Wednesday, May 27, 2009

Mortgage prepayment plan: Own your home in half the time

This post comes from J.D. Roth at partner blog Get Rich Slowly.

Because I recently eliminated all of my nonmortgage debt, I have a significant positive cash flow. The $1,000 per month I was putting toward debt can now be used for investing. I'm making maximum contributions to my Roth IRA, of course, but that still leaves several hundred dollars each month available for other purposes. This has forced me to re-evaluate my financial goals.

For the past year, my wife and I have discussed making accelerated payments on our mortgage. I've written about this choice several times at Get Rich Slowly, and it seems clear that mathematically it makes more sense to invest the money. However, it's also clear that eliminating a mortgage offers a tremendous psychological boost. I've never heard anyone say they regret owning their home outright.

I've researched a variety of mortgage-acceleration schemes:

  • Refinancing from a 30-year to a 15-year mortgage is appealing, but the interest rate drop (from 6.25%) isn't enough to make this worthwhile.

  • I could sign up for my bank's biweekly payment program, but I don't like the enrollment fee, and I don't like the increase in paperwork.

  • We could make an extra payment every year, or pay an extra $100 per month. But I feel that we could do more.

Ultimately, we decided to use the method described by Charles Givens in his 1988 best-seller, "Wealth Without Risk":

"You can pay off your 30-year mortgage in half the time without refinancing by making extra principal payments. On the first of the month when you write your regular mortgage check, write a second check for the 'principal only' portion of the next month's payment."

Wealth without risk

For most homeowners, the principal portion of a mortgage payment is quite small. For j.d. payment summary example, our February mortgage bill was $1,681.79. Of that, $1,119.16 was designated for interest, $295.19 for escrow (taxes and insurance), but only $267.44 for principal.

Using Givens' plan, if I include an extra $267.44 with my payment, I'll also knock off the next month's payment from my mortgage. That $267.44 accomplishes the same thing $1,681.79 usually does, but at 16% of the normal monthly cost. That's a bargain.

The advantages of this method are:

  • It has a sliding degree of difficulty. At first, the extra principal payments are lower. But as we pay down the mortgage, these extra payments will increase. We have time to "grow into" these increased payments.

  • It's easy for us to back out. If we decide our money is better used elsewhere, we can simply stop making extra principal payments.

  • Every time we make a payment, we're essentially making two payments, cutting the term of our mortgage in half.

After discussing the pros and cons, my wife and I have agreed to follow a modified version jd account statement of Givens' plan. To make things simple, we're using round numbers. During 2008, for example, we're going to pay $2,000 toward our mortgage each month, which gives us an additional $318.21 against the principal.

Every January, we'll adjust how much extra we're paying. If our budget gets too tight, we can cut back at any time.

The drawbacks

To be fair, Givens doesn't recommend this method for low-interest mortgages like ours. He clearly states, "Never pay off low interest mortgages -- those under 9%. Instead, use the extra money in a better investment." He wouldn't advocate using this method on a 6.25% mortgage.

The March 2008 issue of Consumer Reports has a brief exploration of this topic. Their conclusion?

"Many people find peace of mind in paying off their mortgages and owning their homes outright, especially as they approach retirement. That can make an investment in your mortgage a worthy choice, psychologically if not financially.

"Still, the bottom line, according to our Money Lab, is this: Although there are exceptions, chances are you'll be better off putting extra money into a good mutual fund, not into prepaying your mortgage."

"Did you see this article?" my wife asked me after she finished reading it.

"Yes," I said. "What do you think?"

"I don't care" she said. "I want to do both. I want to invest and prepay the mortgage."

"So do I," I said.

Financial freedom

If we have a substantial emergency fund, if we're fully funding our retirement plans, and if we're saving for other goals, I believe that paying down the mortgage makes sense for us. We understand that we're sacrificing some theoretical (and probable) future investment returns, but we're also working to create a financial situation that's easier for us to maintain in the long run.

If we have no mortgage, that's $1,400 less each month that we have to pay in expenses (we'll still need to pay taxes and insurance). Since my wife and I split the payment, that's $700 less per month that I have to pay. Without a mortgage, my fixed expenses would be about $600 a month. My total expenses would be about $950 a month. This would provide tremendous freedom, granting me an opportunity to try things that I might not otherwise be able to do.

Another form of diversification

Every investment book I've read says that a smart investor diversifies his portfolio, putting some of his money into each of several different types of investments. I view prepaying the mortgage as diversification. Sure, the stock market will probably beat the 6.25% I'll earn by doing this, but it's guaranteed money. To me, it's better to put my money into my mortgage than into bonds or a high-yield savings account -- especially if we're heading for a recession.

Other articles of interest at Get Rich Slowly:

"Renting vs. buying: The realities of homeownership"

"Is it better to invest or to prepay a mortgage?"

"Accelerated mortgage payments (and the Get Rich Slowly amortization calculator)"

8 big mortgage mistakes and how to avoid them

You can borrow too much or prepare too little. You can misjudge terms or overestimate your credit. With so much at stake, it’s no wonder so much can go wrong.

Applying for a mortgage can be a daunting experience.

It's not enough that you're agreeing to take on the biggest debt of your life, one that represents two to three times your annual income. You're also confronted with piles of paperwork, flurries of fees and a tidal wave of terms, from amortization to title insurance, whose meaning is fuzzy at best.

"Whether it's a professor at Stanford or a ditch digger," said San Francisco mortgage broker Leon Huntting, "most people don't understand the loan process."

In this confusing and pressure-filled atmosphere, it's easy to make some mistakes. Here are some common ones that lenders and mortgage brokers see, and what you can do to prevent them.

Not fixing your credit

Mortgage brokers say they're confounded at the number of buyers who apply for a mortgage with their fingers crossed, hoping their credit will allow them to qualify for a loan.

Before you even think about applying for a mortgage, obtain copies of your credit report and your FICO credit score. Your FICO score is the three-digit number that's used in 75% of mortgage-lending decisions. You can order your FICO score on the Web for a fee of $14.95, which includes a copy of your credit report.

Doing this at least six months in advance should give you plenty of time to challenge any errors on your report and ensure that they're removed by the time you're ready to apply for a loan. You can also see the legitimate factors that are hurting your score and do something about them, such as paying off an overdue bill or paying down credit card debt.

Not looking for first-time home buyers' programs

These programs, typically sponsored by state, county or city governments, often offer better interest rates and terms than you'll find among private lenders, said mortgage consultant Diane St. James. Some are tailored for people with damaged credit, while most can help people with little saved for a down payment.

Some of these resources are listed on St. James' educational Web site, ABC Mortgage Consulting. You can also call the housing agencies for your state, county and city to see what they offer.

Not getting pre-approved for a loan

Many first-time borrowers confuse being "pre-qualified" with being "pre-approved." Pre-qualification is a pretty casual process, where a lender tells you how much money you probably can borrow based on how much money you make, how much debt you already have and how much cash you have for the down payment.

Getting pre-approval, by contrast, is a much more rigorous process and involves actually applying for a loan. You typically submit tax returns, pay stubs and other information. The lender verifies the information and checks your credit. If all goes well, the lender agrees in writing to make the loan.

In a hot or even warm real estate market, the house hunter who is only pre-qualified is a cooked goose. Home sellers and their agents give much more weight to offers being made by buyers who already have a loan lined up.

Borrowing too much money

Many people take out the biggest loan they possibly can, figuring that their incomes will eventually increase enough to make the payments comfortable. But few first-time buyers have any clear idea of how expensive homeownership can be. Not only will you shell out more for mortgage payments than you probably did for rent, but you'll also need to cover property taxes and homeowners insurance, as well as higher bills for utilities, maintenance and repairs than you faced as a renter.

Lenders are perfectly willing to let you overextend, knowing that you'll probably forgo vacations, retirement savings and new clothes for the kids rather than default on your mortgage.

"Mortgage money … is way too easy to get," said Ted Grose, president of the California Association of Mortgage Brokers. "People tend to overbuy … and that can really stress family life. It's also a formula for foreclosure."

Continued: Stay within your means

Instead of going to the edge of affordability, consider limiting your housing costs -- mortgage payments, property taxes and homeowners insurance -- to 25% or so of your gross income. That's a much more sustainable level for most people, financial planners say, than the 33% lenders are typically willing to give you.

Not shopping around for rates and terms

Mortgage broker Allen Jackson of Bristol Home Loans in Bellflower, Calif., sees too many borrowers with decent credit getting stuck with loans meant for people with poor credit. So-called "subprime" loans are often more profitable, so less ethical mortgage brokers may push them.

If the borrower doesn't know what the prevailing interest rates are for someone with their credit standing, Jackson said, they can easily pay thousands of dollars more than they need to. You can see a listing of loan rates by credit score at, and a comprehensive listing of prevailing rates and fees can be found in MSN Money's mortgage loan center.

Even people with a few dings on their credit can often qualify for better loans than they're typically offered, said Grose of 1st Mortgage Advisors in Los Angeles. He believes most of the people being shunted into government loan programs, such as Federal Housing Administration (FHA) loans, would pay less if they used mortgages now being offered by private-sector lenders.

Paying junk fees

Lenders can boost their profits by adding on a variety of fees. Some may be legitimate, some may be inflated and others may be pure fluff. Lenders may charge for "document preparation," for example, when all that involves typically is having a computer spit out a form. Or they may charge $150 for a credit check that cost them $15.

The time to challenge junk fees is not when you're about to sign the loan papers. Use a mortgage broker or call a number of lenders to compare their loans. Ask about the interest rate, the "points" charged to get that rate (each point is 1% of the total loan amount) and any other fees the lender charges. Then you can compare terms.Once you've selected a lender, you'll be given a good-faith estimate of closing costs, which should include any fees being charged. Ask about each fee, and try to negotiate down the ones that seem excessive.

If the lender won't negotiate, "take that estimate to someone else," St. James said. "I'll bet they can beat it."

Unfortunately, this doesn't absolutely guarantee you won't face junk fees when it comes time to sign the loan. Many borrowers complain that they still face higher costs than were originally estimated, and so far the federal government has done little to prevent the practice. You can try challenging junk fees at this point, but most likely you'll have to bite the bullet and pay the fees to get your loan.

Not planning for closing costs

The day you're scheduled to get your loan, known as closing, you'll also be expected to write a check for a number of expenses, which typically include attorney's fees, taxes, title insurance, prepaid homeowners insurance, points and other lenders' fees. Together, these are known as closing costs, and the total can be eye-popping: somewhere between 2% to 7% of the selling price of the house.

"Usually, when people see the closing costs, they're like a deer in the headlights," said mortgage broker Huntting, who works for Pacific Guarantee Mortgage. "It's much more than they ever think it's going to be."

Plan for closing costs by getting a good-faith estimate from your lender as early in the loan process as possible. Make sure you have the cash on hand (or rather, in your checking account) and that it doesn't "disappear" before closing because of sloppy bookkeeping or a last-minute emergency.

Video on MSN Money

Not having enough cash on hand after closing

After borrowing too much, and scraping together every last dime for closing costs, many home buyers have nothing left in the bank to pay for anything unforeseen happening --and something unforeseen always happens.

"It costs so much just to move in," Grose said. "Then the water heater breaks."

Some people are so tapped out by the process, Jackson said, that they're not able to make their first mortgage payment on time. That's why "more and more lenders are requiring [borrowers have] three months' reserves after closing," Jackson said.

That's a smart idea for borrowers, anyway. Having three months' reserves, which means a fund equal to three months' worth of expenses, will help you handle the added costs of homeownership with much less stress.

Liz Pulliam Weston's latest book, "Easy Money: How to Simplify Your Finances and Get What You Want Out of Life," is now available. Columns by Weston, the Web's most-read personal-finance writer and winner of the 2007 Clarion Award for online journalism, appear every Monday and Thursday, exclusively on MSN Money. She also answers reader questions on the Your Money message board.

Prime time to refinance your mortgage

Homeowners facing resets on their adjustable-rate mortgages or hoping to refinance into less-burdensome loans may be the biggest beneficiaries of the Federal Reserve's surprise rate cut this week as mortgages continue to get cheaper.

As many as 2 million homeowners face ARM resets this year and declining interest rates hold out the promise of at least limiting the sticker shock of higher payments on loans linked to Treasury indexes used to calculate many adjustments.

Lower rates also will make it easier for homeowners to qualify for refinanced loans, mortgage professionals say.

"For anyone on the margin, this will provide some relief," said Richard Musci, vice president of Charles Schwab Bank. But he warned that for those already struggling or already behind on credit payments "the die has been cast."

The Federal Reserve's emergency interest-rate reduction of three-quarters of a percentage point brought the central bank's key lending rate down to 3.5% from 4.25%. It was the most aggressive one-time cut in more than two decades, and its bombshell nature underscored the Fed's worries that credit conditions for consumers and businesses are at a breaking point.

"Whenever you lower rates, it can't hurt the consumer," said Bernard Baumohl, managing director of the Economic Outlook Group. "The Fed never promised it could change things dramatically overnight. There's a certain timeline with a cut in rates of nine months to 18 months when the economy feels the benefits."

'Consumers should be able to afford more'

While mortgage rates are not specifically tied to the rates the Fed controls, they have dropped significantly in the last three weeks and may be drop further.

"Mortgage rates already have fallen and they still are falling," said Dave Loyst, vice president of retail lending at Stearns Financial in San Diego. "Every deal is a struggle, but we're still doing loans. I think this rate cut absolutely is going to help the real-estate market."

"This definitely will help the mortgage situation," Loyst said. "With rates falling, more people are able to qualify for refinancing and more people who were left out from buying homes before will be able to do so now."

Consider what's happened since September's rate cut for creditworthy Schwab borrowers. On Oct. 7, a 5-1 adjustable-rate mortgage of $350,000 carried a 6.52% interest rate, assuming a 20% down payment. (A 5-1 ARM gives borrowers a fixed interest rate for the first five years and then converts to a loan that adjusts annually after that.)

The rate this week for that same loan was 5.04%. That translates into an annual mortgage payment that's $5,100 cheaper, Musci said.

"This is the affordability piece," he said. "Consumers should be able to afford more (of their living and discretionary expenses) at these lower interest rates."

By Loyst's thinking, that kind of reduction will push consumers to tiptoe into the home-buying market. "People will come out looking to buy houses . . . and it will help slow down the depreciation of real estate (values) in certain areas."

Now here's the gamble: Should consumers wait for what might be another cut in interest rates next week when the Fed holds its next regularly scheduled meeting -- and maybe even another cut at its March meeting -- or take the plunge now?

Get the paperwork started

Richard DeKaser, chief economist at National City Bank, encourages consumers to go for it now. "This doesn't apply to all cases, but for those who have an adjustable-rate mortgage and good credit this is probably a very good time to lock in some fixed rates for the long term."

But he warns that credit-lending standards are much tighter than they were two or three years ago when many borrowers took out their current loans, with full documentation of income required on nearly all loans.

"Don't go out and borrow money for the sake of borrowing money. But if consumers can consolidate and lower some credit-card debt, it probably makes sense to do so," he added.

Musci said those who want to refinance should get the paperwork started and look for lenders that offer a "float down" option that gives the borrower a one-time chance to lock in a lower rate should mortgage rates continue to fall in the wake of any additional Fed cuts.

"Even though it costs money to refinance, rates have gone down so much that you're probably locking in rates at the bottom or close to the bottom," Musci said.

Even though mortgage rates may be low, some homeowners may have trouble refinancing if the value of their house has fallen, as has been the case in many parts of the country. But home-price patterns vary by locale.

In Boston, for example, home prices are starting to inch up again after falling sharply, but in Bakersfield, Calif., more fallout is expected. So borrowers will need to monitor their property appraisals.

This article was reported and written by Jennifer Waters for MarketWatch.