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Most people’s initial reaction is to eliminate their mortgage debt. Living in your home free and clear can give you an incredible sense of accomplishment. After all, the bank will not be able to repossess your home, and the entire value will count towards your net worth.
However, before throwing yourself a mortgage burning party, there are other considerations. Financially, it may not be in our best interest to pre-pay the principal on your mortgage under current conditions.
What is prepaying?
When you take out a mortgage, you agree to pay back the money over a period. The most common loan terms are a fixed rate over 30 years.
However, a very little principal is paid in the early years. Each month, you earnestly pay your mortgage, and your balance does not decline very much. For instance, on a $500,000, 30-year mortgage at an interest rate of 4.5%, the mortgage payment (principal and interest) would be $2,533.43. In the first month, the principal sum would be $658.43, and the interest is $1,875. It does not get much better the next month when the amount of principal is $660.90. For the first 15 years, less than $126,000 in principal is paid, and over $287,000 in interest.
Over the life of the loan, over $412,000 will be paid in interest.
If this does not seem fair, the banks are the ones that lend you the money and get to make the rules. The first one is that the lending institution gets paid first.
There is something you can do about it, though. Pay extra money towards the principal. This is known as prepaying. It is merely done by noting the additional amount, either with your physical check or online. It is essential to do so, otherwise it may wind up in a “suspense account,” or unapplied until you notify the lender.
Applying an extra $100 to your mortgage payment every month cuts off more than two years from your mortgage. It also saves roughly $37,000 in interest over the life of the loan.
A mortgage calculator can be found on some websites. This will allow you to do your calculations.
Sounds great…what’s the catch?
As we have seen, this can allow you to save thousands of dollars in interest over the life of your loan and cut down the length of your mortgage. Nonetheless, taking the emotions out of the decision, there is a crucial financial consideration that must be weighed before deciding whether or not to make extra principal payments.
In finance, there is a concept known as the opportunity cost. Simply put, this is the cost of not choosing an alternative path. For instance, instead of putting your money under my mattress, one could invest in a bond at a 5-year bond at a top rated company and earn 1.8% annually over five years.
The same principle applies here. Stripping out the emotional benefits, we need to consider if it is worthwhile, financially, to prepay your mortgage or invest it. We do so by comparing the mortgage rate to the rate of return that can be achieved by an investment opportunity.
To make the proper comparison, we need to factor in taxes. Since mortgage interest is tax deductible, your mortgage rate is lower than stated. For instance, if you have a 4.5% mortgage rate, and your marginal federal income tax bracket (i.e., since we have a graduated income tax, this is the rate you pay on your last dollar of earnings), is 25% your effective rate is 3.375%. This is merely the 4.5% and multiplying by 75% (1-tax rate). In New York, it will be even lower since there is a state income tax, and your mortgage interest is also likely to be tax-deductible on your state return.
Now we need to compare the 3.375% to the rate of return you can earn. However, this is not a very high threshold. If you can get a modest return of 5%, your after-tax return is 3.75% (5% multiplied by 75%, although dividends and capital gains may have lower tax rates, or it will grow tax-deferred retirement accounts such as a 401k or IRA). Since the return on your investment is higher, this makes it worthwhile to invest the money rather than prepay your mortgage.
Since mortgage rates are very low right now, you should think twice about prepaying your mortgage. Instead, it might be wiser to invest the money. For instance, if you are not taking advantage of your company’s 401k match, that is a viable option.