Six Secrets to Mortgage Loan Decision - Interest Only or Pay Down Early?

Does it makes sense to pay off my Home Loan as Soon as Possible? Are interest only loans Bad?

A common myth in the home loan business is that it makes financial sense to pay off the home as quickly as possible. A corollary of that myth is that interest-only loans are bad. The fact is, it is not necessarily bad to pay off your home, but often it is simply not a good choice what so ever. There are several components to this answer.

The first is, not all debt is the same. Consider that you might be borrowing potentially hundreds of thousands of dollars for ten, twenty or thirty years, and you can lock that interest rate in today at under 5%. Plus, the interest on that money is very likely tax deductible, so if you're in a 25% tax bracket which is close to the national average, a 5% interest rate means your effectively borrowing 3.75%. Where else can you get debt like that, certainly not from your credit cards?

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The second reason to consider not paying off your mortgage is this; think about the use of the funds. Paying down the principle, which is to say increasing your equity in the house, feels like a good thing and I respect that havaing a really good feeling may be a good reason to do it. From a strict financial point of view, your house is an asset and if you put money into any asset you want to see that the asset appreciates in value; that it grows. It sounds somewhat counter intuitive until you realize no matter how much you put in to your house in terms of the equity, whether you put down 100%, or you borrow 100%, the price of your home is established by the market. Therefore, paying money into your mortgage is technically a zero rate of return.

With that in mind, the issue that comes up is if you don't put it into your home, what else could you do with it? Right now, investments in the market are very poor. CDs are paying on average 1.6% in the country, but that's today. Looking further down the road, we've been accustomed to five, six, seven, eight percent returns on investments. So if you can borrow from the bank at three, four, or five percent and put it in stocks or even just very secure treasury bonds, you can probably be getting five, or six percent down the road. You are doing what a bank does, you're borrowing low, and you're investing high at a secure rate.

A third reason that paying interest only makes sense is something that I've experienced for these last two years, with a number of people around the country that I've been helping. People have been dutifully paying down their mortgage and then all of a sudden for a variety of reasons they can no longer refinance. Then they are in a situation where they don't have cash in the bank, which they might need for anything from school, or a big medical debt, and other expenses that came along. Whereas, if they had had the money and kept it in a separate account, yes they would owe more on their home, but they'd have that extra cash in a bank.

Again, arguably that cash is going to be earning interest so it's worth more, and the key words that you should be thinking about are net worth. When you add up your home and all your other liquid assets, less your liabilities, that's what your worth is. So whether you own a $100,000 home of which you owe $90,000 and therefore you have a net worth of $10,000; or you have a $100,000 home of which you owe $100,000 but you have $10,000 in the bank, you still have a net worth of $10,000. They are the same, except from these last 2 years I couldn't count the number of people that would have been better off having the cash outside the house.

A fourth reason to consider not paying off your mortgage is to recognize that the more you own of your home, the greater your equity share, and arguably the more viable that asset is to a potential creditor who is going to be looking to claim it. There is a wonderful story from the 1930s, where Walt Disney owed Bank of America $7million dollars that he had borrowed to finance Snow White. And Walt and his brother started laughing because they realized that the last thing Bank of America was going to do was foreclose on them. There was nothing to foreclose on of any value unless the film did well. In fact the bank wound up giving them more money because they couldn't afford to take the studio from them. Luckily for everyone, Snow White was a hit and they were able to resuscitate.

The same thing works in your favor. Just imagine if you own a home that is completely paid off versus your neighbor who has the exact same home but owes the bank 90% of the money and you both have some kind of financial problem. I can't promise you, but hypothetically I'll promise you, if the bank has to choose who to go after, they're coming after you because the bank could put your house on the market and sell it to get their money back. The person who owes the bank a lot of money - that house isn't worth anything and they are more likely to keep the house.

The fifth reason to give some consideration about not paying down your mortgage is to have maximum financial flexibility One reason interest only loans have always been attractive to some people is it obligates you simply to make a low payment. Any time you want you can voluntarily make extra payments that will go directly to the principle. If you made the exact same payment of principle and interest voluntarily that the 30-year fixed commands, you'd be exactly on that schedule but now you have control of your funds. If something comes up one month that you need the money, you don't make that payment and you make the interest only payment that's fine. There are 30-year fixed loans that include an interest only component for ten years, so having an interest only loan doesn't mean your going to have an adjustable rate mortgage, or something happening five years down the road that's going to put you in trouble with the bank. It's a fixed rate and a fixed minimum payment; it simply gives you the option to pay interest for those couple of years.

Lastly here is the solution if the goal is that you want to pay off the house as quickly as possible; there are several ways of doing it. One is to make extra payments. That's one way. Two, there are home accelerator loans that give you a lot of flexibility on how to do that. Another is to get a loan that has a shorter term to it. Now the shorter the term means your going to make a larger payment, but that payment is going to be largely equity. On a shorter-term loan, and here I'm talking about a fifteen, or twenty-year loan as apposed to a thirty-year or forty year; not only will you pay it off more quickly because the timing is shorter, but the interest rates on the shorter-term loans are generally anywhere from a quarter to three-quarters of a point less than a thirty year fixed.

For instance, using a $500,000 mortgage at a 30-year fixed rate; over 30 years you will pay $466,000 in interest. If instead you did a 15-year loan, the interest rate is a little bit lower. At the end of 15 years you will have paid $176,000 in interest. The difference is roughly a little short of $300,000 in interest. Well if you figure the interest you don't pay over 15 years you're really saving legitimately, out of pocket, roughly $20,000 a year. So if you can afford the higher payment and the goal is to pay down the house quickly, save yourself a lot of interest and do a shorter term loan. I am always happy to have a conversation with you about your options. Contact information is at

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