Getting out from under your mortgage probably sounds like a no-brainer. If you have the cash, why not pay off the house and avoid the hundreds of thousands of dollars in interest payments you'd otherwise have to make over the next 30 years? Even forking over a little extra each month will save you a boatload and pay off your debt years early. But prepaying your mortgage may not be a smart money move.
Determining whether it’s wise for you means weighing variables including your mortgage rate, tax bracket, age, other debts, and even your outlook for the stock market. Answer these six questions to decide if prepaying your mortgage makes sense.
1. Will I need the cash?
Putting more money into bricks and mortar may build home equity, but it won’t be easy to get the money back quickly if you need it. Don’t even think about prepaying your mortgage unless you have at least three to six months’ worth of living expenses in liquid interest-bearing accounts or bank CDs to cover emergencies. This is particularly critical if your job might be at risk.
2. Do I have any other debt?
If you’re paying interest on your plastic, get rid of those costly debts first. Then turn to your tax-deductible mortgage payoff decision.
3. Am I saving enough for retirement?
About 4 in 10 homeowners make the wrong choice by accelerating their mortgage payments instead of saving extra cash in tax-deferred retirement accounts, says Clemens Sialm, an associate professor of finance at the University of Texas at Austin and co-author of a research paper on mortgage prepayments versus retirement savings. Using Federal Reserve data, researchers found that investors would have earned 11 to 17 cents more on the dollar by investing in 401(k) plans than by prepaying a mortgage. That’s because you pay off a mortgage with after-tax dollars, while you fund a retirement account with pre-tax dollars. The higher your income, the bigger the advantage of putting money in the 401(k) instead of the house.
“Many homeowners may be so averse to debt that they prefer to pay down their mortgages rather than to maximize their overall wealth,” the researchers concluded. So fund your 401(k) or an IRA to the max before prepaying your mortgage. You don’t want to have to sell your house to pay your bills in retirement because you didn’t save enough.
4. What are my mortgage and tax rates?
Your true savings from prepaying a mortgage is the difference between your loan’s rate and what you really pay after factoring in your mortgage-interest deduction. In general, if you have a low mortgage rate (7.5 percent or less), investing the cash that could otherwise go toward prepayments may give you a better return. (And if you do have a mortgage higher than 7.5 percent, you should probably refinance, as long as you have enough years left on the mortgage to cover the costs.) “It isn’t the slam-dunk you automatically get from paying off high-priced debt like a credit card,” says Gary Schatsky, a fee-only planner with ObjectiveAdvice.com. To calculate the after-tax return on your prepayment “investment,” take the rate on your mortgage and multiply it by the inverse of your tax bracket (which you get by subtracting your bracket from 100). Say you have a 6.5 percent mortgage and you’re in the 28 percent tax bracket. Your average after-tax cost for the mortgage is 4.68 percent (6.5 x .72). If you think you can earn more than that by investing — Vanguard founder Jack Bogle told MoneyWatch.com he thinks stocks will return 8 percent in the long term — don’t prepay the loan.
When 55-year-old Cyndee Davis’ divorce settlement came through last year, she considered paying off the $122,000, 6.75 percent mortgage on her suburban Houston home. But she wasn’t sure what the best use of the money would be. “I didn’t know whether I should use the cash to pay off my house, my credit cards, or go into investments,” Davis says. Marc Schindler, a fee-only planner with Pivot Point Advisors, concluded: Don’t pay a dime extra of the mortgage. Instead, get rid of your credit card debt and then invest any spare cash. His reasoning was that since Davis was in the 25 percent bracket, her after-tax mortgage cost was just 5.06 percent. She could earn more — he thinks 9 percent a year, on average — investing in stocks over the 29 years left on the mortgage.
5. How close am I to retirement?
The nearer you are, the more appealing the argument for paying down your mortgage faster. By doing so, “you won’t have to pull as much out of your limited nest egg in retirement to pay the monthly bills,” says Greg McBride, senior financial analyst at Bankrate.com.
Moreover, you probably have a more conservative investment mix than someone 20 years from retirement (at least you should), so the rate-of-return hurdle for prepaying becomes lower. If you are 55, earn 4 percent on your investments, and have a 6 percent mortgage, prepaying the loan looks pretty smart.
- Monthly Prepayments: Here, you round up your monthly payment to an even number — for example, the next $50 or $200 — and tack that extra amount onto each check. If you have a $100,000, 8 percent, 30-year loan, prepaying just $10 per month will carve 19 months off your term and save you over $10,000 in interest, according to Keith Gumbinger, a vice president at mortgage industry publisher HSH Associates.
- Occasional Prepayments: You could try making, say, two bonus payments of principal and interest each year. Prepaying this way could trim about nine years off a 30-year mortgage.
- Biweekly Payments: If you prefer the discipline of an automatic prepayment plan, switch your monthly mortgage to biweekly. This method has a surprise additional benefit: Since there are 26 biweekly periods per year, you’ll actually make the equivalent of 13 monthly payments each year, paying off the loan faster. Check with your lender or mortgage servicing company to see if it offers a biweekly plan or can recommend one.
6. Can I sleep at night?
Face it: There’s an intrinsic psychological reward to owning your home free and clear.
From a sheer numerical calculation, you may determine that you’re likely to earn more investing your spare cash in stocks than prepaying your mortgage. But that’s only half the story. Emotionally, you may just feel better getting rid of that mortgage albatross. After all, the savings will be a guaranteed return. “Think of paying down the mortgage as investing in a risk-free bond that is likely paying more than you could get on an equivalent risk-free investment,” writes MoneyWatch.com columnist Allan Roth.
Many advisers think Roth’s conservative argument is wise. “Today, it’s all about reducing risk and paying down debt,” says financial planner Ron Rogé, CEO of R.W. Rogé & Company in Bohemia, N.Y. “People want to feel good about their finances and sleep better at night.”
How to Pay It Off
If you’ve decided to prepay your mortgage, here’s how to do it.
First, check the terms of your loan contract to make sure you won’t be socked with a prepayment penalty. Most loans don’t charge one, but those that do might charge a fee of 2 percent of the outstanding balance or the equivalent of six months of interest. Some mortgages permit partial prepayments, letting you pay off up to 20 percent of the balance penalty-free.
Next, figure out how much interest you’ll save by increasing your mortgage payment. Use an online amortization calculator like this one at Bankrate.com.
Then pick a regular prepayment method. There are three ways to go:
A caveat: You might have to pay fees for a biweekly switch. Your lender or a third party may charge a setup fee of about $350, plus a monthly service charge of around $5.
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