Being mortgage free is generally a good thing. But there are times when you want to accelerate your mortgage pay down and there are other times when you want to leave it well alone. With the aggressive spike in interest rates post election, it’s now time to reassess whether paying down your mortgage quicker is a good idea.
Borrowers who took on debt and locked in a lower rate before the election are winning. Banks who lent people money before the election are losing because they could be earning a higher return today. In other words, the VALUE of the mortgage has risen for borrowers and declined for lenders.
When something rises in value, you do your best to hold on for as long as possible. Therefore, paying down your mortgage faster when your interest rate is fixed is a suboptimal move.
Here’s an example of a $500,000 mortgage that demonstrates this point.
5-Year ARM Interest Rate Lock Before Election: 2.5% = $1,975/month
5-Year ARM Interest Rate After Election: 3.25% = $2,176/month
Instead of prepaying down a fixed 2.5% rate, when the best a borrower can now get post election is 3.25% for the same loan, save the difference. The most conservative strategy is to save the $201 monthly difference for 60 months and then pay down $12,060 in principal the last month the 5-Year ARM adjusts if you plan to refinance or let the mortgage adjust. If you plan to sell the property by then, you’ll just keep the change.
A more aggressive strategy is to invest the $201 monthly difference in some now higher yielding bonds, given they have sold off due to the interest rate increase. An even more aggressive move is to invest the $201 monthly difference in a mix of stocks and bonds. Finally, the most aggressive strategy for a lot of people is to invest 100% of the difference in stocks and hope the raging bull market continues.
Your decision will depend on your risk tolerance and financial goals. For those of you wondering about 30-year fixed rates, they’ve risen from around 3.625% to 4.125% post election.
What Am I Doing?
Because I operate under the overarching belief that less debt is better than more debt, I will continue to pay down some extra principal on my 4.25%, 30-year fixed Lake Tahoe property mortgage that cannot be refinanced. However, my original plan of paying an extra ~$50,000 a year in principal over the next six years to pay the sucker off by 2020 is now no longer happening. Instead, I plan to reduce extra principal payments by 50% to $25,000 a year. The $25,000 in freed up capital will now be used to primarily focus on building a municipal bond portfolio in order to live for free in my primary residence.
I have a 5/1 ARM at 2.5% that is adjusting in July 2019. Although the interest rate is low, with only 25 months left of the fixed rate, I’ve got to come up with a plan to pay down extra principal payments so that if it were to adjust to 3.25%, I’ll still be paying the same amount of interest. Surprisingly, all I’ve got to do is pay down $19,000 of principal by July 2019 to maintain my same payment at 3.25% because I’ve already paid down $70,000. Plan done!
Finally, for my property with the newly refinanced 2.35% rate, I will no longer be paying down extra principal until the last month of the 5-year fixed term ending August 2021. When the time comes, I will reassess the interest rate and real estate landscape to decide whether to pay down a lump sum, refinance or let the mortgage float.
Stay tuned for an upcoming post where I highlight all new money investments made for 2016, including mortgage pay downs. It’s quite eye opening.
Stay Fluid My Friends
The rise in interest rates post election proved temporary as investors realized many of Trump’s economic policies aren’t going through as quickly or as cleanly as first proposed (tax reform delay, health care reform delay, etc).
For those who missed the refinance window, you best try again now that interest rates have come back down. But if interest rates start going back up again, it’s wise to not pre-pay your mortgage until you are flush with cash or simply don’t know where else to invest.
Pay attention to what’s happening in the world and adjust your allocation of capital accordingly. I’ll help keep you abreast through topical posts and my monthly newsletter. Don’t be fixed in your way of thinking. So long as you have capital coming in, you have the luxury of figuring out how to best optimize your finances.
It’s comforting to know that sooner or later, our mortgages will be paid off and we’ll be able to drastically lower our cost of living or generate an increase in rental cash flow. We just have to decide how soon we want to experience that day.
In the short term, higher interest rates are bad for the real estate market. You’ve seen the homebuilding stocks decline by 20% – 30% in 2018. But over the long term, real estate will simply inflate with inflation as it generally has since the beginning of time.
Real Estate Recommendations
Explore real estate crowdsourcing opportunities: If you don’t have the downpayment to buy a property, don’t want to deal with the hassle of managing real estate, or don’t want to tie up your liquidity in physical real estate, take a look at Fundrise, one of the largest real estate crowdsourcing companies today.
Real estate is a key component of a diversified portfolio. Real estate crowdsourcing allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible. For example, cap rates are around 3% in San Francisco and New York City, but over 10% in the Midwest if you’re looking for strictly investing income returns.
Sign up and take a look at all the residential and commercial investment opportunities around the country Fundrise has to offer. It’s free to look.
Shop around for a mortgage: Check the latest mortgage rates online through LendingTree. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible from them or your existing bank. When banks compete, you win.
Updated for 2019 and beyond. With rates up, it’s good to borrow less and pay down more debt.