One Size Doesn’t Fit All

If you speak with others or read articles or books about prepaying your mortgage, you’ll come across those who think that prepaying your mortgage is the world’s greatest money-saving device. Surprisingly, people have written entire books on the topic. You’ll also find that some people consider it the most colossal mistake a mortgage holder can make. The reality, as you find out in this chapter, is often somewhere between these two extremes.

Everyone has pros and cons to weigh when he decides whether prepaying his mortgage makes sense. In some cases, the pros stand head and shoulders over the cons. For other people, the drawbacks to prepaying tower over the advantages. At the crux of the decision is the fact that you’re paying interest on the borrowed mortgage money, but if you use your savings to pay down the loan balance, you won’t then have that money working for you earning an investment return. More important, what happens if that rainy day comes along and you need those handy cash reserves?

Interest savings: The benefit of paying off your mortgage quicker

Mortgage prepayment advocates focus on how much interest you won’t be charged. On a $100,000, 30-year mortgage at 7.5 percent interest, if you pay just an extra $100 of principal per month, you shorten the loan’s term significantly. Prepayment cheerleaders argue that you’ll save approximately $56,000 over the life of the loan.

It’s true that by making larger-than-required payments each month, you avoid paying some interest to the lender. In the preceding example, in fact, you’ll pay off your loan nearly ten years faster than required. But that’s only part of the story. Read on for more.

Quantifying the missed opportunity to invest those extra payments

When you mail an additional $100 monthly to your lender, you miss the opportunity to invest that money into something that could provide you with a return greater than the cost of the mortgage interest. Have you heard of the stock market, for example?

Over the past two centuries, the U.S. stock market has produced an annual rate of return of about 9 percent. Thus, if instead of prepaying your mortgage, you put that $100 into some good stocks and earn 9 percent per year, you end up with more money over the long term than if you had prepaid your mortgage (assuming that your mortgage interest rate is below 9 percent).

Conversely, if instead of paying down your mortgage more rapidly, you put your extra cash in your bank savings account, you earn little interest. Because you’re surely paying more interest on your mortgage, you lose money with this investment strategy, although you make bankers happy.

If you’re contemplating paying down your mortgage more aggressively than required or investing your extra cash, consider what rate of return you can reasonably expect from investing your money and compare that expected return to the interest rate you’re paying on your mortgage. As a first step, this simple comparison can help you begin to understand whether you’re better off paying down your mortgage or investing the money elsewhere. Over the long term, growth investments, such as stocks, investment real estate, and investing in small business, have provided higher returns than the current cost of mortgage money.

Taxes matter but less than you think

Now, you may be thinking that — up until this point in this discussion — we haven’t presented all the facts, and you’d be correct. One important detail we’ve left out of the discussion thus far is income taxes. (Don’t we all wish we could ignore paying our income taxes!)

In most cases, all your mortgage interest is deductible on both your federal and state income tax returns (see the nearby sidebar “Not all mortgage interest is tax deductible ” for exceptions). Thus, if you’re paying, say, a 6 percent annual interest rate on your mortgage, after deducting that interest cost on your federal and state income tax returns, perhaps the mortgage is really costing you only about 4 percent on an after-tax basis. For most people, approximately one-third of the total interest cost of a mortgage is offset by their reduced income tax from writing off the mortgage interest on their federal and state income tax returns.

However, don’t think that you can simply compare this relatively low after-tax mortgage cost of, say, 4 percent to the expected return on most investments. The flaw with that logic is that the return on most investments, such as stocks, is ultimately taxable. So, to be fair, if you’re going to examine the after-tax cost of your mortgage, you should be comparing that with the after-tax return on your investments.

Alternatively, you could simplify matters for yourself and get a ballpark answer just by comparing the pretax mortgage cost to your expected pretax investment return. (Technically speaking, this comparison isn’t as precise as the after-tax analysis because income tax considerations generally don’t exactly equally reduce the cost of the mortgage and the investment return.)

NOT ALL MORTGAGE INTEREST IS TAX DEDUCTIBLE

If you’re a high-income earner, are subject to the Federal Alternative Minimum Tax (AMT), or have low levels of itemized deductions, be warned that some of the itemized deductions from your mortgage interest may not effectively be tax deductible and may result in less tax savings than you think. For tax year 2017, for example, if your income exceeds $287,650 (for married couples filing jointly, it’s $313,800), you lose some of your Schedule A itemized deductions (which includes mortgage interest and property taxes, too).

Also, be aware of the following standard deductions: $12,700 for married couples and $6,350 for singles for tax year 2017. Ignoring your mortgage interest deductions, if your itemized deductions total less than these threshold amounts, some of your mortgage interest is effectively not tax deductible. For example, if you’re married and your itemized deductions, excluding mortgage interest, total to $10,000, then $2,600 of the mortgage interest you pay is essentially not tax deductible because you automatically qualify for the standard $12,600 deduction if you elect not to itemize.

Last but not least, IRS tax laws limit the amount of mortgage interest on your primary and a secondary residence that’s tax deductible to no more than the interest on up to $1 million of mortgage debt. Also, the interest is allowed to be deducted only on debt equal to the amount you borrowed when you originally bought your home plus $100,000.

Deciding Whether to Repay Your Mortgage Faster

In the first section in this chapter, we discuss the all-important comparison of the interest rate you’re paying on your mortgage to the expected investment returns you can earn by investing your money. With extra cash that you have, you could pay down your mortgage and save interest or you could invest that money and earn investment returns.

But the decision of whether to pay down your mortgage faster isn’t so simple. You need to weigh numerous other factors, such as the terms of your current mortgage, your overall financial situation (including your ability to fund retirement accounts), what type of investor you are, your refinancing options, and more. We discuss these factors in this section.

Does your mortgage have a prepayment penalty?

An important issue to clarify is to find out whether your current mortgage has a prepayment penalty (it shouldn’t if you read and follow our sage advice in Chapter 4 before obtaining your mortgage). If your mortgage does have a prepayment penalty, it could negate some or all of your expected interest savings from paying down your mortgage early.

Just because a mortgage has a prepayment penalty doesn’t mean that you shouldn’t examine the possibility of prepaying it. In fact, when you investigate the prepayment terms on your mortgage, you may well find that you can prepay a significant amount of the outstanding loan principal balance (such as 20 percent per year) without being hit with a prepayment penalty.

How liquid are your assets?

If you’re considering paying down mortgage debt, don’t leave yourself cash poor (lack of liquidity). As a homeowner, you’re probably already painfully aware of your home’s tendency to need fixing up and maintenance over the years. Suppose your roof needs replacing and you don’t have the cash to pay for it, or what if you lose your job and finding a suitable new one takes a few months?

You should have access to an emergency source of readily available funds, such as in a money market fund, of at least three to six months’ worth of living expenses. Otherwise, when unexpected expenses come up, you’ll have to go into hock on high interest (and non-tax-deductible) credit cards.

Have you funded retirement savings accounts?

If you have extra cash each month and you’re debating the merits of paying down your mortgage versus investing the cash elsewhere, be sure you’ve fully contributed to retirement accounts. Through your employer, you may have access to a plan such as a 401(k) or 403(b). If you’re self-employed, you could fund a SEP-IRA, for example. For 2017, the maximum SEP-IRA contribution is $54,000, which can provide great tax benefits and really contribute to your overall retirement assets as it grows over time. In all these plans, your contributions are effectively tax deductible, usually at both the federal and state levels.

By contrast, if you make extra payments on your mortgage, you get no tax relief from so doing. Thus, if you haven’t fully funded tax-deductible retirement plans, do so before paying down your mortgage debt (unless, of course, you’re going to leave the retirement money dozing away in a low-return investment such as a savings account or money market fund).

How aggressive an investor are you?

When you’re deciding between paying down your mortgage and increasing your investments, you need to examine your risk tolerance. If you get antsy at the thought of your money going into stocks or other volatile investments, then paying down your mortgage faster may be the right investment for you.

Years ago when interest rates were high, Miriam and Bert were in their early 60s when they called Eric for some financial counseling. Over the years, they had accumulated about $50,000, which they had in a money market account. They knew that they didn’t want to leave the money there, but they didn’t know what to do with it.

Reviewing Miriam’s and Bert’s investments and discussing their investment likes and dislikes, Eric discerned that this couple was financially conservative and especially so about their impending retirement. They had their portfolio about equally split between stocks and bonds and weren’t comfortable taking more risk.

Their outstanding mortgage balance of $32,000 was at 8 percent interest. Eric suggested that they use their cash to pay off their mortgage. He reasoned that if instead of paying the mortgage they invested half the money in stocks and half in bonds, their longer-term expected return would likely be no more than 8 percent — the cost of the mortgage. Why take the risk of investing, which Miriam and Bert didn’t enjoy doing, in the hopes of getting an 8 percent return, when paying off the mortgage and saving the 8 percent interest was a sure thing?

By contrast, Phil was an aggressive 30-something investor when he consulted Eric. He invested his new savings into nearly all stocks, so he expected to be making a high enough return to beat the interest cost on his mortgage. Also, Phil likened paying down his mortgage to watching the grass grow — not very rewarding or exciting.

What are your refinancing options?

Don’t forget the option of refinancing into a better mortgage. In some cases, you can lower your interest rate, thereby lowering your monthly payment. However, if you make larger-than-required monthly mortgage payments, you’ll likely shave years off the repayment schedule.

Or you may choose to refinance to a shorter term. You can refinance a 30-year mortgage into a 15- or 20-year mortgage. Your payments will increase, but you’ll cut the length of repayment by a third or half.

Consider another of Eric’s clients. Mary had a fixed-rate mortgage and was leaning toward paying it down instead of investing her spare cash in mutual funds. Then she found out that her loan amount was just above the conforming loan limit (see Chapter 4 ). If she reduced the amount she borrowed by just $10,000, she would qualify for a lower interest rate on a conforming loan. She also saved by refinancing at rates that were lower than her original loan.

At these new and lower rates, Mary felt that she could earn a higher return investing her money, so not paying off her mortgage faster than necessary made sense to her. She was also able to fully deduct her mortgage interest to achieve that maximum benefit. Ask your lender for a written explanation before you prepay your loan.

Refinancing your mortgage isn’t as easy as trading one payment for another. You have to jump through the lender’s hoops and spend some money out of pocket for the privilege of getting a better interest rate or term length. See Chapter 11 for the details on refinancing.

Considering psychological and nonfinancial issues

Many of the issues we suggest considering when you decide whether to pay down your mortgage balance faster are purely financial. However, we don’t want to diminish or overlook the importance of psychological issues.

Specifically, would you derive any solace from paying your balance down or off completely? Miriam (whom we discuss in the preceding section) said, “I felt a tremendous sense of relief when we paid off our mortgage. Bert [my husband] thought doing so wasn’t real exciting, but I feel better knowing that we don’t owe any more money.”

Another of Eric’s clients, Kevin, chose to pay his mortgage off at the relatively young age of 35. “While I could have kept my mortgage going, paying it off completely freed me psychologically from feeling like I had to keep working as hard as my peers did at their careers. Now that I have a family, spending time with them is my first priority, not climbing career ladders.”

Of course, if you have investment properties, you’ll find that income property loans are always more expensive than your owner-occupied home. Interest rates for income property loans are typically 0.25 to 0.5 percent higher. So you may actually want to consider applying some of any “extra cash” to accelerate the payoff of your investment properties — of course, all the time keeping adequate reserves. If you own or plan to own rental property, then you know that savvy real estate investors always have a cash cushion for the unexpected vacancy or maintenance and repair bill.

See the latest edition of our book Real Estate Investing For Dummies (Wiley) to find out how you can build a real estate empire. Or, to keep your property in top shape and minimize surprises, see Robert’s book Property Management Kit For Dummies (also published by Wiley) for everything you need to know as a landlord.

Paying Down Your Mortgage Quicker