'Free and Clear' Ownership: An Overvalued Concept

Q: Our condominium is worth about $350,000, and we owe only $25,000 on our mortgage. We are from the old school and want to own this property free and clear. We have the money and are considering paying off the loan. Is this a good idea? If so, how do we go about making sure it is done correctly?

A: The old school is a reference to our parents (or grandparents) who lived through the Depression in the 1930s. When the stock market crashed and lots of people were unemployed, those who owned their home free of any debt at least had a roof over their heads and did not have to sleep in the streets or under the bridges.

There are many people today with this mind-set. While I disagree with this concept, I certainly respect and understand their views.

Let me play devil's advocate, though: You have $325,000 in dead equity. This is the difference between what your property is worth and what you owe -- and it's an asset that's not doing anything. A few years ago, your condominium unit probably increased in value by 10 to 20 percent per year, if not more. In today's market, the value of your home has probably decreased slightly, though some recent statistics on the District of Columbia indicate that while sales have slumped, property values nevertheless increased last year.

Appreciation is not dependent on what you owe. The house will increase or decrease in value whether or not you have a mortgage. The money you have in your property, which we call equity, is just sitting there.

You now want to take $25,000 out of your savings and pay off the loan. Why? You are getting some small tax benefit from the interest deductions, and presumably you are getting a decent rate of return on your investments. Other than the satisfaction of owning your house free and clear, I do not see any benefit.

In fact, I would recommend that you weigh refinancing to increase your debt. Interest rates today are comfortably low, with the national average for a fixed 30-year loan hovering below 6 percent. You could borrow $100,000; pay off your outstanding debt; and, after paying closing and settlement costs, walk away -- tax-free -- with about $73,000.

The monthly mortgage payment on this loan (at 5.625 percent) would be $575.66, which is probably close to what you are now paying on what remains of your previous loan. And because this is a new mortgage, your interest deductions would be larger.

For example, if you are in the 28 percent tax bracket (married, filing a joint tax return and earning less than $200,300 per year), this would provide you with a monthly deduction of $161.18 (or $1,934 yearly). Your real monthly payment would be only $414.48. (Note: Unless the money you borrow is used to improve your property, under current tax law you are able to deduct interest only on the first $100,000 when you refinance.)

Many readers will challenge me. They will point out that it makes no sense to pay 5.625 percent on a mortgage while getting only 4 percent or so on the refinanced money in a money-market account.

I do not disagree. But over the years, I have had too many clients from the old school who have been "house rich and cash poor." They own their house free and clear but do not have sufficient money to pay their increasing real estate taxes or their insurance premiums. I firmly believe that everyone should have money in the bank, even if it does not pay a lot of interest, for that rainy day.

If you still want to pay off your mortgage, here's what you should do:

First, make absolutely sure that there is no prepayment penalty attached to your loan. Because your remaining balance is so low and you have had the mortgage for a number of years, I doubt that there is such a penalty, but you have to confirm this.

When you obtained that loan, you signed two important documents: a promissory note and the deed of trust, also known as a mortgage. The terms and conditions of your loan, including any prepayment penalty, will be spelled out in those documents. Read them carefully. If you have trouble understanding the legal language, discuss the situation with your lender or your lawyer.

You should send a formal written request to your lender asking for a payoff statement and advise the lender of the exact date that you expect to send in your payment. The lender will tell you the outstanding balance and will provide you with the "per diem" interest.

Mortgage interest is calculated in arrears. So when you make your February payment, for example, that pays the principal and interest that accrued in January. For most loans, other than those insured by the Department of Veterans Affairs, you can pay off your loan on any day of the month. Example: Assuming you made the February payment, the payoff statement will indicate the principal balance as of Jan. 31 and will tell you what the daily interest will be. If you plan to pay it off on Feb. 23, multiply the per diem interest by 23 and add this amount to the outstanding balance.

Keep in mind, however, that interest will continue to accrue until the lender actually receives your check. So I would add 10 days of interest, just to be on the safe side. All legitimate mortgage lenders will refund any excess payments.

To my knowledge, a VA-insured loan is the only mortgage that requires you to pay a full month of interest. In that case, try to time your payment so that it reaches the lender by the end of the month.

What about any escrow money that your lender is holding to pay real estate taxes and insurance? The payoff statement should advise you of the amount being held. Some lenders will deduct this amount from the outstanding balance; most lenders, however, will send you a separate check after you make your final payment.

Don't forget to advise both your real estate tax office and your insurance company that you will be responsible for these payments. I recently represented a lawyer who paid off his loan but forgot to advise the taxing authority. It was only when he learned that his house was about to go to tax sale that he was able to resolve the situation.

When you took out your loan, the deed of trust was recorded among the land records in the jurisdiction where your property is. Now that you have paid off the loan, you want to make sure that it will be released from land records. Some jurisdictions require that a certificate of satisfaction be recorded, while others use a deed of trust release.

Your lender will either arrange to record the release or send it to you for recording. Either way, you want confirmation that the release has been accomplished. This means that you want proof of recording, which you can get from your local recorder of deeds.

Finally, your lender should return the original promissory note, marked "paid and canceled." The note is what is known as a "bearer instrument." This means that anyone who has that document could claim that you still owe the money. This is not a major problem because you will have proof that you paid off the note. But why ask for trouble? Make sure that the lender returns the note to you.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site, http://www.kmklawyers.com.