Do NOT Prepay Your Mortgage

As pointed out in the article below there are many good reasons for prepaying your mortgage on a monthly basis. But if you are in a securitized mortgage and you are either underwater or facing payments that are resetting, be aware that any prepayments will take you far out of the running for any modification. Yours will be a super-performing mortgage that doesn’t “qualify” for even a first look at modification. In addition, if there is a new mortgage, or elimination of the mortgage, note or obligation in store for you, you will have sent the money down a rabbit hole.

March 19, 2010

When Not to Pay Down a Mortgage

By RON LIEBER

New York Times

This week, the Federal Reserve reaffirmed its intention to stop buying mortgage-backed securities, signaling the likelihood that the mortgage rates you can get today are as good as they’re going to be for a long while. Once the Fed stops buying, after all, rates are likely to go up.

And current rates are quite good. At about 5 percent, in fact, they’re so good that they’ve helped change the age-old debate over whether homeowners should make extra mortgage payments to pay off their debt well before their loan periods are up.

Back when rates ran at 7 or 8 percent, making extra payments offered what amounted to a guaranteed return on your money. When you’re ridding yourself of debt that costs you much less, however, it’s easier to imagine a future when you could more easily earn a higher return by investing those potential extra mortgage payments someplace else.

Meanwhile, at a time when just about everyone knows someone who is unemployed or who owes more on a home loan than the house is worth, keeping extra cash someplace more liquid than a mortgage seems like a safer approach.

So is the case against extra payments closed for good, given that so many people have locked in rock-bottom mortgage rates for the long haul?

The answer depends on two things: how likely you are to leave the extra money in savings and how good it would feel to wipe your debt out years earlier than your mortgage requires.

THE BASICS First, let’s dispense with the standard boilerplate. Don’t even think about making extra mortgage payments unless you’ve paid off higher-interest debt. Credit card debt is the easiest win here.

Also, if you’re not saving enough to get the full match from your employer in a 401(k) or similar account, increase your savings there first. And don’t make extra mortgage payments if you don’t already have a decent emergency fund set aside.

YOUR REAL INTEREST RATE Now, take a look at the interest rate on your mortgage. That 5 percent? It’s not your real rate if you get some of the interest back each year in the form of a tax deduction.

Let’s say you have a household income of $175,000 and are paying 35 percent of that in total to the state and federal tax collectors. If you pay $20,000 in mortgage interest each year on a loan that charges 5 percent, the deduction effectively brings your taxable income down to $155,000.

As a result, you’re paying $7,500 (35 percent of $20,000) less in taxes than you would have without the deduction. So ultimately, you’re not really paying $20,000 in interest at all; your net cost is $12,500 after you subtract the $7,500 tax savings.

And that makes your effective, after-tax interest rate on your loan just 3.25 percent, which is simply 35 percent (your tax rate) less than the original 5 percent.

BETTER RETURNS? So any money you set aside in lieu of making extra mortgage payments would need to earn more than 3.25 percent annually. That seems like a reasonable possibility in the future.

In fact, you could have done that well during the supposedly lost decade we just finished. Vanguard Wellington, for instance, a popular low-cost mutual fund that holds about 65 percent stocks and 35 percent bonds and other short-term securities, earned an average annual return of 6.15 percent in the 10 years ended Dec. 31, 2009.

The Vanguard Balanced Index Fund would not have outperformed our 3.25 percent benchmark, however, as it only returned 2.64 percent over the same 10-year period.

STORING THE SAVINGS Wouldn’t taxes eat into the returns from the money you’d save instead of making extra mortgage payments? Not if you place it into an account shielded from taxes. A Roth individual retirement account would fit the bill here, as would a 529 college savings account or health savings account.

Bruce Primeau, whose note to his financial planning clients at Wide Financial Group in Minneapolis on this topic inspired me to re-examine it, adds that this isn’t simply about keeping more assets under his watch so he can earn a better living. “I’m not telling them that the money has to come to me,” he said. “A 401(k) match beats the return on paying a mortgage off automatically. There’s real estate and buying employer stock through a purchase plan at a 15 percent discount and all kinds of things.”

Then you need to preserve those savings. When extra money goes toward a mortgage, it’s hard to get at it when the urge strikes to flee to an Asian beach for a few weeks of playtime. If the money is not locked up in retirement or college savings, however, you may be tempted to spend it.

THE LIQUIDITY PROBLEM Capital-gains taxes might eventually come due with some of these investments, and the rate could well rise above the current 15 percent long-term rate before too long. Still, having some of your savings in a taxable account makes sense for several reasons.

If you hit a stretch of long-term unemployment after having plowed most of your extra cash into paying down your mortgage, your bank probably won’t pat you on the back for being a good saver and give the money back to you. Nor is it likely to let you borrow it through a home equity loan if you have no income with which to repay it.

Elaine Scoggins, who had the mortgage department chief reporting to her at a bank before she became a financial planner, suggests imagining a situation where you need to move quickly but can’t sell your home or extract equity to use as a down payment in your new town. Given that possibility, why create more home equity through extra mortgage payments than you have to?

“The whole housing debacle has reminded us all, including me, that real estate is not liquid,” said Ms. Scoggins, who is the client experience director for Merriman, a planning firm in Seattle. “And it takes cash to support it.”

Those who have used their cash in an attempt to be conscientious have learned some tough lessons, meanwhile. Imagine people who scraped together a 5 percent down payment and bought a home in Florida or Arizona in 2005 and then made extra mortgage payments the first two years to try to increase their equity. Now, post-collapse, they owe, say, 30 percent more than their homes are worth and need to seriously consider walking away from the loan — and all of those extra payments.

REASON AND EMOTION So the reasoned case for making no extra payments is very strong. But there’s one counterpoint that almost always carries the day, even when there’s only a mild risk with the financial strategy of putting extra money elsewhere.

And it’s this: I need to be able to sleep at night.

Even Mr. Primeau concedes here. “Emotionally, you’re right, and financially I’m right, and emotionally, you win,” he said. “If emotionally, people want to pay down their debt, than that’s what I help them to do.”

If you’ve just started paying down your mortgage, any extra payments should go toward principal (make sure your mortgage company is applying it properly). That will have the effect of shortening the term of your loan from, say, 30 to 25 years, depending on how many extra payments you make. The extra payments won’t lower your monthly payment, but they will reduce your balance.

Many people who are years into their mortgages — and perhaps paying less in interest and getting less of a tax break as a result — tend to develop stronger feelings about making extra payments. Those feelings are often even more acute as retirement approaches and homeowners become determined to quit work with no debt to their names.

Those who do retire their debt rarely regret it or wring their hands over the big gains they might have scored by investing the money elsewhere. Tim Maurer, a financial planner and co-author of “The Financial Crossroads,” describes the feeling that washes over people who have paid their last mortgage bill as “beholden to no one.”

So he doesn’t feel as if it’s his business to separate people from their emotions if they feel strongly about working toward a debt-free existence. “The whole point of planning is to make life better,” he said. “It’s not to have more dollars at the end of the day.”

2 Responses

  1. My storie is about Bank of America an me losing my home in 2007 on a short sell trying not two be foreclosed on in 1967 my house brought for $15000 then my house flip upside down an I own $242000 on it I kept on paying the mortgage on it but they kept rising the loan each month started $1100 to$1500to$1800to$2400 an so on boing I could em keep up so I was force to do a short sell in stead of letting them foreclose on me then they promise if I agreed with the short sale they’ll give me $13000 to relocate but some how I only got $3000 stating some sneaky reason

  2. MORTGAGES; FORECLOSURE; STANDING: Although state law requires that the defendant raise the issue of standing at the beginning of a case, where foreclosure defendant does not appear and files no response, court may raise standing issue independently and will dismiss if it determines that filed papers do not support verified complaint stating that plaintiff is owner of the note and mortgage.

    Deutsche Bank National Trust Co. v. McRae, 2010 Westlaw 309105 (N.J. Sup. 1/25/10)

    This case likely is a product of the current turmoil, well known to the New York courts, concerning whether mortgagees seeking to foreclose in fact have control over the debt. New York law apparently that the mortgagee of a “high cost home loan, or the mortgagee’s agent, demonstrate when filing for foreclosure that it “is the owner and holder of the mortgage and note.”

    “1. Any complaint served in a proceeding initiated pursuant to this article relating to a high-cost home loan or a subprime home loan, as such terms are defined in section six-l and six-m of the banking law, respectively, must contain an affirmative allegation that at the time the proceeding is commenced, the plaintiff:

    (a) is the owner and holder of the subject mortgage and note, or has been delegated the authority to institute a mortgage foreclosure action by the owner and holder of the subject mortgage and note; and

    (b) has complied with all of the provisions of section five hundred ninety-five-a of the banking law and any rules and regulations promulgated thereunder, section six-l or six-m of the banking law, and section thirteen hundred four of this article.

    2. It shall be a defense to an action to foreclose a mortgage for a high-cost home loan or subprime home loan that the terms of the home loan or the actions of the lender violate any provision of section six-l or six-m of the banking law or section thirteen hundred four of this article.”

    It is not clear whether possession of the debt might be deemed the possession of the rights under the mortgage. The editor would venture the conclusion “probably not.” but that issue is moot in this case, because the question raised by the court on its own motion was whether the mortgagee in fact held the note at the time of filing for foreclosure. There was a written assignment of the mortgaage.

    As indicated the mortgagee filed a verified complaint stating that is was the owner of the note and mortgage, but the attorney’s verified the complaint on the basis of “information and belief.” It attached a xerox copy of the note, made out to original lender, was attached to the complaint filing. The court commented that this clearly does not satisfy the statutory standards for ownership of the note

    The judge first determined that the mortgagee had not met New York’s new statutory procedure mandating a kind of mediation period prior to final foreclosure, and also that it had not demonstrated to the court’s satisfaction that it owned the note and mortgage. In this opinion, the court does not give the basis for that original opinion.

    Later, after meeting the requirement concerning mediation, the mortgagee sought to reargue the question as to whether it was the holder of the note. This time it attached a copy of the note that contained an endorsement of the note from the original mortgagee to an apparent related party to the original mortgagee and then an endorsement in blank, executed by the original mortgagee. Both were undated. The judge did not indicate whether these endorsements were on the note body itself or in allonges attached to the note.

    Although there was authority, and the statute suggested, that issues of possession of the note are to be raised defensively at the first hearing, the judge determined that, in the absence of the mortgagor or its counsel at that hearing, the court should represent the interest of the mortgagor and make a ruling on standing where appropriate.

    “Today, with multiple and (and often unrecorded) assignments of mortgage obligations and multiple securitizations often related to the same debt, the courts should carefully scrutinize the status of parties who claim the right to enforce these mortgage obligations. For the unrepresented homeowner, the issues of standing and real party in interest status of the foreclosing party are never considered. Without such scrutiny, there is a risk that the courts will give the judicial “seal of approval” to foreclosures against unrepresented homeowners who have little, if any, understanding of these issues, much less the legal significance thereof. To quote my colleague in Kings County, “[a]llowing this case to proceed on behalf of a plaintiff without standing at the commencement of the action would [also] open the door to potential fraud and place in jeopardy the integrity of title to the property to be foreclosed.”

    Comment: This case could have been avoided easily if the parties responsible for the foreclosure had arranged their ducks in a row prior to filing. They clearly had an assignment of the mortgage and control over the note. But the editor agrees that the circumstances suggest that the formal endorsements of the note did not occur until after the mortgage was first filed. And it might have been difficult for the mortgagee to demonstrate that the original note was actually in possession of the foreclosing party, unendorsed, prior to the filing.

    There is a lot of fuss and feathers about the propriety of behavior of mortgage foreclosure lawyers. It seems likely that, in the past, they routinely fudged the rules because, after all the debt was not paid and the mortgagor was not contesting the foreclosure proceeding. No more fudging. But why haven’t they heard this message already???

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