Should I Prepay My Mortgage? What "They" Say
"They say you shouldn't pay off your mortgage early"...
I cannot tell you how many times I have heard someone repeat this phrase. It always comes up when someone hears that another person is making extra payments or has a goal to pay of their mortgage before term. If asked to elaborate, the makers of this statement will sometimes refer to tax deductions, and more often that not, they will really have no idea. It is oft heard financial advice so they assume it must be true.
In theory, this is sound financial advice. In reality, this is a loaded proposition.
The actual reasoning goes like this. Let's say you take out a 30 year mortgage and finance $200,000 at 5%. Your monthly payment would be $1073.64, and after 30 years with interest you would pay a total of $386,511.57. You will pay a premium of $186,511.57 to borrow this money. In actuality, depending on your tax bracket you will be able to deduct some of this interest. So lets assume a 25% tax bracket. The homeowner will be able to deduct a fourth of their payments over the term of the loan. $46,627.89 will be received back, so the actual total of the interest would be $139,883.68.
Do you make extra principal payments on your mortgage?
Let's say a homeowner then decides they want to pay off the loan early and makes an extra $500 payment each month. By paying about 50% more each month, the loan term is cut almost in half. The homeowner now pays off the mortgage in a little over 15 years and pays a total of $85,390.30 in interest. After the mortgage tax deduction the total paid would be $64,042.73, a savings of $75,840.95.
Assuming of course you could swing the extra payment this seems like a no brainer. Right?
Well, if you listen to the financial sages you would be a fool to do this. Their reasoning is that if you would take that extra $500 a month over the course of 15 years and invest it in the stock market, you would have much more. In fact, because of the tax deduction the actual effective rate of interest on the mortgage is actually a tad under 4%. The stock market, so they will say, returns an average of 7% a year. So if you would invest the $500 a month for fifteen years it would amount to $159,405.62. You would ignorantly give away $83,564.67.
This is where the theory holds. If you are the type of person who is committed and regimented enough that you will dutifully put away that $500 each month into a brokerage account and invest it wisely, their advice falls in the category of science. This of course makes some very broad assumptions though. To determine if this advice will work for you, consider if you will be able to live under these guidelines.
Are you committed enough to put away this $500 a month and never touch it? Or will you be like the majority of people and use it as an emergency fund, a vacation fund, or an excuse to buy a bigger car? Even the most disciplined of savers will have a hard time reaching this objective.
Other Financial Articles
- It's Actually the Big Things...
Everyone has read a financial article that encourages you to give up some of the smaller things in life in order to save money, but I will make the case that it is actually the big things that matter.
- The Hidden Investment- Preferred Stocks
Mutual Funds, bonds, money markets, ETF's, CD's... Most take advantage of these assets in their retirement accounts. I would suggest one other category that gets little to no press- preferred stocks.
Are you a skilled enough investor to achieve a 7% return per year? According to a JP Morgan study in 2013, the average investor achieved returns of only 2.3% over the last twenty years. Don't believe that? How about a 2012 study by Dalbar that showed an average twenty year return of 2.1%. Yes, when you add in fees and basic investor behavior the average investor does horribly. A bank account currently yields about .01% interest a year, so that would be an even worse choice.
How does that 4% return on your mortgage sound now?
So I will argue and profess that for the average person, blindly following the "don't pay off your mortgage early" advice is bunk. Many people don't actually save that money, much less invest it. They put it into their monthly kitty to spend and fifteen years later have little to show for it.
If you are the type of person who can meet the above guidelines, by all means, don't pay off your mortgage early and rather invest the money at your guaranteed rate each month. You will have more in the end. BUT.... I would bet that 90% of people would not be able to do what your expert financial planners advise you. If you are part of the 90%, put extra money down on your mortgage each month.
One last thing to note. The feeling of paying off your mortgage and owning your home outright is worth it's weight in gold. This is the X factor that cannot be measured in dollar signs. For many people, including the author, it is well worth the extra sacrifice that it takes to achieve.