A few months ago, I shared this article on with a friend which highlights the incredible return on investment you receive when prepaying your mortgage. Well, this friend asked me if he should consider using this strategy for himself.
He gave me the following particulars about his situation:
1. His monthly mortgage payment is around $1,600 per month. This payment does not include property taxes and homeowners insurance.
2. His interest rate is 5.85%. This rate is higher because he hasn’t refinanced to a lower rate.
3. His goal would be to have his mortgage paid off in full in 8 years.
I did some rough math based on his outstanding mortgage balance and his current interest rate and determined that he would need to prepay around $600 a month on his principal balance in order to have his mortgage paid off in full in 8 years.
When he heard this number, he decided it wasn’t possible to achieve this goal. He didn’t have an extra $600 a month in his budget.
So I gave him another way of doing this and I think this way might actually provide a better overall result. I suggested he move a portion of his retirement savings into a “self-directed” IRA. A true “self-directed” IRA allows you to invest your retirement savings in just about any asset including real estate. He could use the funds transferred into this self-directed IRA to buy a single-family home for cash.
The home would be purchased and owned by his “self-directed” IRA. All income and expenses for this property would flow into and out of his “self-directed” IRA.
As an example, he could purchase this home in our area for around $55,000:
This home is a 3 bedroom, 1 1/2 bath colonial on a slab. The home would easily rent for $995 per month. After deducting property taxes and insurance, the monthly net income would be around $795. If we then saved another $75 a month out of this income for future maintenance and repairs, he would have around $725 of monthly net income after property taxes, homeowners insurance, and maintenance and repairs.
His “self-directed” IRA would receive $995 per month and would then pay the various expenses directly leaving $725 a month in his IRA.
My suggestion was for him to consider withdrawing this $725 each month from his IRA and using it to prepay his mortgage payment.
Yes, he would have to pay taxes and penalties for this early withdrawal. I don’t know what his taxes and penalties would be exactly, but I’ve used $125 a month as an estimate. If we now subtract this estimate for early withdrawal taxes and penalties, he would have around $600 per month available to prepay his mortgage.
Assuming he keeps this home rented, he will be able to prepay his mortgage in about 8, or 9 years. Obviously, he will have a few vacancies during the next 8 years. These vacancies may set his mortgage payoff date back a year or so, as he won’t have the monthly withdrawal from the rental income during each vacancy.
When his mortgage is finally paid off in 8 to 9 years, he can stop taking the monthly withdrawals from his IRA. Even better, he will have an extra $1,600 a month each month as his mortgage payment will be eliminated. Plus, he’ll also have the $725 a month flowing into his IRA from the rental home.
We have always been told to never withdraw money from our retirement savings and I believe this is good advice for the most part. However, I think if we are smart, we have the ability to use our retirement savings to our advantage.
The reason why we are advised never to withdraw our retirement savings is because we lose the future use of the funds withdrawn. We also lose any future compounding or appreciation of the funds would have earned if not withdrawn. These loses can be significant if we simply spend the money we withdraw and this would certainly be a BIG mistake.
This idea is different.
The money withdrawn is not being spent. It is being reinvested into the mortgage prepayment. At the end of 8 or 9 years when his mortgage is paid off in full, his self-directed IRA will still own the mortgage-free single family home. This home will hopefully have appreciated a little during these 8 years. In addition, the rental income would still be flowing into his IRA after he stops his monthly withdrawal allowing these funds to be reinvested inside the self-directed IRA.
His $55,000 investment today inside his IRA, will provide him with $725 a month of income inside his IRA and an extra $1,600 a month outside of his IRA in 8 years, 0r 9 years. Plus, he’ll still own the $55,000 mortgage-free home inside his IRA.
Would you invest $55,000 today to receive $2,325 per month in 8, or 9 years? (The $2,325 is determined by adding the $1,600 mortgage payment that will be eliminated plus the $725 of net rental income after the mortgage is paid off.)
On a high-level, the idea is to have his tenants prepay his mortgage on his behalf. If he were to withdraw the funds from his IRA and use these funds to directly prepay the outstanding principle balance, he would not have the use of these funds in the future. He may eliminate his monthly mortgage payment, but he wouldn’t have the mortgage-free rental property.
This idea gives him the best of both worlds. His mortgage his paid off early AND he keeps the income producing asset inside his IRA. He gets to have his cake and eat it, too.
Oh and the return on investment from this idea is extremely attractive. Take a look:
1. Return on investment on the single family home after deducting taxes, insurance, maintenance, repairs, and IRA withdrawal penalties: 13%
($600 of net monthly rental income is $7,200 annually. $7,200 divided by $55,000 to buy the home for cash)
2. This monthly income is then reinvested into prepaying the mortgage. Based on his amortization schedule, this 2nd investment would provide another 50% return on his investment. This amount is determined by looking at the monthly breakdown of principal and interest payments per his amortization schedule. See this article for these calculations.
The approximate combined return on investment for this idea is…. 63% annually. This combined return on investment will decline over time as he reduces the principal balance of the mortgage and more of the monthly mortgage payment is allocated towards principal instead of interest.
What do you think about this idea? Do you think it makes sense, or is it a mistake?
Notes & Assumptions:
1. The $75 set aside each month for maintenance and repairs may not be the right amount. This would be around $900 annually. The home pictured in this article is a nice home and hopefully won’t have any major repairs during the next 8 years. In most months there won’t be any maintenance and repair issues. In some months there may be some plumbing, or other problems. If his repairs and maintenance expenses are higher, his mortgage payoff date would obviously be pushed back.
2. The estimate for taxes and penalties for withdrawing funds from his self-directed IRA may also not be accurate. These amounts would be based upon the type of IRA (traditional vs. Roth) and his tax rate.
3. Each vacancy he has with this rental property during the next 8 years will set his mortgage payoff date back a month or two as he won’t be able to make mortgage prepayments during those months. He may also have larger repairs and maintenance expenses during these vacancies as he has to get the home ready to show to new tenants.
4. If during any vacancy he were to continue making the $600 mortgage prepayment out of his own funds, he would still be able to pay his mortgage off in full within the desired 8 years.
5. This idea SHOULD BE DISCUSSED WITH A CERTIFIED PUBLIC ACCOUNTANT and other professionals to determine accurate forecasts for all penalties and taxes based upon your complete financial situation including income from other sources.