Pretend a middle-aged client comes to you with a dollar. Let's say it's a shiny new Sacagawea coin (bear with me, it will come in handy later). The client asks you, “Should I invest this or use it to pay down my mortgage?”
This question has been vexing clients and their advisors for years. And it's likely to be on the minds of many of your boomer clients, if the behavior of their slightly older counterparts is any indication. According to the Survey of Consumer Finances, about a third of homeowners aged 65 to 74 have a mortgage. The Senior Sentiment Survey from reverse mortgage originator Financial Freedom says that of those seniors who still have a mortgage, almost two-thirds have one that they will still be paying down a decade from now.
The conventional planning wisdom is to get out of any debt you may have as soon as possible. But that may not apply to everyone. Here are 10 questions that can help you and your client weigh where that dollar should actually go:
Can your investment recommendations outperform their mortgage rate? Net of fees? Risk-free? For the length of the remaining payment schedule? If the client is paying 6 percent interest on the mortgage, money used to pay it down gives an automatic, instantaneous, guaranteed 6 percent rate of return. An easy number for you to surpass over the longer term, it seems — until you consider that if a client has 10 years left on a mortgage at 6 percent interest, the DJIA would have to go from 11,500 today to 20,600 in 2016 just to equal a 6 percent annualized rate of return.
Can the client deduct the mortgage interest? If so, you may have a friend in the IRS. If the client itemizes and is in the 25 percent bracket, for example, then the return bogey you have to beat drops down to 4.5 percent (after tax). This is a number that might be attainable with insured, tax-free bonds held to maturity.
But mortgage interest is only deductible to taxpayers who itemize. So your married-filing-jointly clients have to have at least $10,300 in itemized deductions for 2006 (for a single the number is $5,150) before they can exploit this part of the tax code. And while a mortgage balance in the mid-six figures will easily cost enough today to help meet the standard deduction threshold, as the balance shrinks so will the size of the yearly interest, and it will become less likely that the mortgage interest will be deductible.
Is the client maxing out pretax retirement-plan contributions? Hopefully, he's reached his limit for socking money away in a 401(k) (for 2006 it's $15,000, plus another $5,000 for workers over 50). If not, the answer to the payoff decision tilts towards the “no-brainer” territory — especially if the answer to question No. 2 is “yes.”
Go back to our hypothetical client residing in the 25 percent tax bracket and in a house with a 6 percent mortgage. If he has $5,000 to invest at the beginning of the year, itemizes and has suitable room to contribute to his at-work plan, here's how the choice stacks up over the next 12 months:
Put towards mortgage Puts into 401(k) plan Saves $300 in interest Reduces federal tax bill
Pays $300 more in interest …
… Cuts $75 from taxes
Net advantage: $ 1,025
And the benefit of directing the money towards the 401(k) goes even higher if the deposit generates a matching contribution from the employer.
Is all the other debt paid off? Yes, paying off a mortgage is usually more emotionally satisfying than whacking away at other types of debt. But the interest rate on credit cards, auto loans and student loan balances is usually much higher and often not tax-deductible, so it's best to address those first before prepaying the mortgage.
OK then, are there any large expenses coming up in the next few years? Even if the answer to question No. 4 is “yes,” there may be a car, college or cabin in your client's future. If these expenditures require him to borrow the money to foot the bill, he will likely pay a higher interest rate than what his current mortgage is priced at. Better to put cash aside now than towards the big bill later.
Is the mortgage rate fixed or adjustable? Comstock Partners recently estimated that $2.7 trillion in mortgages will be subject to higher rates in 2006 and 2007. If your client can expect his payments to ratchet up in the near term, he may want to refinance to a fixed mortgage now. If he can't or won't, any extra money should be applied to the principal now, while it can do the most good.
Is the client paying private mortgage insurance? Most unfortunate souls who have equity in their homes of less than 20 percent of the value are forced to purchase private mortgage insurance — a guarantee that the bank will be made whole if the borrower defaults. The annual payment amount can be anywhere from 0.25 percent to 1 percent of the mortgage balance. Putting any extra money toward the mortgage can rid the client of this nuisance.
Will future mortgage payments have to come from an IRA distribution? If the current payment schedule takes a client well into his golden years, then he is forced to draw from his retirement account to make the payments, the effects could be devastating. First, the extra money taken from the IRA could push him into a higher tax bracket — requiring him to take even more out of the accounts. Second, the withdrawals could also make his Social Security taxable, which would then boost his tax bill and require him to bump up his cost of retirement even more. The ensuing higher withdrawal rate will make it more likely that his wealth will expire before he does.
Is the client more likely to get sued than the average person? The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 made it easier for persons declaring bankruptcy to shelter seven figures (or more) of retirement-plan assets from creditors, subject to certain conditions. But the exemption for home equity can be as little as $125,000, depending on the client's state of residence (you can find a discussion of each state's asset-protection laws at www.aicpa.org/pubs/jofa/jan2006/altieri.htm).
This new wrinkle means that all other things being equal, a client declaring bankruptcy with a debt-free home and little else in an IRA or 401(k) may have a lot more to lose than one whose biggest slice of the pie is in retirement accounts.
Is the client comfortable with an asset allocation that's heavy on the real estate? Yes, we're well aware of the hundreds of thousands of dollars in phantom appreciation you've made just by living in your house over the last few years. But Thornburg Investments published a piece recently showing that after inflation, taxes and maintenance, homes appreciated barely more than 1 percent per year for both the 10- and 20-year periods ending on Dec. 31, 2004 (more available here: www.thornburginvestments.com/research/articles/real_real_0705.asp).
These disappointing long-term returns don't even include maintenance costs. While it's hard to say how the value of your client's home will change in the coming years, it may not be prudent to have all of his eggs in one three-bedroom Cape Cod nest.
Going with the Gut Instead of the Brain
Even when you present your client with these logical arguments to holding off on prepaying a mortgage, it may just feel better for him to retire the debt before he does. If so, so be it — but at least suggest he then open a home-equity line of credit that he can tap in an emergency.
Besides, if all else fails, the best thing to do might be to just flip the Sacagawea coin and let fate decide.
Writer's BIO: Kevin McKinley is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future. kevinmckinley.com
The Long and the Short of Mortgages
Is your client one of the six Americans left who's actually looking to buy a home? Assuming she's not paying cash, she'll be confronted with two likely long-term fixed-rate mortgage options: a 15-year at X percent, and a 30-year at X-and-a-half percent. A shrewd borrower will spy the former's lower interest rate, lower overall interest cost — and a chance to be mortgage-free 15 years sooner — and decide the higher payment is a small price to pay for all that is gained.
But you may want to point out the obvious choice may still be the wrong one. Suppose the client wants to borrow $350,000 and finds a tasty rate of 5.75 percent on a 15-year mortgage (monthly payment of $2,900). Her friendly lender also offers a 30-year note at 6.25 percent, costing $2,150 per month. The shorter option will cost $172,000 in interest, while the longer mortgage will set her back $424,000.
Hard numbers with which to argue. But, if she takes the 30-year mortgage and pays the monthly payment that would have been required by the 15-year option, she'll still retire the debt in less than 16 years. In the meantime, she will have the option to reduce or skip payments if some unexpected emergencies arise. Better yet, if rates paid on deposits rise above 6.25 percent, she'll have the distinct pleasure of “arbitraging” the bank by earning more on her savings than she's paying on her borrowings.