Question: I have a friend who is considering putting a few thousands dollars toward the princple of her home loan. She’s owned the home a year and a half and right now only plans to spend a few more years there.
To me this doesn’t sound like good financial sense. Sure, she’ll gain more equity in her house, but what advantage does that give her? (She put 20% down when she bought the house; no PMI.) It seems like there are better things to do with the cash she has. I’d rather have my money readily available instead of locked into a house.
Does anyone have any advice, pro or con, on reducing the principle amount of a home loan?
Answer: The real cost of borrowing the money against the house is the mortgage rate minus your tax bracket. The money you make on investment is the interest rate minus your tax bracket. The principle put into either the mortgage or an investment doesn’t disappear and so it doesn’t fit into the equation. Thus the general rule of thumb for what to do is this: if you have a way to invest the money with a greater rate of return than your mortgage rate, then you are better off investing; otherwise you should pay off the mortgage. As it is difficult today to get a return rate greater than a mortgage rate, it would seem that paying down the mortgage would be preferred.
It gets more complicated if you also consider the direction that interest rates will take in the future. Money you put into the mortgage today is no longer liquid; that is, you can’t easily take it out of the mortgage to invest if interest rates rise significantly. Thus, anticipation of large rises of interest rates in the future would weigh against paying down the principle on the mortgage, other factors being equal. If your friend is only planning to keep the house for a few years this is probably a moot point, as it’s probably better to take the sure money today rather than gamble on what is going to happen in the future.
If you really want to sweat the details, you have to make a spreadsheet which incorporates the tax tables into it, as there are limits on tax deductions, and the difference between interest and deductions may drive you into another tax bracket.
A third option is to simply spend the money and increase your standard of living today as a trade against your standard of living in the future. I can’t help you here!
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