Big-ticket items have been relegated to the back burner for now. The reduce-your-debt environment continues — just ask the major home-improvement contractors who have taken on more and more jobs.
Consumers clearly are pulling in the financial reins. One of the reasons Congress has passed a stimulus package is to get Americans to loosen their grip, spend more cash and begin to turn the economy around.
I’ve always been a pay-it-off kind of guy when it comes to home loans. I believe there are huge benefits — financial and philosophical — to owning the roof over your head. When that roof now covers your office, as it does for millions of small-business owners across the country, isn’t there an extra incentive to make a bigger dent in the domestic debt load as we get older?
Now, with the residential real estate 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.
But should the same philosophy hold true for the family cabin? Should you pay it off or diversify?
According to Jack Guttentag, professor of finance emeritus at the Wharton School of the University of Pennsylvania, consumers should view the yield of principal prepayments on their mortgage as equal to the interest rate on their loan — as long as there is no prepayment penalty included in the loan. Hence, if you are paying 6 percent on your loan, prepaying your mortgage would make more sense than plunking any extra cash into a savings account paying 2-3 percent interest.
Guttentag also states that if the yield on mortgage repayment is being compared to the yield on other taxable investments, it doesn’t matter whether yield is measured before tax or after tax (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 similar way to Guttentag’s guidelines of weighing the yield of a potential investment against the interest rate of your loan.
I have also subscribed to the belief that average consumers should never invest money they can’t afford to lose. For example, I cringe when I hear of folks taking the monthly grocery money and plunking it down on a stock tip they overheard at the high-school basketball game. But 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 always need to be weighed are risk, comfort and discipline to carry out the work. Would I have the discipline to actually invest additional cash instead of paying off the mortgage? How would I feel if a sure-bet stock went bust, blowing not only my hard-earned extra dollars but also the chance of reducing the number of years on my 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 money in the form of mortgage interest by prepaying your loan. In fact, if you make an extra payment on your principal every month, you can reduce the loan term of a 30-year loan by approximately 12 years. Conversely, by prepaying the loan, you also lose a piece of your mortgage-interest deduction. Your actual savings is computed with your marginal tax rate and you mortgage interest rate.
There are several home-loan-acceleration computer programs that show you the cost-effectiveness of various options in the mortgage market. Guttentag’s site, www.mtgprofessor.com, offers several excellent calculators, as does www.smartmoney.com.
To get even more valuable advice from Tom, visit his Second Home Center.
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