In my last post, I compared the debt snowball and debt avalanche strategies. I noticed that when I see people compare the two methods, I rarely ever see mortgages being addressed. Why is that? I realized this is such an important topic that it deserved its own post. When paying down debt, when should you pay down mortgages?
Debt Free Except a Mortgage
The general thinking excludes a mortgage from the debt snowball or debt avalanche equation, only looking at all other debts. Obviously, a mortgage will typically be significantly higher than all these other debts, which means even debt avalanche proponents are still using debt snowball principles if they aren’t factoring a mortgage. They are essentially saying, “This mortgage balance is so large… we’re not even going to consider it until all other debts are paid off.” At the same time, mortgage rates tend to be lower than other interest rates, so it’s also naturally lending itself to debt avalanche principles.
But not always.
Net Worth State of Mind
A fantastic lens to make financial decisions is through a net worth mindset. Thinking “How can I maximize my net worth?” leads to smarter decisions as you’re thinking critically about what will help your bottom line. Would you rather be debt-free except a mortgage or maximizing your net worth?
It’s also important to be aware of what timeframe you’re looking through the net worth lens. The timeframe is your filter. A short-term filter will lead to different decisions than a long-term filter. Looking at the long-term impact on net worth is a much better strategy.
This is one of if not the biggest mistake I see prevalent in our society today. Most people make decisions with a short-term outlook ignoring the long-term consequences. The entire gambling/casino industry is built upon this. Another common example is refinancing your mortgage. You could “save” money by lowering your monthly payment but extending it those extra years could cost you tens of thousands of dollars in the long run.
In the business of YOU, you don’t have a board or stockholders to report quarterly results. You’re in this for the long haul. Consistently making good long-term decisions will compound on each other and set yourself up for a successful future. Right now we’re deciding between paying different debts — both good long-term decisions — so it’s a matter of determining which is better.
When to Pay Down Mortgage
Unlike credit card or student loan debt, both cars and homes are backed by assets. But the appreciation or depreciation of the underlying asset is completely independent of the amount of debt owed. For this analysis, the debt part is our focus.
If the difference between the auto and mortgage interest rates is 0.5% and the car loan is $15,000 for 5 years, we’re talking about a $200 difference in interest over that entire period. That’s less than $4/month. Mortgage interest is also tax deductible while car loan interest is not, which makes the net difference less than $3/month. Although it is something, we’re almost splitting hairs.
But there is one very important factor that people often don’t consider.
The Cost of PMI
According to data from the National Association of Realtors, the median down payment on a home is half of what it was 30 years ago. It has fallen from 20% in 1989 to 10% in 2016. For first-time home buyers only, the median down payment last year was even lower at 6%. This means very few homebuyers are putting 20% down, the necessary level required in order to avoid private mortgage insurance, or PMI.
PMI is insurance paid by the borrower to protect the lender in case the borrower defaults. Makes sense, right? It’s the cost required for the privilege of purchasing a home with less than 20% down and it typically costs $30 to $70 for every $100,000. Since the average purchase mortgage amount has risen to $294,900, that means the average monthly PMI cost is $88 to $206 on a new home. The cost is determined by your total loan amount, down payment amount, and credit score. Other than buying yourself that privilege, PMI does nothing for you. It’s pretty much throwing extra money away.
PMI is paid each month until the loan-to-value ratio (LTV) hits 80%. And then you have to request it be terminated. If you don’t request it to be terminated, you keep paying until you hit 78% LTV at which point it is automatically terminated. That’s an additional 10 months if you’re not paying close attention. Aren’t lenders wonderful?
Hitting that 80% LTV is a big milestone on your debt payoff because you eliminate the PMI payment. It’s almost a car payment in itself! If you’re going to pay down your mortgage, it makes sense to do it as early as possible so you can hit that milestone sooner.
With a 5% down payment on a 30-year fixed mortgage, it takes about 8.5 years to hit 80% LTV. That’s 102 PMI payments. On average, that equates to a total cost of $9,000-$21,000. With a 10% down payment, the time period drops to about 6.25 years or 75 payments. Still $6,600-$15,400. But there are also many homebuyers who put less than 5% down, have lower credit scores, or buy more house. All of these people are the ones paying more than average.
The cost of Mortgage A and Mortgage B is not equal. PMI is the additional cost to borrow that smaller chunk. Sounds almost like interest, right? Which means your effective interest rate on the smaller chunk becomes MUCH higher. If you’re paying $125/month and you still owe $15,000 before you hit 80% LTV, that’s an effective interest rate of 10%.
Effective Rate = (Monthly PMI * 12 Months) / Remaining Balance to 80% LTV
Not only that — it keeps increasing! As you pay your mortgage down, the PMI amount stays fixed until it’s gone. So when you’re $10,000 away from 80% LTV, that a 15% effective rate. And at $5,000 away? It jumps to 30%!
Now add your actual mortgage rate on top. Would you still rather pay a 4% car loan over a 15-35% effective interest rate?
When comparing different debts to pay down, you should absolutely factor your mortgage into the equation. Saving a mortgage for last so you can be “debt-free except a mortgage” can cost you money. If you’re currently paying PMI, you’re essentially paying credit card interest rates on your mortgage (or will be soon).
Until that PMI payment is gone, it’s an absolute no contest to prioritize your mortgage payoff over a car loan or even student loans with comparable rates. Once you hit the mortgage milestone, then you can re-evaluate where your money will work for you best.
Featured Image courtesy of Image Money.