Introduction
In yesterday’s post about paying your mortgage off early, a reader commented wondering if he should take out a balance transfer at 0% APR with a 2% fee to pay down his 3.75% mortgage. Before you roll your eyes, it’s actually a valid question. But let’s rephrase the question – if I gave you $20,000 cash, what would you do with it? Here are some options:
- Buy a new car!
- Invest that money into an index fund and hope to get a 5% return in a year
- Pay down your mortgage of 3.75%
- Put the money into a savings account at 4.59%
- Use it for MS, reselling float, start a new business, etc.
I know there are more options, but let’s just assume those are the most popular.
Buy a new car
Hey, you do you. I’m not here to judge. But let’s say you don’t need a car.
Invest that money in an index fund
As you can see from the chart below, 2015 was a neutral year for the S&P500 index, but for the most part, it’s been a pretty solid investment. There’s still some risk in it, but if you are truly risk averse, you might say, “I’m not playing the stock market. It’s one big ponzi scheme!” then well, I’m not gonna argue with you so let’s just move on.
Pay down your mortgage of 3.75%
Let’s say you want nothing to do with the stock market or you are afraid it’ll only return you 1.4%. Then taking that 20K and saving yourself 3.75% doesn’t look like a bad option. You’ll be paying down your mortgage principal and you’ll pay off your house sooner. This option assumes you already have a rainy day emergency fund by the way. Before you go this route though…
Put that money into a savings account of 4.59%
Now before you trolls bring out your pitchforks, let me just say this deal has already been posted by DoC here, so just put the pitchfork down. I’m not gonna kill the deal. They’ve already neutered the program starting in 2016 by lowering it from 5% to 4.59% and also capping the Visa card. Anyway, there are some hoops you’ll jump through, but it’s worth it. Trust me.
- First, sign up for the checking account.
- Secondly, sign up for the Visa card. The Visa card earns 3% at grocery stores (up to $6K spend)
You then park the $20K into the checking account, make 12 debit card transactions per calendar month and then put $1K on your Visa card at a grocery store (uhh you know what to buy.) And that’s it! Every month you’ll earn the equivalent of 4.59% APR. This route clearly beats the mortgage route of saving 3.75% APR. Plus this has the added benefit of being very liquid so if an emergency arises, you can easily withdraw it in days.
Hate making 12 debit card transactions? Well I can assure you there is a pajama method to doing that at zero fee. I’m not gonna post about it because that for sure will bring on the pitchforks, and I surely don’t want to kill it for myself either. Just think of a zombie MS method from the past.
Use it for MS or reselling float
When I got the WF card, I actually took the $20K from Consumers and used it for MS float. The rationale was this – why would I want to earn 5% a year when I can earn 5% in 2 days? Exactly.
Conclusion
So which method is best? I can’t tell you that. I don’t know your financial situation. I can tell you now that WF has died, I’m moving $20K back into Consumers. Since it’s capped at $20K, I like the “guaranteed 4.59%” vs the stock market. Don’t get me wrong – I still put money into the market and if I need the float, I can easily move money back out of Consumers (vs trying to take out a HELOC on my house.)
Paying down / off a mortgage is never a bad choice in the long run. Is it the best choice depends on your situation.
Question for Miles per day. You mention “Consumers” (I’m moving $20K back into Consumers.) this is a term I am unfamiliar with in this context. Would you please help me out with what you are saying here.
The bank that is paying the 4.59% APR. Click through to the link in the article
Be aware that how many years remaining on your mortgage is an important factor in determining whether it makes sense to pay down vs save/invest that money. In this example the interest rate may be 3.75%, but this isn’t the whole story. You make equal monthly payments over the life of the mortgage; in the first few years, most of the mortgage payment is made up of interest, but by the latter half of the loan life, most of the monthly payment is principal. By paying down early if you are even just a few years into the loan, you are not actually saving 3.75%; it is less than that. As others have pointed out, your “savings” from not having to pay future mortgage payments are diminished by the loss of the tax benefit from deducting interest expense, but more importantly it means forfeiting months of earning cumulative interest income (look up “time value of money”). In general, unless your investment/savings options are dismal (they are not thanks to some high interest savings/checking available) and the interest rate on your mortgage very high, prepaying is usually a bad idea.
Thanks Elan. And yes, I know about time value of money. I found out overpaying 20K yields an interest savings of 40K over 30 years. Putting 20K into a 4.59% APR compounded annually for 30 years yields 70K, so clearly the savings account wins.
I guess my point is even if the mortgage interest rate were equal to the APY of 4.59% you’d earn by saving that money, saving would still be the better option than prepaying. The rate on the mortgage would have to be higher (how much higher exactly depends on your tax bracket and time left to maturity) for prepayment to make sense.
Thoroughly enjoying the last set of posts – nice change of pace and your PF writing/knowledge is strong. Curious if you and your wife are pursuing financial independence?
Don’t we all… Thanks for the compliments! We are still a long ways to go, but we hope to be financially independent by the age of 50, which I think is attainable. There are a lot of things uncertain, such as college tuition for my kids (I am still torn between believing an exponential growth or a sudden collapse due to cheap/free online courses) and (surprise!) job security, so we are exploring different avenues to generate income, not just to invest, for the long run.
After all, cash is still king. You can only chase so many deals in a day (unless you are Shawn Coomer who doesn’t sleep) or earn so many points/miles and have the time to maximize them. With little cash, eating instant noodle in an overwater bungalow at Bora Bora seems just as fun and memorable as feasting on free bread at a sunset dinner in Maldive (oh wait, certain ex-couple did both). Don’t get me wrong, I will probably do the same, but that’s just because I am…cheap (stop checking my last name), but hopefully one day I can be in the position of flying the Residence on Etihad’s A380, in cash…
All right, folks. Here is the infamous me who made the suggestion. Now to be clear, BT offers used to go straight to trash for me, and I even tried to call the banks to stop sending these offers (if you are listening Chase, please save your paper and send me CSP 50K + 25K offers instead), until Rene Points did a podcast on utilizing the 0% BT offers (http://renespoints.boardingarea.com/2016/05/08/renepoints-podcast-ep4-should-you-ever-do-a-0-fee-balance-transfer-maybe-if/) that got me thinking.
I agree with Vinh’s $20k litmus test, and for all of you in the 20’s, max out your 401k/Roth IRA/HSA AND build a 6-12 month safety (max out ESA and maybe a term life insurance if you have kiddo) will save you from working at age of 70 at WM (assuming it still exist).
But for me, since my MS money is strictly for play in my portfolio, I want to keep my diversification and not let it overlap with my investments, especially through leveraging (i.e. borrowing at 2% fee and hoping the return in 12 months outweighs the fee), which I hate the idea.
We MS because it is quick and easy and has a foreseeable outcome, so I want to keep taking that same stand on this MS money going forward. Index funds are good, but still not FDIC-insured,, so a no-go for me.
I COULD just pay down my mortgage straight with this money, but what if a green or yellow bird comes along next month? Gotta be ready for the game!
Buying a car or starting a business? On it already ; ) The return is inconsistent and low on points/miles , so I don’t want to lock my MS money in there.
Thanks Vinh for pointing out the Consumers account. I totally missed this one! Perfect for the security and liquidity that I was looking for. We got a winner!!
Everyone’s portfolio is different, and I agree financial illiteracy (or ignorance) is the main cause of the country’s financial instability and wealth gap, thus my proposition was strictly for this inner circle of the daily-WM-MS (and Amex FR’d?) who has disposable assets to play around with.
Stay thirsty, my friends!
Two points about the 2% fee 0% APR balance transfer. (1) he/she has to pay the balance when the promotional period ends. He/she cannot take the money out of the mortgage once it’s put there, right? (2) Once you start carrying balances your credit utilization increase and thus your credit score decreases. So you won’t easily get accepted for credit cards if you are playing that game.
All solid points and I hope the reader reads this.
(1) Obviously i would have to assume my MS money can at least double during the 12 months AND commit to paying down the principle. Not an easy feat with the demise of WF cards.
(2) I received multiple offers so I was thinking of splitting the credit utilization among a few cards.
All very good points though!
You’re forgetting taxes. Even considering the deductibility of mortgage interest, paying your 3.75% mortgage off is better than earning 4.59% because the after tax rate of return of the high-interest account is much lower after federal and state and local taxes.
Well if you put the 20K into the mortgage, that all goes to principal, so that actually reduces the amount of mortgage interest you’ve paid and thus less you can deduct on your taxes going forward (not that that’s a bad thing.) Even if we assume your avg tax rate is 25%, now you’re netting 3.44%. While lower than the mortgage, at least it’s more liquid. At this point, it’s personal preference.
I forget you Seattle folks pay no state or local income taxes… crazy
This is arbitrage, plain and simple. You get a deduction for interest paid and have a tax liability on interest earned. With your example rate of 25%, the interest earned drops to 3.44%, but the mortgage interest saved as an alternative is likewise reduced to 2.8125% so you are still ahead. The arbitrage return is .8125% for the mortgage versus 1.44% for the savings account. Paying down the principal reduces the total interest paid this year but the rate is the same. It is easy to get confused about mortgages. BTW, almost nobody in this country pays 25% in income taxes. The effective tax rate for the average American is in the single digits!
What would make the comparison more interesting is if the OP was going to pay down a HELOC or HEL. Then the monthly payment would drop, rather than just reducing the term of the mortgage payments.
Personally, I think it would be foolish to pay down a low rate secured loan that has tax deductible interest. Keep your MS powder dry for opportunities and the unforeseen.
Not sure I understand the drop from 3.75% to 2.8125%. I know you cut it down 25%. Let’s say I make $10K of mortgage payments this year (and say 75% goes to interest and 25% goes to principal since I’m early on the mortgage.) If I made an extra $20K payment, all that goes to principal, so I’m still only deducting $7500 on my taxes. I can’t deduct any of the $20K. Actually I found this tool – http://www.moneysavingexpert.com/mortgages/mortgage-overpayment-calculator#results that says if I make a 1 time lump sum overpay of 20K, I’ll save about 40K in interest, but that’s over the life of 30 years. However, if I invest 20K at an APR of 4.59% compounded annually, I’m 77K richer after 30 years. I think I proved your point. Regardless, I’d never go this route, but thanks for making me dig into this further.
You shouldn’t think about how much “goes to interest” or “goes to principal”; it puts you in the wrong mindset. What matters is that there is now $20,000 of loan that you’re not paying interest on. That saves you $750, easy-peasy.
BUT, you also lose some of your tax deduction; ($187.50 if you are in a 25% combined marginal bracket.) So you saved $562.50 by paying down 20,000 of mortgage. That’s 2.8125%.
No, it’s not. Your savings from the mortgage paydown are also reduced by your combined marginal tax rate (for someone who itemizes.) Show your math if you believe otherwise. If you take the standard deduction, your point could be true for someone with a combined marginal tax rate greater than 18%.
Yeah I don’t have a dollar in (other) itemized deductions and face the 33% federal rate and 10% combined state and local. Maybe that’s more of an exception, but it’s clear to me which is better.
Hmm, you are in a pretty interesting situation. Well, payoff wins by a good margin for you then! Ouch on those state and local taxes.
Good post. Is Consumers didn’t do a hard pull I’d have an account for my wife and I. We already have 5 prepaid cards each and an Insight card on the way. That’ll be $30k for each of us earning 5%. Yup, still kicking myself for not doing the WF card.
Sounds risky. I can’t see information that the the money is insured by the FDCI.
That’s because credit unions are incured by NCUA, not FDIC 😉