10/14/2007

Last week, I began a series of columns about houses and mortgages. The overall theme is that your house is not an investment. In part, it's a big expense.

My goal is to offer insight into managing this expense so you will have more money to put into real investments.

I understand the enormous psychological benefit of paying off a mortgage in, say, 20 years or less. It's powerful enough that I congratulate people who do so.

However, most people also believe that paying off a mortgage early is a sensible financial goal. And that's just not the case.

Let's pretend for a minute that a house is a real investment.

From an investment standpoint, a house is attractive because you can control a very large asset with very little money (the down payment). Even better, you can borrow the balance at obscenely low rates.

If you behave as a true investor, you would take full advantage of those rates by using as little of your money as possible. The smaller the down payment, the larger your return.

If you pay an additional $200 a month toward principal, you are not adding one penny of value to your house. And you're killing your investment return.

Here's some math to consider: You buy a $100,000 house with a down payment of $20,000.

In the first year, the house rises in value by 4 percent, or $4,000. Your return is 20 percent ($4,000 divided by $20,000).

Let's say you set aside an additional $200 a month, or $2,400 for the year, toward the principal. Your return falls to 17.9 percent ($4,000 divided by $22,400).



I know what some of you might be thinking: By making extra payments, you've reduced the interest you'll have to pay.

That's where the obscenely low mortgage rates come in.

When interest rates are as low as they are these days, it makes no financial sense to pay off a mortgage quickly. If you're in the 25 percent tax bracket, a 6.5 percent mortgage effectively is as low as 4.9 percent.

Take that $200 and put it into a long-term investment instead, such as stocks or bonds. Ideally, you'd increase your contribution to a 401(k) plan or a Roth IRA.

Now, let's say you absolutely, positively want to pay off your $100,000 mortgage in 15 years. Giving any additional money to the mortgage company is a terrible way to do that.

Let's assume you get a 30-year mortgage at 6.25 percent and put another $250 a month toward the principal. Congratulations: in 178 months, your house will be paid off.

But if you had invested that $250, after 178 months you would have enough saved to pay off the balance owed on the house — and you'd have $5,000 left over. And I wasn't using some crazy investment return: Just 7.5 percent annually did the trick.

Is that return too high? In this scenario, an average annual return of 5.5 percent still would put the investor ahead.

Still not convinced? At least heed this advice: Don't make extra principal payments until you've eliminated other debt that carries a higher interest rate.

Pay down your car loans, credit cards and student loans before adding one extra penny toward your mortgage. When you're comparing rates, don't forget to include the tax benefit you receive from mortgage-interest deductions.

NEXT SUNDAY: More on mortgages