The Kirkwood Letter

Newsletter from
Steve Richardson & Company, Certified Public Accountants

September 30, 2019

The Kirkwood Letter

With permission and for fun reasons, I am titling this letter the “Kirkwood” letter in honor of a client couple that showed good initiative in including me in a family discussion about investment options related to modest and irregular gifts of cash from grandparents to their infant children.  I was honored to be included in that discussion.  The amounts of money involved are “modest” and most young couples would inappropriately jump to the conclusion that there is no good investment option with “modest” and “irregular” funds.  There are in fact a number of excellent investment options that fit this cash flow scenario. 

The investment strategy we discussed and settled on for this family is additional unscheduled mortgage payments.  This strategy fits the Kirkwood family perfectly.  It also fits with my philosophy that parents need to be in a position of financial strength before they try to help their children financially.

With college educations skyrocketing in costs, family financial strength is more important than ever.  The plan is simple but unexpectedly powerful!

This investment strategy builds upon an indisputable financial principal: good financial behavior, over long time horizons, will always pay off.  Few investment are more long-term that a house and a mortgage.

Please take the few minutes necessary to read this short memo.  This investment strategy is deceptively simple but do not under estimate its effectiveness. 

Why Accelerated Mortgage Pay-Down Is a Good Investment Strategy

The notion of paying down one’s home mortgage balance faster than required is not a new idea. However, even those who are well schooled in personal finance may be surprised to discover how powerful this idea can be. This release prepares you to raise the issue and explain it to clients who might be interested. Before getting started, please note the following key points:

•   The accelerated mortgage pay-down idea can only work for clients who have positive cash flow and/or available cash. It is not for folks who are struggling to pay their monthly bills.

•   The idea is only appropriate for clients who are looking for a very conservative, risk-free way to invest some surplus funds. Obviously, clients who want to earn (and believe they can earn) 8% to 10% annually are not going to be very excited about the idea of expending cash to earn 3.5% or 4% (or whatever their exact mortgage interest rate may be) by paying off their home mortgage early.

•   Finally, the idea is far more powerful when the client intends to continue pumping the monthly accelerated mortgage pay-down amount into a retirement account after the mortgage has been paid off.

With these thoughts in mind, here is a more detailed analysis in the form of sample scenarios.

Sample Scenario: Accelerated Pay-down Strategy Makes Good Financial Planning Sense

Phil, your 45-year-old client, is in good financial shape. He has cash on hand and positive monthly cash flow after paying his bills. Even better, he expects to be in the same position for the foreseeable future. Assume Phil has a $400,000 balance on a recently refinanced 30-year first mortgage on his home that charges 4% interest. (We know the current rates are lower for qualified borrowers, but that may not last forever. Plus, we want to keep things simple to illustrate the points we will make in this release.)

Phil’s monthly payment for principal and interest is only $1,910, but he has a whopping 30 years to go before the mortgage will be paid off (if he sticks to the prescribed monthly payment schedule). That means Phil will be a wizened 75 years old when the mortgage is finally extinguished.

Being 75 years old before your mortgage is paid off probably does not sound so great to most folks. Collecting a guaranteed, risk-free 3.5% or 4% (or whatever rate applies) return by paying down one’s mortgage quicker (thus avoiding the interest that would otherwise be charged on the principal that is paid off early) probably sounds like a solid investment idea to many homeowners. After all, the stock market is looking rather frothy, and fixed income investments are currently paying pitiful interest rates.

Impact of Mortgage Interest Deductibility

One argument that may be mounted against the accelerated mortgage pay-down idea is that your client will lose tax deductions because interest charges will go down more rapidly than if he or she sticks to the scheduled monthly payments. This is true, but so what? Consider the following points:

•   The TCJA imposed stricter limitations on home mortgage interest deductions for 2018-2025.

•   The greatly increased standard deduction for 2018-2025 means that many more clients won’t be claiming itemized deductions. Even if they itemize, the larger standard deduction reduces the incremental tax benefit from itemizing.

Impact of Future Inflation or Deflation

While the accelerated mortgage pay-down strategy will yield guaranteed results, it is not foolproof. If we have a period of roaring inflation, paying down a mortgage with a relatively low interest rate earlier than required may no longer make sense. In this situation, it may be better to stop the accelerated pay-down program, allow the mortgage term to stretch out, and pay the remaining balance back with cheaper inflated dollars.

On the other hand, the accelerated pay-down strategy will work great during a period of deflation because the mortgage is being paid down sooner when dollars are cheaper rather than later when dollars are more expensive.

Big Advantage to “Continuing” the Program
after
Mortgage Is Paid Off

The accelerated mortgage pay-down strategy can clearly be beneficial in and of itself because interest charges are avoided, and debt is eliminated from the client’s personal balance sheet. Another advantage is your client can stop and restart the program anytime he or she wants (for example, when inflation or deflation strikes). However, the biggest payoff from following the strategy will probably be reaped by folks who have the cash flow and self-discipline to continue the program even after the mortgage is extinguished. This involves taking the monthly amount that was previously dedicated to the accelerated mortgage pay-down strategy and stuffing it into a retirement savings account (whether taxable or tax-advantaged).

In our sample scenario, let’s say Phil pays $3,500 per month under the accelerated mortgage pay-down program instead of making the scheduled monthly payment of $1,910. He will pay off his $400,000 mortgage balance in about 12 years, at age 57, instead of paying it off in 30 years, at age 75. He will earn a guaranteed 4% rate of return because that is the interest rate he avoids on the accelerated principal payments.

If Phil continues the program after the mortgage is paid off by putting $3,500 a month into a retirement savings account that earns 4% annually for another eight years, he will have accumulated about $395,000 at age 65. This seems like a much better plan than sticking with the status quo and making mortgage payments until age 75.

More Sample Scenarios

Here are some additional illustrations of how the accelerated mortgage pay-down strategy can work.

Faster Pay-Down. Now say 45-year-old Phil pays $4,500 per month under the accelerated mortgage pay-down program instead of making the scheduled monthly payment of $1,910. He will pay off his $400,000 mortgage balance in eight years and ten months, at age 54, instead of paying it off in 30 years, at age 75. He will earn a guaranteed 4% rate of return because that is the interest rate he avoids on the accelerated principal payments.

If Phil continues the program after the mortgage is paid off by putting $4,500 a month into a retirement savings account that earns 4% for another 11 years, he will accumulate about $745,000 by age 65. Sweet! Once again, this seems like a much better plan than sticking with the status quo and making mortgage payments until age 75.

Really Fast Pay-Down. Now say 45-year-old Phil pays $5,000 per month under the accelerated mortgage pay-down program instead of making the scheduled monthly payment of $1,910. He will pay off his $400,000 mortgage balance in about seven years and ten months, at age 53, instead of paying it off in 30 years, at age 75. He will earn a guaranteed 4% rate of return because that is the interest rate he avoids on the accelerated principal payments.

If Phil continues the program after the mortgage is paid off by putting $5,000 a month into a retirement savings account that earns 4% for another 12 years, he will accumulate a little over $920,000 by age 65. Wow! That would be great!

Slower Pay-Down. Let’s now be a bit less ambitious and assume that 45-year-old Phil pays $2,500 per month under the accelerated mortgage pay-down program instead of making the scheduled monthly payment of $1,910. This only requires an additional payment of $590 per month. Under our basic assumptions, Phil should have absolutely no problem doing this. Paying $2,500 per month will allow Phil to pay off his $400,000 mortgage balance in about 19 years and two months, at age 64, instead of paying it off in 30 years, at age 75. He will earn a guaranteed 4% rate of return because that is the interest rate he avoids on the accelerated principal payments.

Older Individual. Finally, let’s now assume Phil is 55 instead of 45. Say Phil pays $4,000 per month under the accelerated mortgage pay-down program instead of making the scheduled monthly payment of $1,910. He will pay off his $400,000 mortgage balance in about ten years and two months, at age 66, instead of paying it off in 30 years, at age 85. He will earn a guaranteed 4% rate of return because that is the interest rate he avoids on the accelerated principal payments. This seems like a much better plan than sticking with the status quo and making mortgage payments until age 85.

Conclusion

You get the idea. With financial software, you can put together sample scenarios for clients who are interested in the accelerated mortgage pay-down concept. It often makes good sense from an overall financial planning perspective, and it delivers a guaranteed, risk-free rate of return. You can’t say that about too many other investment strategies.

Very truly yours,

Steve Richardson, CPA