Pay down interest only mortgage or invest?

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Pay down interest only mortgage or invest?

Post by familydaddy » Thu Jun 14, 2018 11:53 pm

Hi all,

I am 2 years into a 7 year interest only 2.1 million dollar mortgage. The interest rate is 2.5 percent and I have been paying 5000 dollars per month in addition to the interest to pay down the principal. The balance is now around 2 million dollars. I have over 1M equity in the home. I'd like your thoughts on continuing to pay down the principal for the next five years (leaving me with a balance of about 1.7M when it's time to refinance) vs investing that 5000 dollars per month for the next 5 years. That would be 300K that would hopefully appreciate and allow me to either pay down the principal 5 years from now before refinancing, or keep it in the market long term.
Pros of investing:
1) my mortgage broker says she gives 3/8 percentage rate deductions for loans above 2M because they are so profitable. Keeping my mortgage at this number would help my refinance rate
2) if i invest the money, when it's time to refinance i can put that money in the new lender's accounts to establish "relationship banking' and get a further rate deduction. Sometimes 500K gets you .25%-.5% rate reductions.
3) if that 300K were left in the market for 30 years at 7 percent interest, it would be worth over 2.2M which would be more than the entire balance
Cons of investing:
1) i could lose that money in an abrupt market downturn. high interest rates, high mortgage balance, lower home value in a recession would kind of suck.
2) it's stressful
3) considering tax implications, i would need to get about 4.5% in the market to beat the guaranteed 2.5% returns if paying down the principal.

What do you think?

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Re: Pay down interest only mortgage or invest?

Post by madbrain » Fri Jun 15, 2018 1:45 am

Hard to give any useful advice without knowing your income, cash flow and other assets.
If the >2 million house is 10% of your net worth, don't worry about it. If it's >100% of your net worth, that's another story.

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Re: Pay down interest only mortgage or invest?

Post by Baldrekr » Fri Jun 15, 2018 2:14 pm

familydaddy wrote:
Thu Jun 14, 2018 11:53 pm
3) considering tax implications, i would need to get about 4.5% in the market to beat the guaranteed 2.5% returns if paying down the principal.
I don't think that 4.5% number is accurate. People assume they get a 100% tax deduction on all mortgage interest, but then ignore factors like comparing loss of the standard deduction, the $1M mortgage maximum for deductions, phaseouts due to high income (at least the PEASE limit went away this year), etc.

In my opinion it does not make sense to pay down such a cheap loan, at least not so early. I would, however, ensure your finances could handle the possibility of monthly payments with 5%-6% interest rates when your mortgage ends in 5 years. This shouldn't be a problem if you had enough income to quality for a 2M mortgage in the first place. You have 5 years before the mortgage resets, so if interest rates are sky high 2 years before that date, you can start aggressively paying it down using job income and dividends (as well as money that you would normally be contributing to the stock market at that point). There might even be a recession in the next 5 years and interest rates could drop again.

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Re: Pay down interest only mortgage or invest?

Post by Meg77 » Fri Jun 15, 2018 2:31 pm

Banker here. I wouldn't consider future rate concessions for having investments OR for having a larger mortgage part of your analysis. For one thing, mortgage rates and rules change all the time, and we're talking about five years out. The whole market will look different because refinance rates - which have made up a huge portion of mortgages in recent years - are tanking. Many mortgage companies will close or shrink over the next 5 years. Besides, your mortgage broker isn't the only option in town, and plenty of companies give more competitive rates for loans over $1MM or for any jumbo loan.

Given that inflation is around 2% and your rate is only 2.5%, I wouldn't be paying it down UNLESS you already have plenty of liquidity and are maxing out tax advantaged space and have no interest in real estate investments and literally don't have any other use for the funds. 2.5% fixed for 5 years is basically free money, even if you can't deduct the interest.

HOWEVER there is a lot of middle ground between paying off a 2.5% loan and putting 100% of the money in stocks. The likelihood of a major stock market turndown over the next 5 years is high given that we haven't had one for one of the longest stretches in history. Sure, over 30 years you'll come out ahead by investing, but we aren't looking at a 30 year decision. You're looking at investing versus paying down a mortgage over the next 5 years. At the end of that time you may well find that using your accumulated funds to pay down the loan makes sense versus taking out a 7% mortgage (which could easily be tomorrow's prime mortgage rate - though of course no one can say for sure where rates will go).

I have a 2.75% mortgage that isn't tax deductible anymore (because now we file w the standard deduction), but I'm investing in commercial RE partnerships rather than pay it off. The initial after tax yields are higher than my mortgage rate even before factoring in any expected capital gains over time. But my rate is fixed for another 12 years. If I were facing a forced refi in 5 years, I might invest in the total bond market fund (yields over 3% now and has been on an upward trajectory) and build liquidity "just in case" rather than pay it down early. Then IF rates do continue to rise, and you decide to keep the house, you can make a large principal reduction prior to refinancing and end up in pretty much the same financial spot as if you'd paid extra all along. But you'll have more liquidity/flexibility along the way.
"An investment in knowledge pays the best interest." - Benjamin Franklin

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Re: Pay down interest only mortgage or invest?

Post by delamer » Fri Jun 15, 2018 2:49 pm

What is the maximum interest rate on the loan and what would your monthly payment be in 5 years if the maximum was in effect?

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Re: Pay down interest only mortgage or invest?

Post by grabiner » Fri Jun 15, 2018 9:57 pm

See Paying down loans versus investing on the wiki.

If the mortgage rate is fixed for five years, then paying down the mortgage would give you a risk-free, tax-free 2.5% return over five years. This is the same return you could get on five-year municipal bonds, with comparable risk; Admiral shares of Vanguard Intermediate-Term Tax-Exempt yield 2.49%. Therefore, if you get the same rate upon refinance regardless of the amount of the investment, it's close to break-even. (Which way the advantage works out may depend on state taxes; if you pay state taxes on the munis, and cannot deduct the mortgage on your state taxes, that makes paying down the mortgage slightly more attractive.

If you are likely to get a lower rate by investing, that is a good reason to invest instead. In addition, this is not an irrevocable decision; if you wind up with a $2M mortgage and $400K in bonds, you have the option of refinancing a $2M mortgage, or using the bonds to pay it down then and refinancing a $1.6M mortgage.

But if the mortgage rate adjusts annually, then paying down the mortgage would give you a risk-free, tax-free 2.5% return over one year, and then the return will increase if rates increase. This makex paying it down a better deal.
Wiki David Grabiner

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