Monday, January 21, 2013

Making extra payments on your mortgage - does it make sense?

Jack Guttentag, Professor Emeritus at the Wharton School of business, also known as the Mortgage Professor, wrote an article on this subject that is excellent!  He believes, "every homeowner with a mortgage, has the opportunity to earn a return equal to the interest rate on the mortgage, with no risk, simply by making extra payments. The only downside is that it has no liquidity - once you make the payment you can't take it back if you have an unexpected need for funds."

Most homeowners with mortgages place their savings in bank deposits or money market funds paying less than 1 percent,  While a little cash fund set aside for emergencies is important - the assumption here is that liquidity is not a major concern.

Here are the 5 things to know when making extra loan payments - very simply explained by the professor.

1.  Comparison with low risk Investment - Mortgage repayment is equivalent to buying a bond or a CD.  The only difference is that the income received from a mortgage repayment is cancellation of interest that you would have had to pay otherwise. The difference between receiving $1,000 of interest and eliminating the payment of $1,000 of interest is one of form but not of substance.

2. Loss of Tax deduction - Borrowers who itemize their tax deductions don't want to repay their mortgage because it entails loss of a deduction. But the loss is exactly the same as the tax on income earned from the investment. 

3. Loan life cycle - It is widely understood that in the entire loan cycle, repayment in the earlier stages of the loan is more beneficial.  However, extra payments go entirely to principal, no matter what stage of its life cycle the mortgage is in.  The allocation of scheduled payments between principal and interest are mainly accounting entries.

4. If you are retiring or selling soon - Borrowers planning to sell their home or retirees may feel that somehow this would prevent their obtaining the expected benefit from making extra payments.  That is simply not true.  The payoff at the sale would involve a smaller loan balance or in case of retirees, smaller the unpaid balance, the more they are able to draw when applying for reverse mortgages 

5.  Accounting for extra payments - Borrowers may be concerned that in these days of automatic payments the lender won't credit their account properly.  Apart from having it go to the borrower's underfunded escrow account, the only thing the lender can do with extra payments, other than credit them to the loan balance, is to steal them, which they never do.

I found this article to be very helpful.  What are your thoughts?  Did Professor Guttentag help clear any confusions in your mind?

More real estate articles.

Bela VoraREALTOR®, 
Coldwell Banker Preferred - Exton
Office: 610 363 6006; Cell: (484) 947 3127
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