It might make sense to prepay home No. 2
With the residential market in slow motion, consumers are looking at all sorts of ways to reduce their debt, save interest dollars and pave a faster path to real equity.
The pay-it-off philosophy has both peace-of-mind and financial benefits when it comes to the roof over your head. But does the same hold true for the family cabin? Should you pay it off or diversify?
Consumers considering principal prepayments should look to interest rates for the answer -- as long as there is no prepayment penalty included in the loan -- according to Jack Guttentag, professor emeritus of finance at the Wharton School of the University of Pennsylvania, who writes a nationally syndicated mortgage column that appears in these pages from time to time. If you are paying 6% on your loan, for example, prepaying your mortgage would make more sense than plunking any extra cash into a savings account paying 2% to 3% interest.
If the yield on mortgage repayment is being compared to the yield on other taxable investments, Guttentag says, it doesn’t matter whether the yield is measured before tax or after tax (though tax-exempt bonds could be an exception).
Many financial planners will tell you that folks simply don’t focus on stashing away retirement dollars until the loan on the family home is paid in full. The second home, by definition, is “extra.” If the primary residence is owned free and clear, paying off the second home would be a forced savings account and be judged in a way similar to Guttentag’s guidelines of weighing the yield of a potential investment against the interest rate of the loan.
Stashing extra cash into the mortgage of a second home is a secure investment, especially if the cabin will show long-term appreciation.
The factors that need to be considered before deciding to prepay a mortgage or invest elsewhere are risk, comfort and discipline. Would you have the discipline to actually invest additional cash instead of paying off the mortgage? What if a sure-bet stock went bust, blowing not only your hard-earned extra dollars but also the chance of reducing the number of years on the cabin loan?
Are you one to dig in, do the research and then work the numbers with a broker or handle the transactions yourself? The real challenge for the average consumer is having the discipline to carry out the challenge. Keep in mind that the biggest mistake common investors make is overestimating net returns over the long term.
Remember, you can save a great deal of mortgage interest money by prepaying your loan. In fact, if you make an extra payment on your principal every month, you can reduce the term of a 30-year loan by about 12 years. Conversely, by prepaying the loan, you also lose a piece of your mortgage-interest deduction. Your actual savings are computed with your marginal tax rate and your mortgage interest rate.
There are several home-loan acceleration computer programs that can show you the cost-effectiveness of various options in the mortgage market. Guttentag’s site, at www.mtgprofessor.com, offers several excellent calculators as do many other websites.
Tom Kelly’s new book, “Cashing In on a Second Home in Central America,” was written with Mitch Creekmore and Jeff Hornberger.
