The Pitfalls of Prepaying Your Mortgage

On December 14, 2012

home-equityIt’s the most critical part of the American dream. Owning property means you’ll always have a place to go. Of course, most homeowners only partly own the property they live in, because the bank has a lien on it and can force them to sell if they fall behind in payments.

The equity in your house can be correctly seen as an asset in your investment portfolio. Say, for example, you have 25 years left on your mortgage at a rate of 5%. If you prepay $100, you will save $5 for the next 25 years. Here a penny saved truly is a penny earned. Plus, that $5 is automatically reinvested for you by decreasing your interest paid every month, and therefore increasing the amount of principal you pay. It sounds like a great plan.

Unfortunately, there are some large pitfalls to this plan. For example, if you bought a 25 year government bond with that $100, you could sell the bond at any time to get your money back. CD’s are less flexible, but you can plan to have the savings available when you have to buy a new car or pay for college courses.

If you prepay the mortgage, there are only three ways to get that equity back: sell the house, take out a home equity loan, or refinance. All of these have transaction costs, be they closing costs, points, or commission to the agent. Plus, if you have to sell, you’ll have to fix the house up. It’s a lot more trouble than visiting the bank.

The tax-deductibility of interest is worth considering, but only if you are itemizing their deductions. The standard deduction is $5,900 for a single person and $11,900 for married ones. You’re really only saving on the amount you are saving above the standard deduction. If you have other deductions, however, or if you’re paying substantial interest, or especially if you’re in a high tax bracket, your true mortgage rate, and your potential benefit, is probably lower than any other debt or investment you have.

The best choice is to pay all other, high rate debts off first, put away six month’s salary then look for solid investments that will pay far more than your mortgage rate. You will pocket the difference while increasing the liquidity of your portfolio. Paying off a mortgage is a long-term investment, so look to other long-term investments to match. Or, if investing makes you nervous, consider adding value to your house instead with improvements. Then you can enjoy your house more and have greater borrowing capacity in the future.

There are times when paying off your mortgage makes sense. For example, if you are near retirement and expect a permanent and uncertain dip in income, paying off your mortgage will gain you cash flow flexibility. If your mortgage is older and high rate, paying it off might be less expensive than refinancing it.

Finally, don’t forget the long-term benefits of inflation. Today’s low rates and bad housing markets tend to make us forget that, over 10 or 20 years, the value of our mortgage in relation to our earnings will shrink. Your house is the easiest investment to leverage. Don’t give that up prematurely.

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