Mortgage payback: How much, how soon

To pay or not to pay is not the question. When it comes to your mortgage, the question is when. Should you pay off your mortgage early? What about biweekly payments, which allow you to make payments every two weeks instead of once a month? As tax time approaches, how does a shrinking mortgage affect your tax status?

The answer is not simply a matter of crunching numbers, says Kenneth J. Watter, a Certified Public Accountant and Certified Financial Planner in Bethesda who has guided individuals and small businesses in their financial planning for 17 years. Paying off a mortgage involves an emotional underpinning that is absent in other financial decisions, he notes.

"There is a real psychological aspect to this decision," he says. "You can't just go by the numbers."

For many people, the goal of owning a home "free and clear" has been handed down through generations; it's a measure of success in life. You might be better off holding onto your mortgage, but that's a decision that can be difficult to swallow.

Mortgage broker Daniel Rebibo, president of Rockville-based Mortgage One Inc., recalls one client, a man with a million-dollar portfolio and an uncanny ability to nose out the best investments who nevertheless insisted on paying off his mortgage even though to do so would cost him money in the long run.

"He told me he always took the advice of financial planners when it came to other decisions," Mr. Rebibo says, "but for him, the need to pay off his mortgage outran all other considerations."

Of course, understanding the numbers helps. So does comprehending the ins and outs of your particular type of loan.

For example, do you have a fixed-rate or adjustable-rate mortgage? Having one or the other may factor into your decision on whether to pay off your mortgage early.

A fixed-rate mortgage, as the term suggests, is a mortgage with an unchanging, or fixed, interest rate over a certain period of time, such as 15 or 30 years.

An adjustable-rate mortgage (ARM) differs from a fixed-rate loan in that the interest rate fluctuates over the life of the loan. An ARM may begin with a lower rate than a fixed-rate mortgage, then bump up over the years. At specific times over the life of the loan, such as every two, three, five or 10 years, your interest rate will be recalculated according to the economic indicator mandated by your particular loan.

Adjustable-rate mortgages often come with caps, which are designed to protect the buyer, the mortgage company or both. With a cap, the amount of interest you pay will not stray above or below a set rate.

For many people, an ARM is easier on the pocketbook, so the desire to pay off the loan early may not be quite as compelling as for those borrowers operating with a fixed-rate mortgage. If interest rates are steady or falling, an ARM can be less expensive over a long period than a fixed-rate mortgage. In the Washington area, the large number of military families and political appointees who move frequently may find adjustable-rate mortgages a viable alternative, Mr. Rebibo says.

Having an ARM includes a certain element of risk, however. There always is the likelihood that interest rates will increase. Because there are many different types of adjustable-rate mortgages, there can be considerable differences from loan to loan. It is important to be thoroughly aware of what your highest possible monthly payment could be.

"Nobody has a crystal ball," Mr. Watter says, "and with an adjustable-rate mortgage, sometimes that's what you need."

According to Mr. Watter, most people are better off with a fixed-rate mortgage, especially if they are planning to be in their home for a long period of time.

"These days, interest rates are low," he says. "You can get a decent fixed mortgage and lock in that low rate."

The length of your loan also may be a factor in determining whether to pay off your mortgage early. A shorter amortization period means your monthly payments will be higher, but that extra cash paid out each month repays your loan balance much more quickly, so less interest is paid over the life of the loan.

Generally, 15-year loans have lower interest rates than 30-year loans. They also can save you a great deal of money.

Mr. Rebibo provides the following example:

Suppose you have borrowed $100,00 at 6 3/4 percent interest, fixed, over 30 years. Your monthly payment will be $656.93. Over the life of the loan, you will have paid back $100,000 as the principal and $136,484 in interest.

Now, suppose you borrow $100,000 as a 15-year loan. In this case, your interest will be lower -6 7/8 percent - but your monthly payments will be higher: $878. Over the life of the loan, you will have paid $158,040, $100,000 as the principal and $58,040 in interest.

When you are in the early stages of repaying a loan, more of your payment goes toward the interest than toward the principal. If the loan is in its later stages, the situation is reversed. Because only the interest on a mortgage is tax deductible, this process of amortization means that you conceivably can claim a greater deduction in the early stages of a loan.

Not having a loan at all, of course, means no interest-based deduction - and such deductions can be sizable.

"For mortgages, you can write off interest for up to two residences up to $1 million," Mr. Watter says, "and you can claim up to $100,000 for a home-equity loan."

Your age also is a consideration in deciding whether to pay off your loan early.

"If you are 40 years old, to lose practically the only deduction the government gives you, particularly in today's market, where interest rates are low, may be a waste of money," Mr. Rebibo says. "But if you are older and on the verge of a fixed income, owning your home free and clear may be an advantage."

Then there are the loan payments themselves. Traditionally, most homeowners made their mortgage payments once a month. That means 12 payments per year. Making half your payment every two weeks, or biweekly, means you make 26 payments a year, or 13 full payments.

Biweekly payments often are charted to the same schedule as pay periods, meaning that the mortgage repayment process can be practically painless as payments are deducted automatically from your checking or savings account.

That extra or 13th payment can save you tens of thousands of dollars over the life of your loan.

For example, suppose you borrowed $100,000 to be paid back over 30 years with an interest rate fixed at 10 percent. Making an extra payment each year would mean you would save $69,448 over the life of the loan and pay it off in 21 years instead of 30.

There are a few caveats when paying biweekly, however. For one thing, institutions often charge to set up a biweekly payment plan. Outside agencies that promise to handle payments biweekly also charge a service fee. You may want to check to make sure your loan doesn't include a prepayment penalty.

The alternative? "Be disciplined," Mr. Rebibo says. Set up a biweekly payment schedule on your own, or make an additional payment at the end of the year or at a particular time of the year. You also can mandate that the extra payment be directed toward repayment of the principal rather than the interest.

"It's really a matter of style," he says. "An individual can make the extra payment on his own. Making an extra payment seems to be a reasonable compromise rather than paying off your mortgage and losing all deductions."

If you don't pay off your mortgage, what will you do with your money? Spending it would hardly seem to be a sound financial decision. Investing it means you may be subject to a loss and you will have to claim your profits on your income tax. If all your money is going to do is to sit in a savings account, you are losing the advantage of the interest-based deduction.

Plus, there is the flexibility that comes with extra cash. Having a 30-year loan with lower monthly payments means you could be doing something else with the difference, such as investing in a high-yielding venture.

"In most cases, getting a big mortgage and investing the difference is a sound decision," Mr. Watter says. "Liquidity is important. Get a mortgage you can live with."

In the end, though, Mr. Watter says, what matters most is your comfort level.

"No one answer is appropriate for everybody," he says. "This is a very personal decision. You have to find a balance between theoretical economy and the reality of your situation."

Source: The Washington Times