Q: My question is regarding our interest-only mortgage.
We are still in our house almost two and a half years after refinancing, and the interest rate on our loan is 6.5 percent.
If I have $10,000 that I will not be needing in the foreseeable future, can I send that amount in with our next payment to help pay down the principal on the loan? Or am I better off investing that same amount of money at current interest rates which, of course, are much lower?
It seems to me that paying 6.5 percent on that $10,000 is akin to earning that same amount of interest. Am I wrong?
A: You seem hesitant to prepay your mortgage, but if you’re going to put the money into the bank and earn less than one percent, you might as well pay down your mortgage and effectively earn a much higher rate of return.
If you know you can spare the money, you should always pay down high interest debt first then move to lower interest debt. If you have credit card debt at 30 percent, you would be better off using that money to pay off that debt.
In your case, if your only debt is the mortgage, you should use your extra funds to start paying down the balance of the loan. When your loan resets, your payment should go down (unless interest rates skyrocket) because you’re paying interest on a smaller balance.
For some, keeping the cash in hand might be better for various reasons, including their belief that they will need those funds at some date in the near future. Once you pay down your mortgage balance, it may be harder for you to tap that equity (if you have positive equity in the property) when you need it.
For other people, taking out a long term loan now at historically low interest rates seems like a reasonable thing to do. Locking in a long-term loan today, when interest rates are at 40-year lows means you’re betting that interest rates will be higher in the future and you want to have cash to invest later on.
Let’s say that five years down the line, interest rates are higher than your mortgage loan interest rate. In that case, you could invest the money in the bank at a rate that exceeds your mortgage interest rate and actually make money in the process.
Your choice also depends on what your jobs prospects are, your wife’s employment situation, your current savings, current investable assets, and what your income stream will be in retirement.
If life looks a little uncertain for you, you should take your $10,000 and stick it somewhere safe. If, on the other hand, you feel comfortable with the current state of your finances, you should feel free to start paying down your loan.