Long-term investments may trump cost of mortgage loan

At a time when the stock market isn’t performing so well, some homeowners are wondering whether they should shift any extra cash toward their mortgages rather than make new investments.

Increased mortgage payments lead to lower interest costs during the life of the loan.

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Local financial and mortgage experts say that long-term investments usually will beat out the cost of the loan – so they usually advise against paying down a mortgage – but there are a few cases when it does make sense.

To figure out which is the best move, investors must consider their loan rates, tax rates and risk tolerance in their investments, among many other things.

The first thing to consider is your after-tax mortgage costs, said Lou Barnes, with Lafayette-based Boulder West Financial Services.

“At a 6 percent loan rate your after-tax costs may be about 4.5 percent to borrow that money,” he said. “The likely long-term return on Boulder Valley real estate and a diversified investment portfolio is likely double that mortgage cost.”

For example, if a homeowner is borrowing money at an after-tax cost of 4.5 percent and seeing average returns of about 8 percent in long-term investments, then it makes sense to continue borrowing the money and put any extra money into investments.

In the midst of a U.S. bear market – down 20 percent from its highs – the math may be working against investors this year. Still, they need to look at the long term, said Robert Pyle, with Boulder-based Diversified Asset Management Inc. Consider the average return of those investments during the past 10 years, not just one year, he said.

The investments also provide greater cash liquidity in case of an emergency, Pyle said. “If you lose your job and need money, it’s harder to get that out of your home than it is to take it out of your investments.”

Both Pyle and Barnes said homeowners should try to maximize tax-free investments such as 401(k)s and IRAs before they consider increasing their mortgage payments.

All that being said, there are conditions when it makes sense to pay down your mortgage first, Pyle and Barnes said.

One is if the homeowner is a very conservative investor – usually placing their extra money into savings accounts or certificate of deposits that don’t pay much interest.

So, if a homeowner is borrowing money at an after-tax cost of 4.5 percent, but only seeing a 3 percent return on a CD or savings rate, then he or she is losing money in the deal. In this case, it may be smarter to pay down the mortgage.

Another scenario might be if the homeowner is paying a higher loan rate, such as 8 percent or 9 percent on a second mortgage. It’s tougher to beat those higher borrowing rates with investments.

“When you start getting up to loans at 8 or 9 percent then it might be worthwhile to try and pay down that loan,” Pyle said. “If it’s an adjustable rate you want look at the worst-case scenario and consider how high that loan rate could get,” versus what you expect from your investments.

Barnes said some homeowners who made small down payments might also be advised to beef up the equity in their homes rather than invest the money. Having at least 20 percent equity in your home is usually a good idea, he said.

Homeowners should always check with their mortgage broker or bank before deciding to pay down their loan. Some mortgages have limits, fees or conditions on paying a mortgage at a faster pace. Make sure that by paying down your loan, you will promptly benefit from the interest savings, Pyle said.

Contact David Clucas at 303-440-4950 or e-mail dclucas@bcbr.com.