Does it make sense to pay off a loan early?


J

Jeff

Hi Folks,

I am taking out a 60 month loan at 5% interest (home equity), using the cash
to invest. I am not a sophisticated investor but have done reasonably well in the
past 2 years (>12%). (foreign stocks, commodities, forex).

My belief is that the dollar as well as home prices will go down in the next
2 years, possibly dramatically, so leaving money sitting in a house is not so
smart.

But I want to pay off the 5 year loan in 2 or 3 years. Does this make sense,
or it is true that I will be paying the majority of the interest in the early
stages of the loan, and therefore I would be better of sticking to the
full 5 years (that is if I pay off a 5 year loan at 5% in 3 years, my interest
rate is effectively higher). I would need to calculate the interest rate
to know whether it makes sense to borrow the money in the first place.

Thanks,

Jim
 
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J

John A. Weeks III

Jeff said:
My belief is that the dollar as well as home prices will go down in the next
2 years, possibly dramatically, so leaving money sitting in a house is not so
smart.
Some pundits would argue that leaving money sitting in a home is not
all that smart, but not for the reasons that you have given. These
economic facts do not affect how much you are going to have to pay
back on a home loan. You will pay the same payments no matter if the
dollar is weak or strong. And if home prices go down, you don't save
money like you would if you had shorted stocks.
But I want to pay off the 5 year loan in 2 or 3 years. Does this make sense,
or it is true that I will be paying the majority of the interest in the early
stages of the loan, and therefore I would be better of sticking to the
full 5 years (that is if I pay off a 5 year loan at 5% in 3 years, my interest
rate is effectively higher). I would need to calculate the interest rate
to know whether it makes sense to borrow the money in the first place.
The length of time you keep a loan or how you pay it back really does
not matter. You are simply renting money, and you pay rent on each
dollar each month. If you keep the money longer, you pay a little
more rent on those dollars. If you pay back the money quicker, you
pay a little less rent. At the same time, if you pay back the money
quicker, you get less use out of it. If you keep the money longer,
you get more use out of it. So the use you get exactly balances the
rent that you pay. If you no longer need the money, then you should
pay it back.

-john-
 
H

HW \Skip\ Weldon

My belief is that the dollar as well as home prices will go down in the next
2 years, possibly dramatically, so leaving money sitting in a house is not so
smart.

What do you foresee that would cause a decline in home prices?

(I ask because the direction from which you see the problem arising
might affect what you should do with the money.)

-HW "Skip" Weldon
Columbia, SC
 
R

Ron Peterson

Jeff said:
I am taking out a 60 month loan at 5% interest (home equity), using the cash
to invest. I am not a sophisticated investor but have done reasonably
well in the past 2 years (>12%). (foreign stocks, commodities, forex).
I think that's comparable to the S&P 500 averages.
My belief is that the dollar as well as home prices will go down in the next
2 years, possibly dramatically, so leaving money sitting in a house is not so
smart.
Then you should sell your house and rent. I think that it's more likely
that the value of your house will keep up with inflation. If your house
is relatively new, it shouldn't drop much below the cost of new
construction.
But I want to pay off the 5 year loan in 2 or 3 years. Does this make sense,
or it is true that I will be paying the majority of the interest in the early
stages of the loan, and therefore I would be better of sticking to the
full 5 years (that is if I pay off a 5 year loan at 5% in 3 years, my interest
rate is effectively higher). I would need to calculate the interest rate
to know whether it makes sense to borrow the money in the first place.
You are probably better off not taking the loan, stock market risk is
higher than home ownership unless you are in some area where housing
costs are too high. I paid off my house before I started investing, and
I am happy with that decision.
 
S

Sgt. Sausage

HW "Skip" Weldon said:
What do you foresee that would cause a decline in home prices?
I'm in no way schooled in the methods and models of
economists -- but I had the same question.

My intuition tells me that a declining "real" value
of a currency would tend to lead prices in a distinctly
upward direction. The dollars are "worth" less, so it
takes more of them to buy the home (all other things
being equal (which they never are)).

Where am I wrong on this one?
 
C

Cal Lester

The Dollar IS dropping as against the Euro, but Home prices (at least
here in So. Florida) are still steadily rising.
Cal Lester CLU
 
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C

Cal Lester

I'm in no way schooled in the methods and models of
economists -- but I had the same question.

My intuition tells me that a declining "real" value
of a currency would tend to lead prices in a distinctly
upward direction. The dollars are "worth" less, so it
takes more of them to buy the home (all other things
being equal (which they never are)).

Where am I wrong on this one?

You are most definetly wrong in the fact that you thought that you MIGHT be wrong.............
Cal Lester CLU
 
T

Tad Borek

Jeff said:
I am taking out a 60 month loan at 5% interest (home equity), using the cash
to invest. I am not a sophisticated investor but have done reasonably well in the
past 2 years (>12%). (foreign stocks, commodities, forex).

My belief is that the dollar as well as home prices will go down in the next
2 years, possibly dramatically, so leaving money sitting in a house is not so
smart.
Jeff,
Borrowing home equity still leaves the money sitting in the house, that
doesn't change really. The only benefit of an inflated home price, if
you want to call it a benefit, is that you can borrow more of that
"equity" that exists on paper.

But in fact the loan leaves you more exposed to the risk of home prices
dropping. Absent the HE loan it might just be a lost opportunity to sell
the home at a high price. But what if your investments head south and
you no longer have the option of selling the home to pay off the loan -
because the price dip you're predicting has wiped out your home equity?

As someone else mentioned if you really think home prices will drop a
lot, the way to profit from that is to sell & rent for awhile. People
are starting to do that around here (SF, CA) - it's overdue.

-Tad
 
J

Jeff

The bank applies a greater percentage of my payments to interest
rather
than principal in the early stages of the loan, which is why I think
that paying
off the principal midway through the loan doesn't make sense.

I know the payments will stay the same regardless of the value of the
dollar
or of the house. I am looking from a more global perspecitve of
someone who
might work and buy property overseas, and I am concerned about the
erosion
of my assets caused by declines in the US dollar and in US housing.

Regarding real estate bubble, I am simply observing what seems
irrational prices
in my local market, but also the opinions of many analysts.

I'm thinking of using up to 50% of the loan on forex (eg Aussie
dollars at 5% interest),
gold/gold funds, and the rest in mutual funds. Thanks,
 
R

Rich Carreiro

The bank applies a greater percentage of my payments to interest
rather than principal in the early stages of the loan, which is why
I think that paying off the principal midway through the loan
doesn't make sense.
You need to check out how amortized loans work.

If you make an payment of principal, it will immediately
increase the percentage of future payments applied to
principal, which will shorten the loan, which in turn
reduces the total interest you pay.
 
J

Jeff

Sorry, my earlier remark was unclear. Say I have an investment which is inversely
correlated both to US real estate and to $USD, both of which drop 20% in the next
3 years. Wouldn't it make sense then to use a home equity loan for this
investment?

Instead of renting an apartment, I would be renting money and still living in
my home. By the time I have paid off the loan, if the value of the house
has gone down that is my loss, but I could mitigate that loss by the investment
gains. I agree it is not for the faint of heart.
 
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J

Jeff

I'm not sure I understand why taking a home equity loan still leaves
the money sitting in the house. When I take the loan, the bank
then owns a part of the equity in the home, and I have dollars, which
I can invest as I please.
If I borrow 50% of the equity value of the house and the house goes
down 50% in value, I'd then owe the bank the full value of the house.
My situation would then depend upon whether I invested the money
wisely or spent it.
 
E

Elizabeth Richardson

I'm not sure I understand why taking a home equity loan still leaves
the money sitting in the house. When I take the loan, the bank
then owns a part of the equity in the home, and I have dollars, which
I can invest as I please.
If I borrow 50% of the equity value of the house and the house goes
down 50% in value, I'd then owe the bank the full value of the house.
Usually a person also has a first mortgage when they take out a home equity
loan. You still owe the first mortgage. So if your house decreases in value,
the chances are high that your outstanding debt on the house will be greater
than the value of the house. If that is the case, and you decide to sell,
you're going to have to come up with some cash to satisfy the lienholders.
Is that what you want?

Elizabeth Richardson
 
J

Jesse Meyer

Rich Carreiro said:
You need to check out how amortized loans work.

If you make an payment of principal, it will immediately
increase the percentage of future payments applied to
principal, which will shorten the loan, which in turn
reduces the total interest you pay.
I stumbled over this one myself.

I think he's talking about a morgage scheme where they calculate
interest up front, add that to the principle, and divide it by the
number of months to get an average payment.

Early payments won't pay down the principle then.

Google for "front end" mortgage for more information, I think that is
what he means.
 
T

Tad Borek

Jeff said:
I'm not sure I understand why taking a home equity loan still leaves
the money sitting in the house.
Jeff,
To illustrate using an extreme example...imagine you buy on eBay, for
$30,000, a piece of grilled cheese with the image of the Virgin Mary in
it (or maybe it's Shirley Temple - they kind of look the same) (in case
you missed it: http://www.msnbc.msn.com/id/6511148)

You put it in your safe deposit box for safe-keeping, and while you're
there the bank offers to let you borrow against it...$30,000, as long as
you put The Big Cheese up for collateral. Interest rate is adjustable,
based on the current short-term interest rates.

You sign the papers & take your $30k and, on the advice of the grilled
cheese (it speaks to you), place some forex trades.

Some time passes and the market for Virgin Mary Grilled Cheeses has
crashed. You're lucky if you get $100 for the thing, which was the
recent assessed price of a John the Baptist Blueberry Scone on "Antiques
and Food Relics Roadshow."

How much would you owe the bank at that point? The $100 current value of
the sandwich or $30,000, the value when you borrowed against it? You'd
owe the $30k. It didn't matter that you borrowed the money.

So you were still exposed to the price drop in the grilled cheese and
the only profit you'd make is the difference between your trading
profits on the $30k invested, and the cost of borrowing the $30k. And of
course if you lost money in your investing, now you don't have a grilled
cheese to sell to pay off the loan.

In an inflated housing market (if that's what you think it is), you
might think of that grilled cheese as the "fluff" in your home's value.
Let's say your home is currently valued at $280,000 but you think it's
worth more like $250,100. Borrowing $30k doesn't change the fact that if
you're right, the home is going to be worth $250,100 after a couple of
years. You might have $30k in the bank, but you also owe $30k. So that's
a wash, you didn't benefit from the drop. The only amount you'd be ahead
is whatever profit you could get out of the $30k, through investing,
minus the cost of borrowing that money.

So unless you part with your grilled cheese you're still fully exposed
to any future price drop. The bubble would just allow you to borrow some
money, it doesn't hedge the risk of a price drop.

I guess an exception would be if you were to invest in something that
gains $1 for every $1 drop in home prices. That investment doesn't yet
exist though.

-Tad
 
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R

Rich Carreiro

Tad Borek said:
I guess an exception would be if you were to invest in something that
gains $1 for every $1 drop in home prices. That investment doesn't yet
exist though.
Surely in this day and age someone has developed house futures.

:)
 
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