Should You Prepay Your Mortgage?

Does it make sense to prepay your mortgage or buy real estate with a big downpayment?

Buying with no money down in a rising market can be — with caveats — attractive. The caveats? First, there are no guarantees that either prices or rental rates will eternally rise. Second, less down means more debt and more debt means higher monthly mortgage payments. That’s not a problem — unless income declines or total payments increase and can no longer be carried.

The leverage gained when real estate prices are rising works in the opposite direction when prices and rentals stagnate or actually decline. And declines are possible: Japan, as one example, had what appeared to be a booming economy when the Nikkei reached 38,915 on December 29, 1989. Take a look at it now….

Or, look at various stock market crashes or the U.S. real estate market in 2007 and 2008.

The balance between risk and reward has largely favored those who have maximized risk in recent few years. But the same was once true for those who invested in “sure things” with great track records such as Fannie Mae, Freddie Mac, Enron and Worldcom….

Prepayments

There are surely circumstances where it makes sense to prepay a mortgage — but not always. For instance, before prepaying a mortgage it’s better to first pay off high-interest debt such as credit cards.

Prepaying a mortgage often works because most people in this country are not rich. For most, mortgage amortization — paying down principal over time — and simple real estate ownership are some of the surest ways to increase net worth over time, lower monthly living costs and increase inter-generational wealth.

For most people, putting an extra $50 a month into a mortgage means collecting change at the end of the day or not dining out once a month. In effect, prepayments are simply a better way to use money that might otherwise disappear.

No less important, for most people the choice is not an absolute, either/or decision to either place more money in a mortgage or to invest in stocks, bonds or whatever. Instead, the practical choice is to use some money for mortgage prepayments and other money for other purposes.

At 6 percent, a $100,000 mortgage costs $599.55 a month for principal and interest over 30 years. Add $50 a month and the loan will be repaid in 24.54 years. The potential interest bill will go from $115,838 to $91,292 — a savings of $24,546.

Is this a huge savings? Perhaps not in the context of indicted corporate executives, but $24,546 is a big number in most households.

Imagine that federal, state and social security taxes equal 25 percent of gross income. In such circumstances, an individual would have to earn $32,728 to net $24,546 in cash. Suddenly the persistent saving of $50 a month seems very attractive.

Taxes

Mortgage interest deductions make home financing more affordable because many owners have a greater ability to direct the use of their funds. However, tax deductions — by themselves — cannot justify real estate purchases. No one suggests paying 12 percent interest in a 6-percent market even though the tax write-offs would be greater.

Given a choice of paying mortgage interest with a tax write-off or paying less interest, it’s better to pay less interest. The usual example works like this: If you’re in the 25 percent bracket and pay $100 in interest, you can reduce your taxes by $25. That’s good. However, if you can avoid paying $100 in interest by getting a lower rate or having less debt your taxes increase by $25 because you have $100 less to write-off — but you have $75 extra in your wallet. That’s better.

The value of a mortgage deduction is not the same for everyone. If you’re poor you may not pay much if any income tax so the value of the mortgage write-off is minimal if non-existent. If you’re in the middle class, then mortgage interest deductions make ownership debt more affordable. If you’re doing well, current tax rules reduce your ability to write-off personal deductions once adjusted gross income tops $142,700 (if married and filing jointly) or $71,350 (if single). If there’s no state income tax where you live, there’s nothing to deduct at the state level no matter what your federal tax bracket and mortgage interest in most cases cannot be written off from federal returns for residential financing above $1.1 million. (See a tax pro for details.)

So there are situations where making a downpayment and prepaying a mortgage make real-world sense — and other situations where leverage is best. You have to look at such factors as personal economics, tax obligations, rates of return for alternative investments, risk, local real estate trends, mortgages rates and individual preferences — and then decide what’s right for you.

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Published originally by Realty Times on March 22, 2005 and posted with permission.

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