Instead of paying off the loan, I could refinance at 15 years to pay interest and principal. Or I could pay directly into principal at a rate of $500 to $700 a month, while maintaining the present loan.
Having read your column, which favors having no debt, I am having a difficult time thinking I should reduce my working capital and pay off the mortgage or refinance it to a fixed interest rate mortgage with a term of 15 years. What am I missing?
My wife and I are 66 and 65, both retired, and we have an income of about $128,000. Itemized deductions, including home related interest and taxes, reduce our taxable income to about $96,000. --- E.H., by email from San Antonio, TX
A. If you were still working and paying your mortgage with paycheck money, there would be no need to discuss this. You'd be borrowing at 5.375 percent, and your tax savings on the interest deduction would reduce the effective interest rate to 4.03 percent. For younger workers, wages are likely to rise faster than 4 percent, and the rate of inflation is likely to be close to that. So it's a good thing to do if you are still working.
But you and your wife are not younger workers.
Your investments must generate the income to make your mortgage payments. As a consequence, any time the interest rate on your mortgage exceeds the yield on your investments, you will be forced to sell some of your investments. This leaves you exposed to rising interest rates.
Now, guess what happens when interest rates rise?
The market value of stocks and bonds tends to fall. The greater the increase in interest rates, the greater the possible fall. That means you could be forced to sell depressed stocks and bonds when interest rates are high.
The only way to escape the volatility of interest rates is to refinance your mortgage into a fixed rate mortgage with a term. While that fixes your interest rate, it also fixes a higher monthly payment that includes some principal repayment.
Your interest-only loan, at 5.375 percent, may cost only $559.90 a month now. But if interest rates reset to, say, 7.5 percent, it would cost $781.25 a month--- and you'd be forced to sell securities to make interest payments. Your portfolio would start to decline.
If you converted your interest-only mortgage to a 15-year mortgage at 6 percent, your monthly payment would go up to $1054.82. You'd have to earn 10.1 percent on your portfolio to cover the payments. Even if you took a 30-year loan, your monthly payment would be $749.44 a month. You'd have to earn about 7.2 percent on your portfolio to cover that expense.
However you arrange it, an annual demand for 7.2 percent to 10 percent from your investment portfolio works very destructively in years of bear markets. Suppose, for instance, that you had taken out a 30-year mortgage in September 2001 that required a monthly payment of $750 a month. Suppose also that you had invested $125,000 in the Vanguard Balanced Index Fund at the same time, with the intention of withdrawing $750 a month.
Although the fund returned 5.66 percent annualized over the next 5 years and was in the top 34 percent of balanced funds, the value of your investment would have been reduced to $111,000 by the end of August 2006. Worse, you would have had the experience of seeing your investment drop to nearly $100,000 in late 2002 and early 2003, before it started to recover.
This can happen again. The value of your investment could be much lower than the amount you still owe on the mortgage.
Does this mean making mortgage payments from investments is always a bad idea?
No. It means it's riskier than it seems.
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