inquired about their home mortgages, l learned these couples recently re-financed to take advantage of the low interest rates. With $100,000 or more sitting in checking and savings, I was puzzled why their mortgage balances were so high, and their standard answered was: “With interest rates so low, why pay it down?”
There are several reasons why people keep their hard earned money in savings rather than pay down their mortgages. First of all, we have lived in an era of declining interest rates. From our experience, the 4.0% we are paying on mortgages today seems like a bargain compared to the 7.0% we were paying 20 years ago, or the 15% we were paying 35 years ago. However, 20 years ago we were earning 4% on money market accounts, and 35 years ago money markets were paying 12%. Currently, banks are paying less than 0.25% on savings, and yet charging 4.0% on their home mortgages. No matter how you look at it, the bank always seems to be winning.
Secondly, current tax law allows many taxpayers to receive an interest deduction on their mortgages, so we feel like we are earning something by having a home mortgage; but, this is really just an illusion. Take for example a $300,000, 30-year mortgage at 3.5% interest. The monthly payment will be $1,432.25. At payment #115 (9 years and 7 months into the mortgage), the breakdown is $631.67 (principal) and $800.58 (interest). If you are in the 25% federal tax bracket, you will save approximately $200 in federal income taxes. All politics aside, it doesn’t make sense to pay the bank $800 in interest to save $200 in taxes.
Finally, we feel safe when we have lots of money sitting in the bank. FDIC insurance gives us a sense of well-being, and the more money in a bank account we have that is guaranteed by the FDIC, the more secure we feel. Unfortunately, after taxes and inflation, the purchasing power of the money we have in our bank savings accounts is being eroded; and as a result, the $100,000 we have sitting in savings will purchase less goods and services next year than they are buying this year. In other words, money sitting in cash will probably be worth less next year than it is worth today.
For many people, making a large lump sum payment against their existing mortgage can be one of the smartest financial decisions they will ever make. Take a look at the following example:
|Loan Amount||Term of Loan||Interest Rate||Monthly Payment|
In this scenario, let’s assume the family has $100,000 in a bank savings account earning 0.25%. If they were to apply the $100,000 towards mortgage payment #36 (3 years into the mortgage), they would save $115,000 in interest over the life of the mortgage, and they would shorten their mortgage to 241 months instead of 360 months. This is because American loans are structured so that most of the interest paid occurs in the 1st 20 years of the loan. That 119 months of not paying $1796.18 20 years from now means the family will have an additional $213,745.42 to spend how they choose at a time when they are 20 years older and possibly not as healthy or willing to work 40-60 hours a week. If the family had chosen to leave the cash in savings earning 0.25% for the duration of the mortgage, it would have grown to only $106,982.27! In this scenario, saving $115,000 in interest was better than earning $6982.77.
While it is prudent to keep some funds in cash for emergencies, large purchases, periodic bills, or to jump on great investment opportunities when financial crises’ occur, it may not be wise to keep excessive amounts in cash earning close to zero percent when you still have an outstanding mortgage, even if interest rates are historically low. If you are sitting on large cash reserves while also carrying a mortgage or other loans, you would be wise to consider how much your cash reserves are costing you. If you would like to see how making a lump sum payment can save you money, please give us a call. We would be happy to show you how making a lump sum payment on your mortgage might improve your overall financial situation.