When does prepaying make sense?
For many of us, owning a home is the biggest financial decision we will ever make in our lives. According to the latest data gathered by the U.S. Census Bureau, of the 77 million owner-occupied homes in the United States, 62.3% of these homes have a first mortgage. Let’s figure out if it makes sense to join the 37.7% of homeowners that have paid off their mortgages.
Options homeowners have to pay off a mortgage
Before diving into the pros and cons of paying off a mortgage, let’s first talk about the homeowner’s options:
- Biweekly Payments: making a payment every two weeks results in 13 full payments each calendar year, thereby lowering the number of remaining payments
- Lump Sums: a one-time payment is applied to the loan’s principal, lowering the outstanding balance on the mortgage
- Recasting: a combination approach that involves making a lump sum and working with your lender to adjust the mortgage payoff schedule
- Prepaying: while all the above items on this list are a form of prepaying, this term is typically used to describe increasing your monthly payments to accelerate the paydown of your mortgage
All the above options will reduce the total number of payments a homeowner has to make to a lender and lower the total interest charges paid on the loan. This sounds like a something everyone should do if they have the financial resources. Unfortunately, it is not that simple.
Pros of prepaying a mortgage
While there are numerous protections that allow a borrower to prepay a loan without penalty, anyone thinking about prepaying should check with their lender beforehand. In addition to asking about prepayment penalties, the borrower should also ask about the process. The important point here is this:
Any extra monies included in a monthly payment should be applied to the principal of the loan and not applied to a future payment.
So what exactly are the benefits of prepaying a mortgage? To start, prepaying will lower the total number of payments a borrower will have to send to a lender. Since you’re paying more money each month, the principal of the loan is going down faster than originally scheduled. This means it will take fewer payments to pay off the loan.
The other benefit of prepaying has to do with interest charges. Since the extra money is paying down the loan’s principal, the interest charges will be lower too. Remember, interest charges only apply to the outstanding balance of the loan. If the outstanding balance is going down faster than originally modeled by the lender when constructing the amortization schedule, then the total amount of interest charges on the loan will go down too.
Cons of prepaying a mortgage
You may be saying to yourself – How can there possibly be a downside to prepaying a mortgage? Who wouldn’t want to lower the interest charges on a loan and pay off their mortgage ahead of schedule? Well, there are a total of five reasons you might want to think twice about prepaying:
- Prepayment Penalties: lenders are usually not allowed to charge borrowers a prepayment penalty. That’s why it is so important to check with your lender about their policies beforehand.
- Competing Financial Goals: the extra monthly payment should not interfere with other financial goals such a funding a retirement plan. This is especially true if the borrower’s employer matches their contribution to a 401(k) or 403(b) account and they are not taking full advantage of this “free money.”
- Higher Interest Debt: when a borrower has other debts (credit cards, car / student loans) that carry a higher rate of interest, those debts should be paid off before starting to prepay a mortgage.
- Other Investments: if a borrower can “invest” discretionary money elsewhere and earn a higher rate of return than the rate of interest paid on their loan, they should not prepay that loan. For example, let’s say a borrower suddenly find they have an extra $300 per month, and they were considering prepaying their mortgage. It is more advantageous to invest the money in stocks earning 6% to 8% per year than prepaying a mortgage carrying an interest rate of 3.25% per year.
- Tax Deductions: mortgage interest paid is tax deductible, which lowers the effective interest rate on the loan. Someone in the 32% tax bracket with a loan at 4.00% has an effective after-tax rate of 2.72%. This after-tax rate feeds back into the “other investments” argument against prepaying. Keep in mind this tax-deductible benefit only applies to taxpayers that can itemize their deductions.
Settling the prepayment debate – a simple rule of thumb
While all of the pros and cons are factually indisputable, the decision to prepay a mortgage really comes down to one rule of thumb:
If a borrower can earn a higher rate of interest on another investment, they should not prepay their mortgage.
Here are some examples demonstrating this point:
- If the borrower has a car loan at 7.25% and a mortgage at 3.25%, they are better off prepaying their car loan.
- If a borrower will eventually take out a student loan at 6.00% and the interest charges on their home is 4.50%, they are better off saving the money and taking out a smaller student loan.
- If a borrower can invest the money and earn a higher rate of return than the interest rate charged on their loan, they are better off investing the money than prepaying their mortgage.
With mortgage rates near historical lows, most borrowers would be hard pressed justifying prepaying their loans. There are much better options than “investing” in a loan at 4.25%.