Payoff Mortgage for Better Rate of Return?

There are pros and cons to paying off mortgages (or at least accelerating payments) and a lot of people feel pretty strongly about the subject. I personally avoid accelerating payments on the 2 properties I have owned up until now as I feel I can get a better rate of return elsewhere.

However the mortgage on my wife's townhome presents a new opportunity to do an evaluation on what my best "100% safe rate of return" could be.

Currently, I have established that my high yield savings account at EmigrantDirect is the best place to store my risk-free cash savings.

Here is the scenario with my wife's townhome.
The loan is a 30 year fixed, FHA loan with 3% down, with an interest rate of 5.875%. The loan requires PMI until the loan balance reaches 78% of the original appraisal. There doesn't look to be any costs involved in removing PMI as no new appraisal is needed.

We expect to live in the home for the next 1-2 years and then purchase a new home and sell the townhome.

First off, if we look at the mortgage itself, at 5.875% this by itself is not very attractive to me. My second rental property has a 30yr mortgage at 6.5% and would pay down this mortgage first.

However, things get more interesting when we factor in PMI, and that I will be able to get the money back out likely within the next couple of years when we sell the townhome. This means I could potential put the $30,000+ I have saved for our new home into the mortgage and get it out when we are ready to buy the new home.

Mortgage Details:
The current monthly premium for PMI is $45.14**.
Current mortgage balance:$109,922.11
Payment needed to reach 78% of original home value: $19,052.11
Interest Rate: 5.875%
Effective after-tax Interest Rate*: 3.9329%
*After reducing interest rate by tax savings likely realized.
**The PMI on this mortgage is not tax deductible.

So the question is if I made a principal payment of $19,052.11, what would the effective return be after factoring in tax benefits loss?
I would be saving $62.43 per month in interest if I use the 3.9329% effective return, and save $45.14 per month in PMI premiums. This would total $1290.84/yr in returns or a 6.77% after tax, risk free return on my money.

Risk-Free Short Term Investment Options	Return
	Pre-tax	After-Tax
Emigrant Direct Savings	4.75%	3.18%
Pay Down on 2nd Home w/ 6.5% Mortgage*	6.50%	4.36%
Mortgage Payoff to Cancel PMI on 3rd Home	8.72%	6.77%

*Note:30 yr fixed rate mortgage is not really a short term investment. I can't get the money back out at the same or better interest rate, however it is included for comparison purposes.

While I think the decision to get a mortgage with PMI by my wife was an expensive one, at this point it looks like it we would get a better return on our money by taking $19,052.11 of our home savings from our savings accounts and paying down this mortgage to get rid of PMI.

Stay tuned.

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Comments (4)

There's a lot of complex financial issues when two separate people become one financial entity.
Issues can arise when one person sees the others financial situation as an additional asset. I do see your posts getting better and better about using terms like "we" and "our" instead of "me" and "mine". So that's nice.
:)
And congrats on the nuptials.

Posted by Me | November 22, 2007 12:37 PM

Given the sad state of the current resale market (especially townhouses and condos), what can you realistically expect to sell it for? Based on your wife's (Mrs. 2M) small 3% down payment, I would not sink more money into an asset that has a bigger mortgage than it is may be worth (post-sale including closing costs). Can the PMI provider try to force you to a limit of 78% of the current appraised value if it is less than the purchase appraised value?

In addition to possibly losing money on the townhouse, it might also take a long time to sell unless you are ready to significantly drop the price. In volatile times like these it is best to stay liquid unless you get an outstanding rate of return with minimal risk. Instead you are considering a middling rate of return with the likelihood that a large chunk of liquid assets will be tied up for a while.

Posted by ddlang | November 23, 2007 6:46 PM

I agree I am concerned about the property sucking money when we sell it, but it is what it is. Unfortunetly my wife disagrees with me, but I hope she it right. At this point I can only move forward and still think that getting a 6.77% after tax return for the next few years is not a bad thing although I am still mulling it over. Im going to wait at least a couple more months till all the recent expenses clear out and we have a better picture of our monthly cash flow.

Posted by 2million | November 24, 2007 2:20 PM

it all depends on whether the PMI can generate tax deductions for you - for 2007 and for the future... that should be part of the equation

Posted by anonymous | November 26, 2007 12:53 PM