I currently have a VA loan at 7.5 % interest. What are my options if I had $30,000 to apply to my loan?
A: Most home loans, including yours, may be prepaid "in whole or in part without penalty." That means you, as the borrower, have the right to send in extra sums of money with your monthly payment at any time and get credit for that extra payment. For some of us, that isn't an option - we are doing everything we can to make the minimum payment now.
But what happens if you inherit a large sum of money, or maybe you get lucky and win the lottery (yeah, right)? Stranger things have happened. When does it actually make sense to prepay on your mortgage?
Well, there are two theories here, and to answer this question, you'll need to subscribe to one of them. The first theory is that all debt is bad, and that the sooner you get out of debt, the better off you will be. This theory certainly has a simple ring to it, and it's hard to argue in favor of a crushing debt load. There is only one problem - from a purely financial perspective, the average person would never be able to afford a house if he or she had to pay cash. Likewise, paying down one's mortgage may not be the best use of available funds at any given time.
The alternative theory is that there are two kinds of debt: destructive debt and constructive debt. Destructive debt is best exemplified by credit cards used to buy things you really don't need. For example, it's destructive to charge a dinner for $100 on your charge card and pay 18% interest on that dinner for months after you have digested the meal. On the other hand, if you use your credit card to buy a washing machine for $100 and can save $15 a week in laundry bills for the next five years, you have used credit constructively. Same credit card - different outcomes.
In the case of your mortgage, the debt can be seen constructively. For most Americans, buying their own home is the best investment they will ever make. But is it wise to try to pay off the mortgage ahead of the scheduled payout? Here, the question boils down to your alternatives and your tolerance for risk.
If you send in an extra $30,000 in principal repayment with your next monthly payment, you will have avoided paying exactly 7.5% interest on this money for the next year. Thus your annual return on this investment is a guaranteed 7.5%. No more, no less. Keeping the $30,000 in the bank will only earn you around 6%, and that is a money-losing proposition.
If, on the other hand, you invested that $30,000 in paying off credit card bills that are charging you 18%, you get a guaranteed return of 18%, which is much better.
Likewise, if you put the money into an index mutual fund of the stock market and get a historical return of about 12%, you have come out ahead, but here there is a catch - there is no guarantee! Some years the market will do better and some years it will do worse. Only you can decide if you are willing to take a risk and try to beat the return you will get by prepaying your mortgage.
My advice is to take the constructive debt route and try to beat the 7.5%. Before you do anything else, talk to your accountant about fully funding tax advantaged retirement programs. Then consider investing the remainder for the long haul in quality mutual funds. Over a ten year or longer period, you'll be glad you did.
John Adams
John Adams is a broker, investor and author on the subject of real estate. He is also a founder and Director of the Decatur First Bank, a full service community bank recently chartered in Georgia.
