- The Washington Times - Thursday, September 29, 2005

Q: We refinanced our home in Washington in 2002. We have a 15-year fixed rate

at 5.875 percent. The balance began at $250,000 and we have since been making extra payments. Our balance is now close to $166,000. Our monthly principal and interest payment is $2,092.

We will be overseas on a work assignment for the next four years and are wondering whether it makes sense for us to continue to pay down the loan. If so, we will be close to having the house completely paid for when we return. It’s worth about $600,000 today.

The alternative would be for us to refinance the $166,000 to another 15-year loan, resulting in a lower payment. This would free up a lot of cash to use for other investments which would build an earnings base for retirement.

Would such a move be wise? Please let me know your thoughts.

A: These are excellent and necessary questions in order to make a financial plan. Owning a home outright used to be the goal of many homeowners. But thanks to low interest rates and alternative investment sources, it isn’t always the best course of action.

I have always believed that a personal financial plan should be well-balanced. Personal assets should not be too heavily weighted in one particular investment vehicle. It is for this reason that it often makes good sense to keep a mortgage. Let’s take a look.

You are paying an interest rate that is probably tax deductible of 5.875 percent on borrowed funds in the amount of $166,000.

Assuming that you will continue to work and earn an income for the next few years, deducting the interest paid on the mortgage will reduce your actual “cost-to-borrow” by perhaps 25 percent, meaning your true interest rate would be closer to 4.40 percent.

It’s important to point out that every time you make a principal payment to the loan, it is the equivalent of investing the money that earns a return of 4.40 percent, because a portion of your debt that costs 4.40 percent is reduced.

The equity in your home equals its value minus the mortgage debt, which, in your case, is $434,000.

Here are questions you need to ask yourself: Is having $434,000 in your home’s equity a balanced part of your household wealth? Do you make maximum contributions to a tax-deferred retirement account every year? Are you setting up savings accounts to pay for future expenses such as a college education for your children?

A few years ago, I had a client who was obsessed with owning his home free and clear. He took out a 15-year fixed-rate mortgage and paid it down on a seven-year plan.

Is this a good strategy? It turned out that this fellow had no Individual Retirement Account (IRA). He had no savings account. He had no investment portfolio. To make matters worse, he carried more than a $5,000 balance on his credit card every month. Clearly, this fellow did not have a balanced financial plan.

If you have a healthy investment portfolio, a good IRA plan, and some liquid cash for an emergency, there’s nothing wrong with plowing some extra cash into your loan balance.

But a lot of savvy individuals choose to hold a mortgage for one reason: They can earn more by investing the borrowed money.

Consider this real-life example: A client takes out a $500,000 loan with a 10-year fixed rate of 5.50 percent. The mortgage allows interest-only payments, so his minimum monthly payment is $2,291 ($500,000 X 5.50 percent divided by 12 months).

The program also allows him to amortize the loan over 15 years, with a payment of $4,085. Such a payment made for five years would drop the mortgage balance to $376,445, gaining $123,555 in equity.

Instead, he decides to make the interest-only payment and invest the difference of $1,794 ($4,085 minus $2,291) into a reliable mutual fund that earns an average return of 8 percent annually.

I came up with some interesting numbers.

• At the end of five years, the mutual fund grew from a balance of $1,794 to $134,490. This exceeds the amount of equity gained by paying down the loan by $10,932.

• The amount of tax-deductible interest paid over five years under the interest-only plan is $151,250. Under the 15-year payment plan, the interest paid drops to $131,569 over the first 5 years. Assuming a 28 percent tax, the interest-only plan saves $5,511 in taxes over five years.

The comparison is obvious. The amortized plan increases equity by $123,555. The interest-only plan creates no equity but increases assets by $134,490 and saves $5,511 in tax obligation. Overall, the interest-only/investment plan increases the wealth by $16,443 ($10,932 gain from mutual funds plus $5,511 in tax savings.)

I am not necessarily endorsing such a financial plan. I am merely illustrating the benefits of leverage.

Remember there is no guarantee. If your investment returns less than the mortgage rate, you’re losing money.

If you already have considerable equity in your home and will continue to have a taxable income, today’s low rates provide a good argument to maintain a mortgage and invest wisely.

You asked about refinancing to another 15-year program. I might suggest a program that doesn’t force accelerated principal curtailment, if, indeed, you decide that holding a mortgage fits your overall plan.

Also, since you are overseas, you may have to refinance the property as an investor. These programs carry a higher interest rate. Speak with a good loan officer who can analyze your situation in detail before making any decisions.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-mail (henrysavage@pmcmortgage.com).

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