Archives for September 2009

I received an interesting reader question last week about a scenario where you are very sure that you’re going to sell your house in a few years. In that case, would paying down your mortgage principal create an opportunity for a relatively high return with minimal risk? The e-mail:

Your blog is very insightful. I had an idea that I wanted to run by you. I plan to list my condo for sale in about 14 months. Currently I have a 2nd mortgage with an 8.875% rate. I want to have the most net cash at the time of sale, so I’m thinking the safest investment I can make over the next 14 months is to pay down this mortgage. If my math is correct, I would get a 4.9% return on the avoided interest (less what I would have gotten back from deductions). Am I crazy, or does it seem like I’ve found a good place to put my cash until I leave?

I’m not a mortgage professional, but it would seem to me that in theory this should work. When you make the additional principal payments, every future mortgage payment will also include less interest and more towards paying the loan balance down even faster. When you sell the house, you’ll get your “return” from this lower loan balance.

The annul return from paying down your principal should be roughly equal to the annual interest rate of your loan. The reader had an 8.875% second mortgage, which would seem like a pretty great short-term return over 14 months. The exact return might be a little off to the amortization schedule, it should be close. The mortgage interest may be tax-deductible, but remember that interest from a bank CD outside an IRA is also fully taxable. Check out these related posts:

• Amortization Schedules and Principal Prepayment, Part 1: Shortening a 30-Year Mortgage Into 15
• Amortization Schedules and Principal Prepayment, Part 2: Verification of Returns

Within the posts above, based on the amortization schedule of a 30-year fixed mortgage at a 5% interest rate, I plotted both the effective interest rate paid and the annual investment return from prepaying below:

I suppose that one big risk in doing this is that you don’t end up selling the house, so your cash is now stuck in the home’s equity and will be more difficult to access. So you’ll have to be fairly confident that you will be selling the house, or at least be okay with the possibility of just having a smaller mortgage balance.

I hope that all of you in the Atlanta metro area are safe and dry right now. I’d also like to take this chance to correct a common misconception, which is often promoted by the media every time a flood occurs. As just one example, take this CNN article:

He hustled out of bed and rushed to the door. There were his neighbors, surrounded by floodwaters the neighborhood is supposed to experience only once every 100 years.

The highlighted sentence is not accurate, and gets people thinking strange thoughts like “Oh the last flood was in 1969, I should be good until 2069 or so”. The fact is there is a reason we hear about such floods all the time. Let’s look at what FEMA has to say:

The term “100-year flood” is misleading. It is not the flood that will occur once every 100 years. Rather, it is the flood elevation that has a 1-percent chance of being equaled or exceeded each year. Thus, the 100-year flood could occur more than once in a relatively short period of time.

Again, if you live in a 100-year floodplain, you have 1 percent chance of being flooded every year. Think of how concerned you’d be if you were told there was a 1-in-100 chance of your house burning down every year. The way the math works out, this means that over a 30-year mortgage, there is a 26% chance you’ll have a 100-year flood during that time period (1 – (0.99)³⁰). This is also why most people with home loans in such areas are required to buy flood insurance.

Many people are in 500-year flood plains, which gets people even less worried. “The last flood was in 1909, we’re good for another 400 years!” Actually, having a 0.2% chance of a flood each and every year works out to a 6% chance of occurring at least once over a span of 30 years, or 1-in-17.

If you haven’t already, take some time and check if you are in a flood plain here. Some may consider buying flood insurance even if you are not required to by your mortgage lender. We ended up buying a modest amount of building coverage from the NFIP.