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Is It Worth It to Prepay Your Mortgage?

| Money Rates Columnist.
min read

debt-freeYou don't have to wait out the remaining term of your mortgage to pay it off.

Instead, you can make accelerated payments on an occasional or regular basis, which could save you big money in interest charges overall.

This may be a good strategy if…

 

  • ... your mortgage has a high interest rate and you have extra money in the bank, or…
  • ... you want to worry less about debt.

But your mileage may vary.

Your best option may not be to prepay your mortgage. You might earn a higher rate of return by investing that extra cash. It could be wiser to simply refinance if rates drop. And you may regret prepaying if you need more money later for an emergency.

The best course of action is always to explore your options, crunch the numbers, and weigh the plusses and minuses. Making accelerated payments to pay off your mortgage might help you sleep better at night, but it could also leave you more vulnerable to other unforeseen expenses.

Compare savings rates for your emergency fund

Pros & Cons: Should I Prepay My Mortgage?

Weighing the pros and cons of personal finance decisions naturally comes down to the value you place on each of your choices, and that's why it's difficult to make blanket statements about which course is better.

It's a good idea to try different scenarios on a refinance calculator. You can model each option to help you visualize the impact on your finances over the long term - because it can add up to large amounts. Sometimes seeing actual numbers helps clarify things.

Pros of prepaying your mortgage

  • Financial freedom
  • Peace of mind
  • Reduction of overall interest expense
  • Receive better financial terms in the future

Robert Johnson, professor of finance in the Heider College of Business at Creighton University in Omaha, Nebraska, says prepaying your home loan may provide more financial freedom and peace of mind from debt.

"Once your mortgage is paid off, you have more flexibility to weather life's setbacks like losing your job or needing extra funds for a health emergency," he says.

Paying off your mortgage loan early can also give you the latitude to fund other needs and wants in life, like your child's college savings, a new car, or future medical bills.

"One cannot understate the psychological benefits many people get from paying off a large debt. This is particularly true for individuals who have experienced financial hardships due to profound economic events like the Great Recession," notes Johnson.

Real estate attorney Rajeh Saadeh agrees.

"If your interest rate is high, it's a good idea to pay down the loan balance so that you're not throwing as much money away in interest as you otherwise would be if you didn't pay down the loan," says Saadeh.

Plus, paying down your loan reduces your overall debt, which can make you more attractive to lenders if you need to take out another loan in the future, Saadeh adds.


Favorable math

Johnson provides a hypothetical example that illustrates how prepayment can yield large savings:

Say you just took out a 30-year, fixed-interest mortgage loan for $200,000 at 4%.

Your monthly payment on the principal and interest would be $955.

But if you upped the monthly payment to $1,479, you'd cut the loan's term in half (to 15 years).

"In this example, over 30 years with no prepayments, you'd pay $343,800 in payments over the life of the loan - $200,000 of that would go toward your principal, and the remaining $143,800 represents interest paid on the loan.

"But if you prepay and cut the term down to 15 years, your total payments would be $266,200 ($66,220 of which would go toward interest) equating to a savings of $77,600," Johnson explains.

Shea Adair, a full-time real estate investor and broker, puts it another way:

"Assume you have a 30-year fixed-rate mortgage of $150,000 at a 4.5% interest rate.

"You'll pay $123,609 in interest over the life of that loan, assuming you make the minimum payment of $760," says Adair.

"But if you increase the payment by $188 a month, to $948 total, you'll pay off the mortgage in 20 years and save roughly $46,000 in interest."


Cons of prepaying your mortgage

  • Diverts cash flow from other opportunities
  • Eventual loss of tax deduction

However, Alan Rosenbaum, CEO/founder of GuardHill Financial Corp, cautions that accelerating mortgage payments may not be a wise move.

"I would not recommend prepaying your mortgage while rates remain at historic lows. Prepaying your mortgage reduces the life of your loan, but that gives you less cash in your pocket that you could use to pay for other significant expenses or invest in the stock market," he notes.

Also, once you no longer owe any interest, you'll lose your tax deduction on mortgage interest you can claim, Rosenbaum says.

Brian Koss, executive vice president of Mortgage Network, seconds those thoughts.

"I don't believe it's wise to prepay unless you've paid off all other consumer debt, fully funded things like college and retirement savings, and built up six months of liquid reserves for times like we are going through now," says Koss.

Calculating Investment Value

Johnson adds that many borrowers mistakenly view the purchase of their home as their chief investment when they should actually be valuing other investments higher. It's as if they think buying a home is the same as a retirement plan.

"You should not simply compare the interest rate being paid on debt with the rate of return you believe you can earn on other investments," notes Johnson. "Because mortgage interest is tax-deductible, the after-tax cost of debt can be computed by multiplying the interest rate times 1 minus the tax rate."

Case in point:

If your mortgage rate is 5%, and you're in the 30% marginal tax bracket, your after-tax mortgage debt is 5% x (1-0.30) = 3.5%.

Using this example, "if you can earn more than 3.5% on invested capital, you'd be better off investing the funds and not paying your mortgage down early," Johnson recommends.

Comparing Alternatives to Prepaying Your Mortgage

Investing in the stock market: Alternative #1

Indeed, putting that extra money into stocks or retirement accounts instead could reap larger dividends.

"Nobel laureate economist Robert Shiller has made a compelling case that real estate, particularly residential homes, is a much inferior investment when compared to stocks. Shiller found that, on an inflation-adjusted basis, the average home price has increased only 0.6% annually over the past 100 years," Johnson points out.

Contrast that with the stock market. Per data compiled by Ibbotson Associates, the average return on a large stock index (the S&P 500) has been approximately 10%, while inflation has been around 3%. That means the inflation-adjusted return of the stock market over the past 90 years has been approximately 7%.

"In addition, stocks don't need a new furnace, the lawn mowed, or a new roof, and they don't require annual property tax payments," says Johnson. "The surest way to build wealth over long time horizons is to invest in a diversified portfolio of common stocks."

Adair adds that, "A good rate of return on your money, in my opinion, is 7%. So if you took that extra $188 I talked about earlier and invested it in the stock market, over a 20-year period, it would likely equate to $51,000. That's a bigger sum than the $46,000 you would have saved if you prepaid your mortgage over 20 years, although that doesn't account for what you'd save in tax deductions as well."

Problem is, no investment offers a guaranteed return. Stock values can fluctuate wildly - and, depending on the stocks you choose, you may lose money. By contrast, if you prepay your mortgage you are guaranteed a rate of return equal to your interest rate.

Refinancing your mortgage: Alternative #2

There's possibly an even better choice: refinancing your mortgage.

"For those with good credit and who pay a higher rate currently, it's an excellent time to refinance and take advantage of record low interest rates now," suggests Saadeh.

Say you had a fixed-rate mortgage for $200,000 at 4.5% that has 30 years left. If you refinanced to a 3.375% interest rate for the same term and amount, you'd save $15,521 in interest over 30 years -- without having to pay an extra dime (although you would incur closing costs when refinancing).

Refinance Calculator

Best Candidate for Prepaying a Mortgage Loan

Saadeh says a good candidate for paying down their loan aggressively is anyone with an interest rate higher than the current prime rate:

"For example, say your mortgage rate is 5%. You may want to pay down your loan, as the prime rate is currently 3.25%. But if your mortgage rate is 3%, it wouldn't make as much sense to pay it down."

Johnson adds that individuals who lack the discipline to save money consistently may also benefit from prepaying their mortgage.

How To Make Accelerated Payments

Eager to start prepaying your mortgage?

Check first with your lender to confirm that your loan allows this (most do) and what steps are involved.

Typically, you need to write and mail a separate check to your lender. Specify in the memo field of the check that you want this money to go toward paying down your principal, or attach a separate note indicating this.

Also, contact your lender or log in to your mortgage account online a few days later to ensure that your extra payment has been received and properly applied toward the principal.

"Ask your lender about your options for making accelerated mortgage payments. They may suggest, for example, making a higher payment than what is due, making more frequent mortgage payments, paying by paper check, or paying over the phone," Saadeh notes.

Be aware that, once you begin prepaying your mortgage, you can do so at your own pace by, for example, paying extra once a month, quarter, year, or at other frequencies you prefer.

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