More D.I.N.K. Advice

You may recall my recent advice to Terry, the D.I.N.K. (double income, no kids), who hates debt and wanted to know if it was dumb for him to continue prepaying an extra $500 a month on his 8.5% mortgage. I told him to keep it up. He’d be getting the equivalent of a risk-free 8.5%. Not stellar, to be sure, but not at all bad, either — and, based on his query, something that will, rightly, make him feel good.

(Note that the 8.5% would be the equivalent of “tax-free,” too, if he doesn’t itemize deductions, because he gets no tax benefit from the mortgage interest. Tax-free, risk-free 8.5% is a stellar return. Note, too, that this same notion applies even if he does itemize — to the extent his other deductions don’t fully exhaust the standard deduction that he would have been allowed to take anyway. Say the standard deduction for him is $6,700 and that other than mortgage interest, he has only $3,500 in deductions, leaving $3,200 on the table. On that portion of his mortgage interest — $3,200 — he gets no extra tax benefit beyond what the standard deduction would have provided anyway, so on that portion 8.5% is really 8.5%, tax-free, risk-free.)

Well, as usual, you went me one better. Wrote Doug from St. Louis:

Wouldn’t the “DINK” be better off refinancing that “high rate” 8.5% loan down to the current 7.25% rate available for 10 year fixed loans in much of the country? If he just pays an additional $500 per month on his current mortgage, he’s still paying the higher interest. Or am I off base in my perception?

No, you are exactly right. He would be lowering the rate as well as paying it off sooner. Excellent suggestion (so long as the points/fees involved in the refinancing are not too high and there’s little likelihood of his moving soon).

Similarly, from Dr. Brent Wurfel:

Freddie Mac reported on August 21st that 15-year mortgages are at an average of 6.99 percent. Perhaps the DINK could refinance his 20-year loan for a 15 year one. The principal and interest payment are almost the same! For $80k the payments come to $694 (20-year 8.5%) and $718 (15 year 6.99%). Of course there are the refinance charges, but my mortgage broker has a streamlined refinancing program and maybe his company or bank does too. From the letter it didn’t sound like he is moving, so I would expect that he would be ahead after a year or two. I did the calculation at http://www.smartcalc.com/cgi-bin/smartcalc/hom15.cgi.

Exactly. Same excellent suggestion.

Which then raises the question: at a 7% interest rate, does it still make sense to make extra payments to pay down the mortgage? And the answer is: maybe, but it’s obviously less compelling than at 8.5%.

Once the interest rate is low enough, it’s really kinda dumb to pay it off any faster than you have to. Just what “low enough” means depends on your investment alternatives, tax situation and your own personal preferences. And requires you to make some guesses about the future. There’s no hard-and-fast rule.

With a really low-interest-rate loan, a 30-year maturity might actually be better than a 10-or 15-year pay-off — especially if the mortgage were assumable. Imagine how nice it would be if, unexpectedly trying to sell the house 6 years from now, when mortgage rates had, let’s say, zoomed, you could advertise that your house came with an assumable low-interest mortgage.

Dr. Wurfel also reminds Terry to check to see whether he is paying mortgage insurance and, if he is and he can, get out of it. Many homebuyers have to take out mortgage insurance to get a loan. Once they’ve paid it down and/or the value of the property has risen enough to meet the lender’s requirements, they should be able to have this extra fee dropped. A lot of people forget to do so. (And a lot of lenders don’t make it easy.)

And here’s another idea. In refinancing, Terry should consider the lower rate he could get with an adjustable rate mortgage. Yes, they require somewhat shrewder shopping; there are more pitfalls to avoid. But basically, a good honest ARM is going to cost even less than a fixed-rate mortgage, because with the fixed-rate mortgage you are in effect paying the bank (which then lays it off on bond investors) to take the risk of rising interest rates. You can pocket that premium if you’re willing to take that risk yourself — and since you can afford to pay $500 a month more than you currently pay, you certainly could afford that risk.

Finally, a question from Berkeley:

Following up on today’s column, my partner and I are in the market to be first time home buyers. We are DINKS with a good investing plan in place. Here in Berkeley, CA, housing is, of course, ridiculously expensive. So I’m curious if you advise paying down a mortgage generally, or only if one can’t stand debt or has oodles of extra money. I’m inclined to invest the “extra” cash in the market, and see our mortgage as our never-ending housing cost. Am I on the right track here?

There’s no one right track in this situation, but you’re on a perfectly good one. Especially at today’s modest rates, and if you’re in a high tax bracket (which is all but unavoidable if you live in California), a mortgage clearly is not debt that needs to be paid down quickly. Unlike a car loan or credit card debt, the interest is tax deductible and the thing you’ve borrowed for may actually appreciate rather than depreciate (in the case of a car) or disappear (in the case of a dinner). But if you happen to be in one of those rent-controlled apartments Berkeley is famous for, and if the houses you’re considering are indeed ridiculously expensive (and don’t forget the cost of earthquake insurance, fire insurance, repairs and so on), maybe you should consider staying put and using the enormous savings to buy a vacation home someplace that’s ridiculously underpriced.

Tomorrow: Offshore Funds

Coming Soon: Top 10 Reasons to Buy (Multiple Copies of) My New Book