With all of the financial challenges your clients face these days, “paying down the mortgage too quickly” probably doesn't rank too high on their (or your) list of “things about which we should be worrying.”
Yet it may actually be more conservative if the clients were to not only decelerate their monthly payments down to the minimum amount required, but even (gulp) take out a new, 30-year fixed-rate mortgage for as much as their friendly lender will allow. Here are some ways that making the most of a mortgage can help your clients protect themselves against many personal and global financial crises.
- The inflation fighter
The primary scary scenario in which a 5 percent loan will be especially attractive is if/when the dollar falls, prices escalate, and/or interest rates start to climb. First, the mortgaged clients will be paying back a loan with dollars that have declined in real value, while the theoretical nominal value of their home is increasing.
A rising interest rate environment will make a low-rate mortgage even more valuable. The clients can use money that would have otherwise gone to pay down the mortgage prematurely to instead pay for items that would otherwise force the clients to borrow at a higher rate.
In this picture, the cash they save from cashing out now or making lower monthly payments in the future can also be deposited into safer investment vehicles that may even provide a higher yield than that of the fixed-rate mortgage.
- Going long
Some clients may be rightfully hesitant to take on a new schedule of 360 monthly payments, and may prefer to tap established home equity now via a fixed home equity loan or line of credit. Those alternatives are usually better than nothing. But getting a home equity loan typically means that the term will be shorter, the interest rate higher, and the proceeds smaller than what clients could receive with a new 30-year fixed rate mortgage.
The home equity line of credit is the path to tapping the equity that offers the least resistance. But the interest rate is typically adjustable, and lenders usually reserve the right to cap the available amount on short notice. Other clients might like the idea of getting a new mortgage, but prefer the interest rate, interest amount, and shorter payment period of a 15-year note, instead of a standard 30-year term.
A quick calculation will show your clients that taking out a 30-year loan now, and then making the larger monthly payment that would have been required by the 15-year mortgage will still allow them to pay off the debt in less than 16 years. In the meantime, though, the 30-year mortgage offers them a lower minimum payment, and 15 more years to leave money borrowed at 5 percent interest outstanding — a luxury that may become a necessity if personal or economic conditions change for the worse.
- The real low “real” interest rate
That 5 percent rate on mortgages is even lower than it appears if the homeowners can deduct the interest. Many of your higher-income clients should qualify. To be able to deduct the interest, the clients have to itemize their deductions, and the loan has to fall within the relatively wide guidelines delineated in Publication 936 at www.irs.gov.
According to the calculators at Bankrate.com, if clients have a $400,000 30-year fixed rate mortgage at 5 percent, and are in the 28 percent federal and 5 percent state income tax brackets, the effective interest cost of the mortgage per year is 3.42 percent, assuming they itemize, and they and their loan qualify for the deduction.
- Loving liquidity
Many middle-class millionaires have a substantial portion of their net worth tied up in two places: tax-sheltered retirement plans, and real estate. When things are going well, these are two attractive ways to accumulate wealth and protect the money from Uncle Sam. But problems arise if clients need quick access to a substantial sum of funds.
If they pull the larger amount from a plan like an IRA or 401k, they'll likely lose more than a third of the money to income taxes on the withdrawal, and even more in penalties if they're under age 59 ½. Opening a home equity loan or line of credit during a personal financial catastrophe will also be difficult, as the very nature of the calamity means that bankers will be less likely to allow access to the established home equity.
Yes, the house could be put up for sale. But doing so would put the clients at the mercy of the housing market and the buyer. Even upon closing the sale, the clients might not have enough to buy a new home, and still pay for ongoing necessities. So they become renters, whether they want to or not.
But if the clients establish a new mortgage now and park any proceeds safely away, they can slowly draw from the rainy day fund to cover the new mortgage payment (and other living expenses), until the financial storm passes.
- Hedging housing prices
The past few years have disabused many homeowners of the notion that the value of their homes can only move in one direction: “up.” Clients can mitigate the damage done by a continued slide in the value of their homes by establishing a new mortgage now.
How? Let's say a client has a paid-for home currently appraised at $500,000, and can get a 30-year mortgage right now for $400,000 (80 percent of the appraised value).
The bank will give him a check for that amount, and he gets to do what he wants with the money while still enjoying the comforts of his current home (assuming he makes the new monthly mortgage payment). If the value of that home falls further in the future, whatever he eventually sells the house for may drop right past that $400,000 figure, making his decision to get cash out now that much more prescient.
But if the housing market turns back around (either due to demand or the aforementioned inflation), the house is still his to sell for the eventual higher price, and net out more money after paying off the remaining mortgage.
Once sufficiently convinced of the merits of keeping a mortgage outstanding as long as possible, you (and your clients) may reasonably wonder, “Okay, now what do we do with the extra money?” That's the trickier part of the equation, as losing the proceeds through unwise or unlucky investments tends to diminish the wisdom of the whole proposition.
So next month, we'll discuss conservative ideas for the money left over after a new, lower monthly payment is made, or with the larger sum of cash netted from a cash-out.
CFP© is Principal/Owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book Make Your Kid a Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. Find out more at www.advisortipsheet.com.