Pay down the mortgage?
November 13, 2009 1:19 PM   Subscribe

Should they pay down their mortgage?

My friends, who think I'm a financial guru, have come to me seeking some advice on their mortgage. However, while I have an opinion, I thought I'd ask the folks here at AskMefi too.

Should they pay down their mortgage?

Due to several unexpected windfalls, my friends have about $100k in the bank. They have earmarked $25k for retirement savings, general savings, a trip, and so on. They have ample emergency savings and decent retirement savings funds already, as well as college savings. Their car is paid off. They have no debt outside their mortgage. They live on one income and use the other to pay down their mortgage. They have 2 children and one parent works part-time, while the other has a very good job. When the other parent returns to f/t work, their income will rise substantially, but they are already in a very comfortable household income bracket.

My friends can pay up to $65k as a balloon payment on their mortgage each year. They have previously made several balloon payments, but none this year.

Their current *fixed* rate is 5.89%, with 2.5 years left in the term.
Their marginal tax rate is around 35-40%.
Their mortgage payments are around $2050 a month.
The outstanding balance is now $275,000, down from $350k when they bought 2.5 years ago.
Their condo is worth around $600k and is in downtown Vancouver.

If they break the mortgage, they would pay an interest rate differential of about $17k.

They could refinance at around 4% fixed or 2.2% variable, give or take.

They have excellent credit.

My friends think they should pay down their mortgage by $65k, so that they get a 5.89% return with no tax. This will reduce the burden of a mortage (in a city where a house is $1M) and also mean that, when the term is up for renewal in a few years, they can shorten up the amortization or else benefit from much lower payments. They don't think it makes sense to break the mortgage ,since, over the course of the entire mortgage, they would actually save much more by applying the $17k penalty against the mortgage instead. Besides, they have money sitting in the bank.

Does it make sense to pay down the mortgage by $65k?

Thanks in advance.
posted by acoutu to Work & Money (18 answers total)
Response by poster: *apparently think
posted by acoutu at 1:22 PM on November 13, 2009

If your friends have $100k, they should enlist a full-on financial adviser. There are a lot of variables in play here, and proper advice seems like it's in order -- even if you and/or the hivemind are brilliant with this type of thing.
posted by ellF at 1:26 PM on November 13, 2009 [3 favorites]

If there's literally no other immediate use for the money then yes, paying down your mortgage is a guaranteed way to get a return that's better than any normal fixed return investment like a CD or savings bond. They have no credit card debt or a car loan? If not, sure, pay off the mortgage.

Another alternative is to hold the money until the mortgage comes up for renewal as most CDN mortgages have limited pre-payment ability - I could typically only make one extra payment a year with my mortgage.
posted by GuyZero at 1:35 PM on November 13, 2009

I think the missing piece here is what their risk tolerance is, which really goes also towards their expected rate of return on what they'd do with the $65k should they decide NOT to pay down the mortgage.

There's relatively few low-risk investments which would beat 5.89%...
posted by QuantumMeruit at 1:41 PM on November 13, 2009

Response by poster: Thanks. They don't want to lose this money and they would most certainly not like to lock more than $20k or so of it up in an RRSP, as they figure one day they will want a bigger home and also they're kind of financially conserative. The pre-tax effective rate of return on paying down the mortgage is upwards of 9%, btw.
posted by acoutu at 1:51 PM on November 13, 2009

Yeah, you can certainly beat 5.89% with higher risk tolerance. Find the next AAPL (112% increase over 12 months) or GOOG (83%) and you could net 50-100% RoR. Maybe. :)

Or save some more money and buy one share of Berkshire A!

Also, seriously, have they maxed out their RRSPs? Have they taken advantage of the new tax-free saving accounts? That is one way to improve the after-tax return on a lower-interest low-risk investment like a GIC.
posted by GuyZero at 1:55 PM on November 13, 2009

My friends think they should pay down their mortgage by $65k, so that they get a 5.89% return with no tax.

If they're itemizing federal tax deductions and deducting interest, their effective interest rate is lower than 5.89%, as is their effective return by paying off some of the debt early.
posted by brain_drain at 1:56 PM on November 13, 2009

If they're itemizing federal tax deductions and deducting interest

This is not Vancouver WA.
posted by GuyZero at 1:59 PM on November 13, 2009

Response by poster: Brain_drain...I don't follow. You can't deduct mortgage interest in Canada. And the higher income earner is in a 35 to 40% tax bracket...his income is pretty high. (Although from the lower income earner's POV, the tax bracket is in the 22% or so area.)

They have not maxed out RRSPs. Again, they are not comfortable locking up more than $20k of the $100k, because they want the option of eventually moving to a larger home. (In Vancouver, a house is very, very expensive.)
posted by acoutu at 2:01 PM on November 13, 2009

My bad, I missed the locale. Sorry!
posted by brain_drain at 2:14 PM on November 13, 2009

Based on your description, it seems like a no-brainer, they should definitely pay down the mortgage. They want to use the money to eventually upgrade to a more expensive home, and in that time frame there isn't going to be a reliable investment that will guarantee a 5% or higher return.

Yeah, you can certainly beat 5.89% with higher risk tolerance. Find the next AAPL (112% increase over 12 months) or GOOG (83%) and you could net 50-100% RoR. Maybe. :)

Or they could lose 50%. If it was really possible for someone to consistently predict the next AAPL or GOOG, there would be fund managers who could consistently make those kinds of returns. Think about it this way, would you borrow money at an almost 6% interest rate and use it to invest in the stock market? If not, then investing the money instead of using it to pay down existing debt shouldn't be worth it either.
posted by burnmp3s at 2:40 PM on November 13, 2009

One possible consideration is to increase the monthly payment by an additional $1,000 or more. After a while of making $3,200 monthly payments, it does not hurt at all, and it accelerates the payoff. The return over 20 years in interest savings is very substantial. And if they encounter a setback (illness, loss of a job) they have a $1,000 per month cushion to use.
posted by yclipse at 3:36 PM on November 13, 2009

Many CDN mortgages actually don't allow free-form overpayment like that. At least, mine didn't. If you increased your payment you raised it permanently for the duration of the mortgage.

if you are an American who has never held a mortgage in Canada please think twice before giving advice because Canadian mortgages are sturctured differently enough from US mortgages to make a serious difference in what these people can do to accelerate their payment.

For example, BMO has "20 + 20" prepayment options - you can prepay up to 20% of your principal annually or increase your monthly payments by up to 20% one per calendar year. Most banks have a similar setup. You cannot simply send a Canadian bank a cheque and say "put this on my tab".

In the US I can pay any amount at any time on my mortgage as long as I'm making my scheduled monthly payments.
posted by GuyZero at 4:07 PM on November 13, 2009

Does it make sense to pay down the mortgage by $65k?

Yes, that's certainly what I'd do. (I'm also in Vancouver.) Paying down their mortgage is basically a risk-free investment that earns 6%, tax-free (in their tax bracket, equivalent to a 10% return before tax). That's very hard to beat.

The only reason I'd keep the $65K in cash would be as emergency savings, but it sounds like they've already got that covered.
posted by russilwvong at 4:38 PM on November 13, 2009

It's the first thing I would do in that situation. Safe and has feelgood value.
posted by Hildegarde at 5:58 PM on November 13, 2009

Payoff as much as possible. No one knows where the market is going to head right now, so a 6% return across the board is a good thing.
posted by jasondigitized at 7:31 PM on November 13, 2009

You have stated that they can pay up to $65,000 per year and that they haven't made that additional payment this year. It appears they can do so without penalty. It also appears that they believe they do not need additional rainy-day savings. Last, it appears they can obtain several benefits from doing this. First, whatever the changes in the real estate market, this payment represents an increase in their equity. Second, by reducing the outstanding loan principal, they will be paying less toward interest from now on and more toward building their equity. It is a double boost to equity. Third, they are not going to get a 10% yield on any short-term investment in this market, so they should just look at this as a no-risk, medium yield long term investment.

They should carefully re-assess their belief in their not needing this money and, if they are comfortable with that assessment, go for it.
posted by Old Geezer at 9:12 PM on November 13, 2009

Response by poster: Thanks. That was pretty much my view of things, too.

And, yes, their bank allows them to pay down 20% of the original mortgage every year. They've been making balloon payments of $20k-$30k a year since they first got into the market.

Good point above that making the balloon payment also increases the amount going to equity. They plan to continue making balloon payments, too, so this gives lots of options. They're thinking that, when the mortgage comes up for renewal, they may keep the remaining 16 year term and just make balloon payments, rather than being bound to high payments.

They are keeping $35k to the side for retirement and emergency savings, so the $65k won't leave them with $0 in the bank.

Thanks, everyone!
posted by acoutu at 10:09 AM on November 14, 2009

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