Manage Your Home
Like an Investment

May 6, 2003 -- Smart investing begins at home.

Many folks diligently nurture their portfolios of stocks, bonds and mutual funds. Got a mortgage on your house? You should manage your home loan with the same sort of investment savvy.

Planning to refinance? Considering extra principal payments? Here's how to make smarter decisions when handling your mortgage:

Reducing Your Rate

Imagine you bought your house seven years ago. At the time, you borrowed $200,000 through a 30-year mortgage with a fixed 7% rate, resulting in a monthly mortgage payment of $1,331. Now, a loan officer at the local bank says that, for $2,500 in fees, you could refinance and get a new 30-year loan at 6%.

At first blush, that might seem appealing. Your seven years of mortgage payments has left you with a loan balance of $182,295. If you refinanced that sum at 6% over 30 years, your monthly payment would drop to $1,093.

A sweet deal? It isn't quite as sweet as it seems. Think about it: You are replacing what's now a 23-year loan with a 30-year loan. Even if your mortgage rate stayed the same, your monthly payment would still drop, because you are now paying back the sum borrowed over an additional seven years.

Instead, to make a fair comparison, you have to compare your current 23-year 7% loan with a new 23-year 6% loan. To that end, try playing with mortgage calculators at sites like www.bankrate.com, www.hsh.com, www.mortgage-x.com and www.realestateabc.com.

If you compare the two 23-year loans, you'll find you could save $111 a month by refinancing. Divide that $111 into the $2,500 in fees. Result: Refinancing makes sense, provided you stay in your current house for just over 22 months.

Your local bank won't actually offer you a 23-year loan. Instead, you might opt for, say, a 20-year loan. But taking that shorter loan could be a smart move, says Michael Maloon, a financial planner in San Ramon, Calif.

"If people are refinancing and going back to a 30-year mortgage, they're crazy," he contends. "If you do that and you end up with an extra couple of hundred dollars a month in discretionary income, you will get used to spending that amount. Now, you need even more to retire," because you are accustomed to a higher standard of living.

Instead, Mr. Maloon argues that folks who refinance should look to shorten the length of their loans, with a view to getting their mortgages paid off before they retire.

"To win in the refi game, you want to lower the rate, lower your payments and pay off your mortgage sooner," he says. "I don't know how you retire if you still have a mortgage."

Paying Down Principal

To get your mortgage paid off by the time you retire, you might also want to make extra principal payments. By adding $100 or $200 to each monthly mortgage check, you could save yourself thousands of dollars in interest and pay off your loan years earlier.

Sound attractive? To figure out whether this is the right strategy for you, consider not only the interest rate on your mortgage, but also your tax situation and what else you might do with the money.

Let's say you have a mortgage with a 6.5% interest rate. That 6.5% is the interest expense you avoid by making extra principal payments and thus that is the effective pretax rate of return you earn. You should be able to do better than that 6.5% by buying stocks or bonds within a retirement account or by purchasing stocks in a taxable account.

But what if you have maxed out on your retirement accounts and you already own plenty of stocks? What if the alternative is to buy bonds or certificates of deposit within your taxable account?

In that case, making extra principal payments could be a smart strategy.

Suppose you are choosing between paying down your 6.5% mortgage and buying a corporate bond for your taxable account that yields 5.5%. If your mortgage interest is tax-deductible and you are in the 27% federal income-tax bracket, the after-tax return from paying down your mortgage is 4.75%. But the after-tax return on the corporate bond would be even lower. After paying federal income taxes on the bond's 5.5% yield, you would be left with just 4.02%.

In fact, paying down your mortgage may garner you an even higher return. Imagine you are married and you file a joint tax return. In 2003, you and your spouse are entitled to a standard deduction of $7,950.

But let's assume you don't take the standard deduction. Instead, you itemize your deductions by filing Schedule A along with your federal tax return. This year, you expect to have itemized deductions of $10,000, consisting of $5,000 in mortgage interest and another $5,000 in property taxes, charitable gifts and state income taxes. Because your total of $10,000 in itemized deductions is greater than your $7,950 standard deduction, you save taxes by itemizing.

Even so, the tax benefit you get from your mortgage interest is still fairly modest. Indeed, I would argue that just $2,050 of your mortgage interest is truly tax-deductible.

The reason: If you had $2,050 less in annual mortgage interest, you would take the standard deduction instead and thus you wouldn't get any tax benefit from your mortgage.

Nonetheless, the after-tax return from adding an extra $100 to your mortgage check would still be 4.75%. How come? The interest you avoid by making extra principal payments is interest you could have deducted.

Eventually, however, as you pay down your mortgage and thereby reduce the amount of interest you incur each year, your itemized deductions will fall below $7,950 and you will take the standard deduction instead. At that point, the after-tax return from making extra principal payments jumps to the full 6.5%.

-- Mr. Clements writes the Getting Going column for The Wall Street Journal Online. WSJ.com subscribers can view past columns in the Getting Going archives.

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