Everyone has pros and cons to weigh when they decide whether prepaying a mortgage makes sense. In some cases, the pros stand head and shoulders over the cons. For other people, the drawbacks tower over the advantages.
At the crux of the decision is the fact that you’re paying interest on the borrowed mortgage money, but if you use your savings to pay down the loan balance, you won’t then have that money working for you earning an investment return. More importantly, what happens if that rainy day comes along and you need those handy cash reserves?
Interest savings: The benefit of paying off your mortgage earlyMortgage prepayment advocates focus on how much interest you won’t be charged. On a $100,000, 30-year mortgage at 7.5 percent interest, if you pay just an extra $100 of principal per month, you shorten the loan’s term significantly. Prepayment cheerleaders argue that you’ll save approximately $56,000 over the life of the loan.
It’s true that by making larger-than-required payments each month, you avoid paying some interest to the lender. In the preceding example, in fact, you’ll pay off your loan nearly ten years faster than required. But that’s only part of the story. Read on for more.
Quantifying the missed opportunity to invest those extra paymentsWhen you mail an additional $100 monthly to your lender, you miss the opportunity to invest that money into something that could provide you with a return greater than the cost of the mortgage interest. Have you heard of the stock market, for example?
Over the past two centuries, the U.S. stock market has produced an annual rate of return of about 9 percent. Thus, if instead of prepaying your mortgage, you put that $100 into some good stocks and earn 9 percent per year, you end up with more money over the long term than if you had prepaid your mortgage (assuming that your mortgage interest rate is below 9 percent).
Conversely, if instead of paying down your mortgage more rapidly, you put your extra cash in your bank savings account, you earn little interest. Because you’re surely paying more interest on your mortgage, you lose money with this investment strategy, although you make bankers happy.
If you’re contemplating paying down your mortgage more aggressively than required or investing your extra cash, consider what rate of return you can reasonably expect from investing your money and compare that expected return to the interest rate you’re paying on your mortgage.As a first step, this simple comparison can help you begin to understand whether you’re better off paying down your mortgage or investing the money elsewhere. Over the long term, growth investments, such as stocks, investment real estate, and investing in small business, have provided higher returns than the current cost of mortgage money.
Taxes matter but less than you thinkIn most cases, all of your mortgage interest is deductible on both your federal and state income tax returns. Thus, if you’re paying, say, a 6 percent annual interest rate on your mortgage, after deducting that interest cost on your federal and state income tax returns, perhaps the mortgage is really costing you only about 4 percent on an after-tax basis.
For most people, approximately one-third of the total interest cost of a mortgage is offset by their reduced income tax from writing off the mortgage interest on their federal and state income tax returns.
However, don’t think that you can simply compare this relatively low after-tax mortgage cost of, say, 4 percent to the expected return on most investments. The flaw with that logic is that the return on most investments, such as stocks, is ultimately taxable. So, to be fair, if you’re going to examine the after-tax cost of your mortgage, you should be comparing that with the after-tax return on your investments.
Alternatively, you could simplify matters for yourself and get a ballpark answer just by comparing the pretax mortgage cost to your expected pretax investment return. (Technically speaking, this comparison isn’t as precise as the after-tax analysis because income tax considerations generally don’t exactly equally reduce the cost of the mortgage and the investment return.)