Should you prepay your mortgage? For many years, the answer has always been a resounding "Yes!" But in today's low-rate environment, the picture isn't as clear as it once was.
Traditionally, making additional mortgage payments has been seen as the height of fiscal responsibility. The couple who scrimped and saved in order to make an extra mortgage payment now and then in order to hasten the day they owned their home free and clear were regarded as sober, industrious and prudent.
These days, prepaying your mortgage has lost some of its appeal. For one thing, people tend to move fairly often - the average stay in a single home is only seven years. So if you're never going to own the home outright, there's less motivation to accelerate your mortgage payments.
But the main thing right now is that prepaying your mortgage doesn't provide a big advantage when rates are low. When you prepay your mortgage, you're reducing the loan principle your interest is charged against. But if you're not paying much interest in the first place, your savings are minimized.
How much can you save?
Consider this: Suppose you have a $200,000 30-year mortgage at 4 percent, a rate that until recently was pretty common for borrowers with good credit. Your payments are $954.83 a month and you'll pay $144,000 in interest over the life of the loan, assuming you just make the regular payment each month.
Boosting that payment by $50 a month will let you pay off the loan two years and eight month sooner than you otherwise would have, and save you about $15,000 over the life of the loan. Making an extra mortgage payment once a year would take four years off the loan and save you a total of $21,000.
By contrast, consider someone with the same loan at 8 percent interest, which was common back in the 1990s. Paying an extra $50 a month would whack 3 ½ years off the loan, saving a total of $47,000 in interest - more than 3 times the savings at 4 percent. Making an extra mortgage payment once a year - which would be $1,467.53 - would shorten the loan term by seven years and produce $79,000 in savings over the life of the loan.
The savings add up even faster as rates start creeping up to 10, 12 percent and above, which were typical for the 1980s - and which may be why your parents or grandparents speak so favorably about the benefits of prepaying your mortgage.
Prepaying your mortgage vs. other investments
When you prepay your mortgage, it's like having a safe investment that pays the same rate of return as your mortgage rate. Paying an additional $1,000 toward a mortgage with a 4 percent rate produces the same return as a $1,000 investment with a 4 percent return - you're just saving the money instead of earning more.
It's not exactly the same, however. For most borrowers, mortgage interest is tax deductable - and that reduces the effective savings you'd get from prepaying your mortgage. So if you're at the 33 percent tax rate, you get one-third of your mortgage interest back at tax time. That means your effective mortgage rate is reduced by one-third as well - instead of costing you 4 percent interest, your effective after-tax cost for mortgage interest is a rate of only 2.67 percent.
That's still a savings, of course. But the bigger question is if prepaying your mortgage is the best use of your money? An effective return of 2.67 percent isn't very much - in fact, you can get a much better rate on a 30-year Treasury bond right now, and the earnings are exempt from state and local taxes besides.
You can do even better if you're willing to take on some additional risk. A low-cost index fund based on the S&P 500 would have paid an average gain of better than 9 percent a year over the past 20 years - and that's even with the crash in 2008. Over the past 40 years, the return has been closer to 11 percent. Even with the downturn, the S&P return over the first ten years of this century was about 1.4 percent - not that much less that what you'd get from prepaying your mortgage.
There's also little point in prepaying your mortgage if you're also carrying other debt at higher interest rates - obviously, you want to pay those off first. And it's counterproductive to accelerate your mortgage payments if that means you won't have money for needed home repairs or maintenance - thereby reducing the value of the asset you're trying to pay off.
Of course, many financial advisors do advise paying off your mortgage as soon as possible, noting that getting your mortgage out of the way frees up your budget to do other things. Financial guru Suze Orman is one, making the point that your mortgage offers a guaranteed investment and the promise of security down the road. "You can't live in a stock certificate," she says. "You can live in a home."