When to pay down your mortgage

ear Liz: Should you pay off your mortgage or keep a sudden financial windfall? I’m in that situation and was surprised to find that financial experts, including you, generally recommend investing the cash. I understand the attraction of the argument but am not sure the assumptions hold water.

The experts’ argument boils down to this: You can make more money by investing the proceeds than you’d save by paying off the mortgage. Keeping the mortgage — with an interest rate of, say, 5.8% — is fine because the returns on your investments, plus the tax deduction for the mortgage, will more than cover that cost. A mortgage is the cheapest money you can get and a hedge against inflation. This plan also gives you more liquidity.

I say: Unless I can guarantee that I can make 5.8%, I might lose money. And I’d basically be borrowing money just to invest it (and keep some liquidity). That seems risky! If certificates of deposit were earning 6% it would be a no-brainer, but they’re not. Also, it’s impossible to put a price on the sleep-well-at-night factor.

I’d like to read your thoughts.

Answer: You’re right that the investing argument requires a lot of assumptions that may not hold up in real life. But that’s not the reason most people should think twice about paying down a mortgage.

The reality is that most people have better things to do with their money than pay down a low-rate, deductible debt such as a mortgage. For one thing, they should be taking maximum advantage of their tax-deferred retirement options, especially if their company plan offers a match. They also need to pay off other, higher-rate debt before considering extra mortgage payments, and they should have a substantial emergency fund set aside as well. Then there’s insurance to consider: If you don’t have adequate life, health, disability and long-term care coverage, those policies should be purchased before considering mortgage repayment.

If you’ve got all your bases covered and still want to pay down or pay off your mortgage, then have at it. For many people, the security of a paid-off home is well worth forgoing some extra investment income.

Investor runs risk of “walk away” lawsuit

Dear Liz: My wife and I had two houses built for resale, then as you know, things went bad. The construction loans were continued at 7.75% and we finally rented the homes, but the mortgages are costing more than we’re getting in rent. We have attempted to refinance but will have to pay down each loan by $100,000 to do so, since the homes have fallen in value and lenders are more conservative about loan-to-value ratios. I am thinking of threatening to walk and maybe they will negotiate but am wondering about the downside. I know our credit will be impacted but since I am over 70 and do not plan to do a lot of borrowing, that does not seem to be an issue. I do make enough to keep this going but do not want to. Please advise.

Answer: Walking away from these mortgages will trash your credit, but you may face a much bigger problem: the lender could sue you for the balances you owe. Some states protect borrowers from such lawsuits, but the protection typically doesn’t extend to investors.

You may want to talk to an attorney familiar with debtor protection in your state (a bankruptcy attorney might be a good choice) to get an assessment of your risk. You also should discuss your overall financial situation with an experienced, fee-only financial planner. The planner can help you assess whether sinking another $200,000 into these properties might pay off in the long run, or if you’re risking throwing good money after bad.

What foreclosure does to your credit

Dear Liz: My son and daughter-in-law are thinking about walking away from their underwater mortgage. What are the long-term consequences? The house was purchased in 2005 for $577,000 with no down payment. It’s worth $370,000 and they don’t expect values to rebound any time soon.

Answer: A foreclosure would be a major black mark on the couple’s credit reports and probably would reduce their scores to subprime territory (below 620). Recovering from such credit blows is tougher than it was a few years ago, when lenders were still eager to give money to people with shaky credit.

That means your son and his wife could spend several years in credit limbo. They may have trouble renting an apartment, be required to make bigger deposits for utilities and phone service and even (in some states) pay more for insurance. Whether their credit will recover before home prices do, though, is an open question. Typically, negative marks like a foreclosure fall off credit reports after seven years, and credit scores can recover to near-prime levels before that.

A foreclosure also puts borrowers in a kind of penalty box with lenders. They may not be able to get another mortgage for four to five years. If they were to arrange a “short sale” or voluntarily hand over the keys to the bank, rather than waiting for a formal foreclosure, their “penalty box” period could be as short as two years, although they would still suffer significant damage to their scores.

If the couple are having trouble making their mortgage payment, they should contact a housing counselor approved by the Department of Housing and Urban Development (referrals at http://www.hud.gov to review their options and see whether they should try to pursue a mortgage modification to make their payments more affordable. Relatively few homeowners succeed in getting permanent modifications, but it’s certainly worth a try before they walk away.

They should also read attorney Stephen Elias’ book “The Foreclosure Survival Guide” to understand what may lie ahead.

How FICO treats HELOCs

Dear Liz: I refinanced a while ago, replacing my mortgage with a $193,000 home equity line of credit. The line of credit appears on my credit report as “revolving credit,” which makes it look like a large credit card debt, rather than a mortgage loan. What can I do?

Answer: It’s not clear that you need to do anything. The leading credit scoring formula, FICO, treats large home equity lines of credit as installment loans, even though they’re actually revolving accounts. The company that creates the FICO formula is secretive about what constitutes “large,” but a six-digit line of credit would almost certainly qualify.

Lender wants to see tax return for existing HELOC

Dear Liz: I had a home equity line of credit for about 15 years and was never late on a payment. I didn’t always carry a balance, but when I did, I paid more than the minimum required. My lender froze my account because I refused to sign an agreement to give access to my IRS records. What should I do?

Answer: If you want to tap your home equity, you’ll sign the agreement.

In the boom years, many banks abandoned prudent lending practices and didn’t bother to verify borrowers’ stated incomes. That has changed, and virtually every new mortgage these days requires borrowers to give lenders access to their recent tax returns as filed with the IRS.

So you can close this account if you want, but a new lender is going to want to see the same records.

You may feel your current lender’s demand is invasive, since you’ve handled the line of credit responsibly in the past. But high default and foreclosure rates have lenders spooked. Yours has obviously decided to verify that you are the low-risk customer that you seem to be, so if you want access to the line of credit, you have to play ball.