This article originally appeared on The DIV-Net on January 15, 2014.
I had one of my readers write to me about advice on what he should do with an additional $20,000 he was going to have after selling off an overweight holding that was profitable.
Here’s his question:
“I’m 30 years old, no debt other than the mortgage (30yr @4.875%) and started investing this year. My DGI portfolio is approximately $40k, $8K as an emergency fund and about $22k of Cisco stock in an Employee Stock Purchase Program.
I recently looked into refinancing my house. The appraisal came back lower than expected. My goal with the refinance was to get rid of PMI. We have had our mortgage for 2 years. It turns out we need about $20k to get rid of the PMI. I am considering using the Cisco stock to pay down the mortgage and remove the PMI. I am also looking into moving forward with the refinance because I can get a 15 yr @ 3.5% and only raise our monthly payments about $150/mo.
The Cisco stock was purchased at around $13 (CMV at $22), so there has already been a nice gain. I plan to sell most of the stock regardless. But, I am unsure if I should place that money into investments or pay down the mortgage to remove the PMI. It is a big chunk of our assets that can be used to create a big future income stream. If I continue to pay the minimum on the mortgage, I will pay about $5,600 in PMI.”
This is a pretty good problem to have but it can be tough to know what to do. I think the answer is “It depends…”
There was still some questions I had but my initial response with a few assumptions was the following:
My first question is what type of tax treatment will you be getting if you sell shares of CSCO? I’m not real familiar with an ESPP since I don’t have one but I know selling at different periods after buying will have different tax implications. I would check that out first. I’m assuming you will be paying taxes on your profits.
Next, I don’t know how much your PMI payment is. Let’s assume you are paying $100/mo PMI. That’s $1200/year. $1200/$20,000 is a ROI of 6%. Not so fast though. PMI can be written off your taxes. If you are in the 28% bracket (assuming) then that $1200/year is only costing you $864. If you now take $864/$20,000 you get 4.3%. This is much lower.
Second, I love to use ammortization calculators. If you refinance at a lower rate then you are paying less in interest each month. I would also take a look at the difference in your interest payments from current to the new loan. Keep in mind that these interest payments can also be written off your taxes so a savings of $200/month in interest might only be a savings of $144/month (@28%).
Third, you need to consider what your expected return on investment is going to be for the $20k you are spending to eliminate PMI. This is your opportunity cost. Would that $20k be better in DG stocks? If I knew the markets would do the same thing in 2014 as they did in 2013 I’d definitely put the money in the market. However, nobody knows the future.
So it’s hard to say exactly what to do. I think it’s always great to eliminate debt. You just need to consider the cost of doing so because you are giving up other opportunities.”
About 70% of the stock would be taxed at ordinary income rates, 28% tax bracket, with the remaining at 15% LT capital gains tax. I consider this a reasonable tradeoff because of the large gains made.
Next, the PMI wouldn’t be deductible as I am outside of the AGI income levels for the year.
My biggest concern falls exactly in line with your final point about the opportunity cost. I can only imagine what the income stream $20k+ could make in 20 years. I just want to make sure I’m not being blinded by this year’s amazing returns.
The idea of diversification away from a technology stock in which I have already made a large gain is tempting. I would consider the mortgage prepayment as diversification with a two fold return (removal of PMI and reduced interest over the life of the loan).
All in all, I am glad that my biggest problems right now are deciding where to put an extra $20k. I look forward to your upcoming posts. Cheers to a great 2014!”
That’s a tough one AAI. Ultimately it’s about your reader and what he’s comfortable with. I was in a similar situation not too long ago. I split the difference. Holding some cash for future opportunities and using some to refinance. My refinance shortened the number of years remaining on the term and lowered my payment by nearly $200 per month, so it was a little different but still………I find in these situation I like to hedge my bets and take a little of each option.
-Bryan
Hi Fast Weekly,
That’s not a bad idea either if there is enough money to do both. You get the best of both worlds.
Thanks for stopping by!
PMI gets removed once the LTV reach 78% of the original loan amount. Unless the mortgage is several hundred thousand dollars I would have put that cash straight to the principle.
That’s true and you don’t have to refinance in that case. It can be a tough decision but I don’t think there is a true right or wrong here. It comes down to the person’s objectives and risk tolerance.
Cheers!
If the reader is still wondering what to do, I’ll gladly put my name out there as a place to put the money. But in all reality paying down the mortgage and getting rid of PMI or investing in the markets is a good strategy. 4.875% isn’t an unbearable interest rate but it’s still a solid guaranteed rate of return. I’d probably hedge and go $10k towards the principle and $10k towards investing. How long would it take to get rid of PMI going that route? Lots to consider as there’s opportunity costs abound. I’m struggling with this myself as there’s some investments I would have made under normal conditions but I’m trying to balance that with making a move towards an investment property. Still though, good problems to have.
PIP,
Haha, that could be a third option. I agree, there is a lot to think about here. The amount to reach 78% LTV is important as IE mentions also to remove PMI.
Take care