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


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.”

A Thought About Bankruptcy Petitions: Creditor ID

Upon finding that a portion of those payments should be applied to the subject loan, the declaration of default would be invalid because it would either be wrong inasmuch that the third party payments would at least be prepayments of future monthly payments, or wrong because the third party payments reflected an inaccurate accounting of the principal due.

OK let’s be clear that I don’t know bankruptcy well enough to even have an opinion, but I do have an idea and I would like this post forwarded to bankruptcy attorneys to get their reaction.

Here is the proposition: A Petitioner files for bankruptcy where one of the issues is a securitized loan. My idea is that the schedules NOT show the any of the known parties as creditors, because they are not. Especially if you have an expert opinion that describes the creditors as being unnamed but readily identifiable investors if the servicer will respond properly to the Qualified Written Request.

Upon reflection I don’t see why we would name the pretender lenders as creditors at all. I would leave them off the list of creditors (on any new cases filed) because they are not creditors. Maybe file amended schedules removing them. I would disclose the non-judicial foreclosure attempt wherever you can do that of course. Show the house as an asset with undetermined value. Wouldn’t that force them into being proactive? They would have to say “Hey! We are creditors secured by this property.” That would force the burden of proof onto them even as to standing, wouldn’t it?

Can someone who is not a creditor on the schedules file a proof of claim? What happens if you deny the claim and deny they are creditors? Do THEY have to file the adversary? Your position would be that you have this Expert Declaration that identifies the creditors, at least by description, and these would-be foreclosers don’t meet the description. So you disclosed the fact that they were claiming a default but you deny they are even creditors, much less secured.

It would seem that this would force them into proving to a bankruptcy court that they actually have authority which in turn would require them to produce all the documents granting them that authority. It also seems to me that they would have to come up with a full accounting for all payments from all parties, including from credit default swaps, insurance and Federal bailouts.

In the course of the proceedings, your allegation would be that they did in fact receive third party payments as has been widely reported by the press. They would probably answer something like those payments are irrelevant.

Your response to their assertion is to ask the court, who decides whether third party payments are relevant or not — the court or the creditor? The court would most likely order them to disclose all such third party payments along with documentation thereon so that the court could determine whether the payments should be applied to the pools in which the subject mortgage loan is Located” (assuming the assignments are valid), and then in turn determine what percentage of the payment should be allocated to the subject loan.

Upon finding that a portion of those payments should be applied to the subject loan, the declaration of default would be invalid because it would either be wrong inasmuch that the third party payments would at least be prepayments of future monthly payments, or wrong because the third party payments reflected an inaccurate accounting of the principal due.


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