- Posted by NateKragness on September 25, 2009
Many households send in additional payments on their mortgage from time to time, but does this make prudent financial sense? When you pay down your mortgage balance, you decrease the future interest you will pay on your loan by a certain amount. But, you also lose the ability to invest the money you send in on other investments. In other words, if you send $500 to your mortgage company every month, that's $500 you can't be investing elsewhere. So, the opportunity cost of making extra payments towards your mortgage is that you can't invest that money somewhere else. Thus, it only makes sense to pay down your mortgage balance if you can't get a better return elsewhere.
For example, suppose you have a 30-year interest-only mortgage of $300,000 at 6.0% -- this means you would be paying $1,500 per month in interest on the loan. Now, suppose you receive an unexpected windfall of $10,000 and are faced with the decision of what to do wiith it. If you pay it towards your mortgage, you will reduce your balance by $10,000, which at 6% interest would save you $18,000 over the course of the loan. At first glance, it doesn't seem like a bad idea -- after all, it's probably more than a bank will pay you to keep your money in a savings account. But, since you are most likely getting a tax deduction on your mortgage interest, this means that you are essentially increasing your tax liability by paying down your mortgage interest. When taxes are working against your investment, it slows down your asset growth. Because of these tax ramifications, if you're in the 25% tax bracket, you would only be earning 4.5% interest by paying down your 6% loan; it turns out that $10,000 investment would only save $13,500 over the course of the loan. That's not a great return, and it's an illiquid investment as well -- while you will save money on your mortgage payment every month, you won't be able to get that $10,000 back. If I'm giving up money that I can't touch for thirty years, I want a better return than 4.5%. The opportunity cost is too great to invest in paying down my mortgage.
So, where can we re-direct that money to get a better return? Consider that the historical rate of the S&P 500, which roughly approximates the general returns of the stock market, hovers at just above 9% annually. If you invest that same $10,000 into the stock market, and earned average returns over 30 years, your investment would be worth about $27,000. Regardless of your tax bracket, that's still a lot more money than you would get by making an extra mortgage payment. And, you gain the benefit of liquidity: you have the option to sell off some or all of your assets at any. So, unless you have a very high interest rate on your mortgage, it's generally better to invest your money somewhere that has the potential for higher returns. If you make a 4.5% investment when you could be earning 9%, the opportunity cost of the equation implies that you're actually losing money by picking the relatively lower return.
Of course, there are situations when paying down the mortgage makes emotional sense, and that can be reason enough to abandon financial prudence. Having a general peace of mind about your financial situation is far more important than maximizing every possibly investment decision that you make, and if making extra principle payments improves your sanity, by all means, aggressively pay down your mortgage debt. There is no quantifiable price tag you can place on having peace of mind. For me, this comes from knowing that I'm making the most prudent decisions about my financial future, so I personally avoid paying down my low-interest mortgages, and instead let my money work in more aggressive investment vehicles. As much as I hate debt, mortgage or otherwise, if the opportunity cost of paying down those debts is simply too high, it behooves me to invest my money elsewhere, at higher returns, while continuing to make the minimum payments on my low-interest money.
- Posted by NateKragness on September 23, 2009
Card rebates aren't what they used to be, but there are still some excellent deals out there. The best general-purpose card right now is the Charles Schwab Invest First Visa. It gives you 2% back on everything you buy as a credit to your Charles Schwab brokerage account every month. This is great, since (a) 2% is the best you can get, and (b) most credit cards credit your cash back annually, not each and every month. Once you are credited your monthly rebate, you can easily transfer it directly into your bank account at any time. But there are additional steps you can take, aside from getting the best credit card, to maximize your spending rewards. So get this card if you don't have it already, and move on to the next step.
Once you have applied for your new card, or if you have one already, create an account over at U-Promise, a site that gives you cash back for things like dining out, or buying something in the supermarket, and paying with your credit card. You don't have to do anything special aside from a one-time registration of your card, and you occasionally get cash rewards credited to your account by using your card as you normally would. You can designate anyone (including yourself) as a beneficiary, so this is a great way to begin saving for yourself, a relative, or anyone else that you choose. Setting up your account only takes a moment, so go register now. Note that since the fund is designated as a 529 education savings plan, unless you are using the money towards your tuition you will incur a small penalty for withdrawing your money. But remember, paying a 10% penalty on money that didn't cost you anything is a lot better than not having the money at all!
Finally, make sure that any time you buy something online, you check to see what rebates are available. Use evreward.com, where you can enter a merchant name and get the cash-back results from various providers. You can usually find U-Promise amongst the results, along with at least several other companies. Using this data, you can make a decision which rewards company you want to use. Sometimes the differences between companies can be substantial, so always check evreward.com first, before you buy anything online.
For those who are really looking to maximize their rebates, consider a card like the Discover Get More in additional to the Charles Schwab Invest First Visa. The Discover card has various categories that pay you 5% cash back, and the categories change four times a year. By keeping track of which categories are active as you spend (use this calendar), you can manage a 5% rebate on gas, restaurants, travel, and many other categories. The best part is that the 5% cash-back is completely separate from your U-Promise bonuses, so using both can result in as much at 10% off purchases, and all you have to do is sign up once and forget about it.