- The Washington Times - Wednesday, October 4, 2006

Q:We have about four years left on a mortgage on a home in Arlington. We took out a 15-

year loan at 7 percent in the amount of $190,000 and my balance is now about $71,000.

The principal and interest payment is $1,708 per month.

I am considering paying the loan off once and for all and becoming mortgage-free.

On the other hand, isn’t it true that since we’re only four years away from paying the loan off, most of my monthly payment is principal rather than interest? We have good salaries and about $250,000 in savings and investments. Our house is worth at least $750,000. Any advice is appreciated.

A: I plugged your numbers in to an amortization schedule and indeed, a 7 percent, 15-year mortgage would carry a balance of $71,317 at the end of the 11th year.

If this is your primary residence, current market rates for a 15-year loan are substantially lower than 7 percent, but refinancing such a low balance would not come without incurring some closing costs, potentially offsetting any advantage provided through a lower rate.

Let’s stick with your question as to whether paying off your 7 percent mortgage early makes sense.

Answering this question depends upon what assumptions you make. I’m going to pull up the amortization schedule again and look at some more numbers.

You have 48 months left on the loan. If you choose to continue to pay the loan off in monthly installments the total interest paid between now and then is $10,656. This compares with $71,317 in principal.

You are exactly right that more principal is curtailed than interest is paid toward the end of the loan term. In contrast, in the first 48 months, the loan was paid down by only $33,095. Interest paid during that period totaled $48,878.

So, the question to answer is whether it makes sense to take $71,317 of your money to pay off the loan, saving $10,656 in mortgage interest.

Let’s make assumption No. 1: You pay 30 percent income tax. Since mortgage interest is deductible, we can shave 30 percent off the interest charge. This makes your after-tax interest cost $7,459, which represents your savings if you decide to pay off the loan today.

The next thing to look at is the downside, or “opportunity cost,” to pulling your money out to pay off the loan.

How is your investment portfolio performing? Is it yielding a decent return? A good rule of thumb is to determine whether your investment portfolio is earning a higher return than the after-tax cost of the mortgage.

Again, using a 30 percent tax, let’s shave 30 percent from your mortgage rate. This equals 4.90 percent, which represents your after-tax “cost to borrow.”

The bottom line is that if you think you can earn more than 4.9 percent on $71,317 keeping it invested, you are better off holding the mortgage to its term. But if the money is sitting under a mattress doing nothing for you, you will save the after-tax interest cost of $7,459 by paying it off.

It’s important that these assumptions are fairly accurate in order to make this decision based only on the numbers.

However, there are some intangible issues to consider that are very important.

I believe a financial picture needs to be balanced. You say that you have $250,000 in investments. Does it make sense to reduce that balance by nearly 30 percent to pay off the mortgage? Remember that this decision doesn’t change your net worth. You are simply transferring $71,317 in assets from one vehicle to another, from your bank account to real estate equity.

Paying down a mortgage that’s costing you 4.90 percent after taxes is akin to making a long-term investment that is earning the same return.

Based upon the information you provided, I would be inclined to recommend that you keep your mortgage and retain your investment portfolio.

Consider the facts:

• You have $250,000 in investments

• You have nearly $680,000 of equity in your home

• You have good salaries, suggesting that you are obligated to pay considerable income tax.

Nope. I would keep your money invested. There’s no need to put more of your wealth in real estate equity.

Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail ([email protected]pmcmortgage.com).

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