Perhaps no topic in personal finance causes people to make strong opinions as much as the topic of prepaying a mortgage.
One of the reasons this topic might come up so often is because the math behind the answer changes every few years as interest rates change. This is strange though, because the biggest factor behind your decision to prepay is usually an emotional one, but it’s unlikely you’ll ever meet your retirement goals by investing your money based on emotions.
Emotions may be front and center because of the marketing that goes behind your decision to buy a house in the first place. Often you hear you’ll hear that your house is the biggest investment you’ll ever make. It shouldn’t be, the biggest investment you make should be in your retirement and gaining your financial freedom.
The math for this is easy. Assume you want to buy a $250,000 house, and you have 20%, or $50,000 to put down. You then take out a loan for $200,000 at 4.25% interest. Using a mortgage calculator, you learn your payments are $983.88 a month (assuming no taxes or insurance). Luckily for you, you were planning to spend $1,500 a month, so you have an “extra” $516.12 a month to spend. Should you invest it, or use it to prepay your mortgage?
If you prepay, you’ll pay off your mortgage 179 months early, almost cutting the repayment time in half (15 years and 1 month). Since you expected to pay $1,500 a month on your mortgage over 30 years, and you’ve paid it off on 15 years and a month, you now have 14 years and 11 months to invest $1,500 an S&P 500 index fund averaging a rate of return of 7%. At the end of 30 years you’d have a paid off house and $479,846.42.
If you instead invest the extra $516.12 a month in an S&P 500 index fund averaging a rate of return of 7%, and take the full 30 years to pay off your mortgage, at the end of the 30 years you’d have a paid off house and $625,989.82.
That’s pretty significant, $479,846.42 versus $625,989.82. It’s a difference of $146,125.40, or 23.3%.
There are a couple of things to consider. The first is that many people get a mortgage tax deduction. It’s a great deduction, but remember it’s never worth paying $10 to get $1 in return. Anyone who disagrees, for every $10 you send me, I’ll send you $1 in return! The second is, depending on what you’re investing in, you’ll be paying taxes on the gain.
Think 7% returns are too high? Here is the return after paying 15% capital gains tax each year at different interest rates. This is pretty pessimistic, as it’s unlikely you’d pay that much in taxes each year.
|Int. Rate||No prepay||Prepay|
Imagine you’re not investing in a Roth IRA, not maxing out an HSA if you have one, or not contributing the maximum to your 401(k). This is the same chart, but without the tax penalty above.
|Int. Rate||No prepay||Prepay|
As you can see, the decision to prepay your mortgage is an emotional one in more than one way. If you invest conservatively and don’t expect to earn more than 4% in interest, you should consider prepaying.
Also, consider the maximum you can invest in certain accounts each year. Currently you can invest $458.33 a month in a Roth IRA, so if you wait until you have your mortgage paid off to contribute, you’ll lose out on 15 years of tax-advantaged growth. If prepaying prevents you from investing in tax-advantaged accounts, you may really be limiting your potential returns.
What are some other factors to consider when making this decision?
If you bought a $500,000 house, take out a $400,000 loan, and pay it down to $300,000, then lose your job and have to move, and the housing market collapsed where you live, what will you do? If you invested in an index fund you can wait for the market to recover before selling the investment, you may not have that luxury with a house.
Another well publicized example is the effort in taking money out of your house. It’s possible to get a HELOC or do refinance, but it’s easier to sell a few shares of an investment if you have an expense you can’t cover another way.
Another is that prepaying your mortgage provides you with a guaranteed return. Prepay your 4.25% mortgage by $100 and you save $4.25.
Prepaying your mortgage is also better than letting money sit in a savings account, better than a CD, better than a money market account, better than many bonds, and can be almost the same as stocks, depending on how bad you pick them and how much you invest with your emotions.
A final consideration is if you put all of your money into your house, what happens if you ever want to move? Where will the money for a down payment on another house come from? It’s always great to have options.
Like many things retirement related, there’s no single best answer, but it’s really important to have facts to base your decisions on. If you can’t sleep at night because of the debt on your house, you might want to take a step back and figure out why that is.
What do you do with extra funds, invest them, or use them to pay down a mortgage?