Should I Prepay My Home Equity Loan?
Does it make sense to sell mutual funds to prepay a home-equity loan?
By Thomas M. Anderson, Associate Editor
From Kiplinger's Personal Finance magazine, January 2008
The Question: Does it make sense to sell mutual funds to prepay a home-equity loan?
The Answer: Jeremiah Bodner is well on his way to a junior membership in the millionaire's club. The 34-year-old bachelor owns a condo and two rental properties and has saved $285,000, including $100,000 in retirement accounts. Bodner, who lives in Berlin, N.J., makes $72,000 a year as a social studies teacher and on the side runs a vending business selling hot dogs at a local flea market. "When everyone else is having fun on the weekends, I'm working my stands," he says.
Although his finances are in solid shape, Bodner can't help fretting about a $59,000 home-equity loan, on which he's paying a fixed rate of 8.5%. "Making that loan payment every month seems like a waste of money," says Bodner, who's considering selling some of his mutual funds to pay off the debt, even if it means paying capital-gains taxes. Worried about the recent gyrations in the stock market, he'd like to eliminate the loan while lessening the possibility that his portfolio will take a big hit. But he wonders if a loan payoff would be the best use of his savings.
Other options. Bodner does have other ways to make his debt more manageable. That 8.5% rate is slightly higher than current rates for similar loans, which have been averaging 8.2%. With his good credit rating, he could probably get a lower rate by refinancing.
But it usually doesn't make sense to refinance unless you can shave at least one percentage point from your interest rate. Otherwise, the cost of refinancing will eat away at your savings on the new loan.
Plus, Bodner's debt comes with a valuable benefit: The interest on the home-equity loan is tax-deductible. As a single filer who doesn't qualify for some tax deductions and credits that families can claim, the loan interest is one of the few deductions available to Bodner, says Diane Park, a financial adviser in Minneapolis.
Solid portfolio. Paying off a home-equity loan at 8.5% is the equivalent of earning a taxable return of 8.5% on your money. If Bodner's fund portfolio is earning less than that, it might make sense to sell some of his holdings to repay the loan. If his funds have the potential to earn more than 8.5%, he should hang on to them.
A peek at his assets helps settle the issue. Bodner invests in a solid portfolio of low-cost Vanguard funds, including domestic and international index funds and an energy-sector fund. So he's well diversified and very aggressive.
U.S. stocks have delivered an average annual return of a little more than 10% over the past 80 years, so it's fair to assume that over the long term Bodner's portfolio will beat the 8.5% return he'd get from paying off his loan. "His mutual funds are earning a buck," says Frank Presson, a financial adviser in Tucson, Ariz., "and his house will appreciate whether he owns it free and clear or has a loan."
Even if the market looks as if it's headed for a fall, that's no reason for Bodner to pull back on his stocks. He doesn't plan to retire for decades, and timing the market to get back in at the right time is a loser's game.
It might be different if he had a bigger portion of his assets in bonds or cash, which would reduce the chances that his portfolio would out-earn the 8.5% he'd get by paying off the loan. As it is, however, he's better off keeping the loan and building his nest egg.
If the debt bothers him, he can always make extra payments out of the income from his rental properties, says Pat Hinds, a financial adviser in St. Cloud, Minn. "Depending on the term and the amount of the loan, paying ahead can shave off a few years," says Hinds.
Reader Comments (8)
Posted by: bret at 12/10/2007 02:37:43 PM
Getting 8.5% ROI with absolutely no (repeat no) risk. I'd take that over a "historical" 10% any day... Don't forget - although you're deducting the loan interest, you're gonna pay taxes on the investment returns, so that just about washes.
Posted by: Joe Lambert at 12/10/2007 03:05:37 PM
This is only true if the home equity line is NOT secured by his residence. If it is, the interest is likely tax deductible, meaning that the effective interest rate is much lower than 8.5%, and the comparison should be adjusted accordingly.
Posted by: Nancy C., at 12/10/2007 03:52:06 PM
Good work JB. I am in the same situation. I'm a 27 year old math tacher from CA. I help run a family business on weekends if I don't work. I am also a real estate agent- more for myself. I have a 6 unit. I understand what JB is going through. Yes- Im using my Heloc as a down payment for the 6 unit. So the interest on a 60,000 loan is about 500 with a 7.1 interest rate. Now my next move- suggestion for JB is to try and hit the larger loan from his two other properties. The larger the loan- the more interest he has to pay each month. Although the heloc is 7-8 percent- if it is little- does not hurt as much as the larger loan even with a lower interst rate. If the investments - which I lost some money this period- is good- then hold it. But I rather put the extra money in the loan mortgages. good luck- hope for the best
Posted by: Adam at 12/10/2007 05:35:11 PM
Two items missed during your analysis. 1) The 10% gain on stocks is a pre-tax gain. At any point, when cashing in the mutual funds he will at "least" be paying 15% tax on those gains, hence bringing the realized gain down. 2) You're not timing the market if your putting that same monthly payment that was going to your Home Equity Loan back towards repurchasing mutual fund shares on a monthly basis. Taking those to factors into consideration (and assuming Bodner would actually put the equivalent of the saved monthly loan payment back into the market) I would side on the plan of paying off the debt.
Posted by: Vernon Sneed at 12/10/2007 09:04:13 PM
Two quickies: 1. Joe is worried about the stock market. Why worry, sell! 2. His gain may be minimal since you are taxed on dividend reinvestments of the mutual fund and his basis may be higher than he thinks. Many people have a loss in a mutual fund account and don't even know it.
Posted by: Rich B at 12/10/2007 11:22:04 PM
One thing has to be taken into account, that the story does not talk about. Risk. Even in good mutual funds, risk is always present at a higher level, than in a roof over your head, which is a basic need, in any case. Every month that interest is paid out to someone is $ that will not come back. Get it paid, then use that $ to build wealth and collect interest (assets). At that point, risk is not such a factor.
Posted by: ageorge at 12/11/2007 01:30:20 PM
I may be missing something here but the $285,000 in savings only has $100,000 in retirement accounts. If you have $185,000 liquid, WHY pay intrest at 8.5% on $59,000. So 1/3 of your liquid goes bye bye your notes go down equity goes up. Additionally anyone suggesting that you pay down your highest bill first isn't considering long term growth. One note I owe 5 years on, the other I owe 17 years on. The 5 year note is 1/2 the cost monthly of the 17 year note. If I pay off the 5 year note early any extra I added to my monthly and the note itself can then be applied to the larger note. If a tragedy strikes I will have more available "breathing room" SOONER. However excellent planning and keep up the good work.
Posted by: Steve at 12/13/2007 03:33:33 PM
As a mortgage professional, here is what I would recommend. First is to look at the overall debt structure on his 1st and HELCO mortgages. If he can combine the two mortgages into a better overall monthly payment on a fixed rate providing him with a greater monthly savings, then that would be a good decision. If he does refi, make sure you properly structure the cost so you get the maximum tax benefits. Since he is in his 30's, he has another 30 years for his money in his investment account to grow. By leaving the $59,000 in the account and it's able to earn 8% over 30 years, it would grow to over $600,000. Since the compounded effect of his investment account will provided a greater financial benefit than having the money buried in the home. Realize the rate of return on home equity is ZERO. Mortgage interest is tax deductible, since he is single and probably in a 25% tax bracket, his home will act more like a tax shelter.