November, 2011
By Michael Kalscheur, CFP®
Senior Financial Consultant, Castle Wealth Advisors, LLC

Last year we wrote about an opportunity that only comes around once in a generation – a 3% mortgage (read the 2010 article: We went to some pains describing how rare of an event this is and what opportunities it presented. By now we thought that this feat would be long gone.

Surprisingly, here we are again, one year later talking about 3% mortgages. The opportunities are just as good, if not better, than a year ago. In addition to low rates, lending standards have eased, making loans easier to acquire. Even housing prices are lower as measured by the Case-Shiller Index: 135.48 as of 9/30/11 vs. 137.56 on 9/30/10.

Note: For comparison purposes, 3/31/2000 is the base of 100.00 and the index peaked on 6/30/08 at 189.93. That means current housing prices are almost 30% lower than the peak 3 years ago. The Case-Shiller Index has not seen current levels since 2003.

However, instead of just rehashing what we discussed a year ago, let’s look at how we would have done if we would have taken the advice in the newsletter, and what the future might look like going forward. Last year we proposed two opportunities that might make sense given what we knew at the time:

  • Borrow as much as you can for as long as you can. If you can borrow at 3% - 4% and reinvest at a higher rate, you could make a small fortune using someone else’s money.
  • Refinance at the lowest rate possible and pay your home off sooner. Reducing your interest rate from 5.25% to 4.25% will save $60 per month on every $100,000. Adding that money to the monthly payment can cut years off your mortgage.

Let’s start with the second option first. Let’s say that last year you owned a $250,000 home with a $200,000, 30-year fixed mortgage @ 5.25%, with a monthly payment of $1,104.41. After one full year, you would have paid down your mortgage by $2,820.11. If you refinanced @ 4.25% (saving $120.53 per month), but kept your payment the same, you would have paid off $4,846.60 – an increase of $2,026.49. You would also be on track to pay off your mortgage in just 24 years, 3 months. Not too bad.

Note: There are some people out there who did refinance last year but are still kicking themselves – those who “paid down” their interest rate with points. 1 point = 1% of the mortgage balance, and would normally decrease the interest rate by 0.25% - 0.50%. A typical person might have paid 1 point ($2,000) to reduce their interest rate to 3.875%, only to find that rates reached this level just a few weeks ago. The moral of the story is this – don’t pay points.

Now let’s see if we had taken the refinancing savings of $120.53 per month and invested it. Here are a couple of possible allocations and the money you would have after one full year:

Asset Class Trailing 1 Year Return Ending Value
Under the Mattress 0.00% $1,446.36
Money Market Fund 0.01% $1,447.30
100% Bonds1 5.07% $1,509.85
50% Bonds1 / 50% Stocks2 6.58% $1,479.16
100% Stocks2 8.09% $1,448.48

1 – November 1st, 2010 – October 31st, 2011 return of the Vanguard Total Bond Index Fund
2 – November 1st, 2010 – October 31st, 2011 return of the Vanguard S&P 500 Index Fund

Two questions jump out from this analysis. First, even though the 100% stock portfolio had the highest trailing return, it barely made more money than putting your savings under your mattress or in a money market fund earning a paltry 0.01% (this equals a whopping 94 cents for the year). How is this possible?

The answer is in the volatility of the stock market and the fact that the savings was put in monthly, not all at once. Most of the positive performance months for the S&P 500 came early in the year, when all the funds were not deposited, while the negative returns came later in the year when the account balance was higher. Only the 10.9% return in the month of October saved the all stock portfolio from being the worst performer.

This is why an investor in the stock market must have a long-term investment horizon, and why we always stress that any cash needs over the first several years should be invested in cash and/or bonds to insure that these market fluctuations do not impact your standard of living.

The second thing is that none of the investment options came close to the over $2,000 in savings from paying down the mortgage, even though the mortgage interest rate was only 4.25%. How could the difference be so large after just one year?

This is because the refinance reduced the interest rate on the entire mortgage balance of $200,000. The lower interest rate reduces the portion of your monthly payment that goes towards interest, putting more of your payment towards principal. More principal payment one month further reduces the interest the following month, and it snowballs from there.

If you break out the savings of the lower interest rate vs. the extra $120.53 per month in payment, you would find that $551.62 of the $2,026.49 in savings is due to the lower interest rate on the mortgage. That means a true apples-to-apples comparison would compare the difference in these numbers ($1,474.87) to our investment options above. Based on this, a 50/50 investment portfolio had roughly the same return.

However, this is just showing paying down a mortgage. Many people have installment debt with much higher interest rates. Here are some examples of the savings realized by paying off these high interest rate loans:

Installment Debt Interest Rate 1 Year Savings
Auto Loan 4.9% $1,485.33
College Loan 6.8% $1,500.76
Credit Cards 19.5% $1,608.62

While this analysis may be rather simplistic (we ignored tax implications), the moral of the story is that refinancing and reinvesting the savings into paying off debt can provide competitive returns with no market risk – a reassuring prospect during these uncertain times.

Michael Kalscheur, CFP®, is a Senior Financial Consultant at Castle Wealth Advisors, LLC. Castle specializes in helping families and closely-held business owners with strategies to protect and transition family assets from one generation to the next. Castle’s senior partners also work with clients throughout the country in making logical decisions to help them fulfill their personal and business financial goals. For more information visit, call 1-888-849-9559 or contact Michael directly at .