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The Case Against Mortgage Pre-Payment

This article was written by in Debt Reduction. 34 comments.


This article was written for Consumerism Commentary by Adfecto, a mid-20s guy with a masters degree in engineering. He aspires to be wealthy and writes frequently for his own blog, Adfecto Abundantia.

When I purchased a home it was not a lifetime commitment. I view a person’s choice of housing first as a financial decision and second as a lifestyle decision. A house gives you place to live and the added bonus of potential price appreciation and tax deductions on mortgage interest. If it is cheaper to rent then by all means that is the way to go. Owning your own home can also give you a tangible increase in your standard of living, but personally that is considered a distant second when compared to the financial benefits. What I find interesting is that so many people tend to make emotional decisions about the home rather than rational ones.

Frequently, when home owners find themselves with a little extra cash at the end of every month, the idea of paying off the mortgage is often brought up. Is early payment the right way to use the money? Should the money be invested instead? Is my real motivation to build wealth or to play it safe?

The first step in analyzing this decision is to compare the interest rate on the mortgage to expected investment returns. Historically the S&P 500 with dividends reinvested has returned 10.43% annualized from January 1926 to December 2007, and the current rate for a fixed 30 year mortgage is about 5.76% according to www.bankrate.com. Based on this simple comparison it is plain to see that in the long run you will build more wealth by investing than by prepaying your mortgage.

houseIf you want to further hone this comparison of rates, next you can consider not just the entire history of the stock market, but also every 30 year rolling period of stock market data. Since 1953 the S&P 500 has returned at least 9.34% over every 30 year period which is again well above the interest rate for a 30 year mortgage. Plowing your money into prepaying your mortgage has a huge opportunity cost that will hurt your ability to build wealth.

Why then would people consider prepaying their mortgage? Most people consider their home as a safe investment, and paying off a mortgage as a guaranteed return. A certain piece of mind comes from owing the bank less money. There is a big problem with this argument; there is still a great deal of risk involved with your primary residence!

Some of this risk comes from the fact that the value of real estate is not fixed. It absolutely goes both up and down as many people in Florida, California, and all over the country are now experiencing first hand. Every dollar that is put into a residence is not necessarily money you will get back when you sell.

Additional risk comes from the fact that until your loan is paid in full, the bank still holds the mortgage on the property. The bank will not give you credit for the extra payments made to pay down the debt if you start to struggle further down the line. Even if you are way ahead on your mortgage, a hardship may cause you to miss payments. The bank can foreclose even if you spent years paying down the mortgage balance early.

Investing your free cash into your mortgage is very similar to investing in a bond. It may seem odd, but you are literally investing in a fixed income asset, the mortgage, lent to yourself. The return you get will be equal to the interest you would otherwise pay on your mortgage. One problem that arises is that the bank has first crack at the collateral; your house. Even worse, your mortgage isn’t even a very good deal when compared to the types of bonds; for example, Toyota AAA rated bonds currently pay as much as 7.652%. I bet your mortgage rate isn’t that high.

Furthermore, understanding the nature of your mortgage as a bond brings to light another risk; improper asset allocation. Mortgage prepayment shifts your asset allocation to rest more heavily in fixed income type investments than you might otherwise consider. A 40 year old person should have at least 60% but more likely 80% percent of his/her portfolio in stocks, but add in all of that mortgage prepayment in the bond category and you may find yourself far out of line from you ideal asset allocation.

Another risk related to mortgage prepayment is a lack of diversification. You may think that your mortgage is not very risky because you believe in your own ability to pay. This personal bias can cloud a person from see the true risk factors such as job loss, poor real estate conditions, natural disaster, and a plethora of others. A single unfortunate event can wipe out a large chunk of the equity. A single job loss may bring about a short sale or foreclosure that could wipe out the value of your home. Would you advise someone in your circumstances to invest in individual mortgages? I sure wouldn’t, and neither should you.

Deciding whether or not to prepay a mortgage is another financial and lifestyle choice which depends on several factors, but most of all it is a choice between building wealth (logical) and piece of mind (emotional). People who focus on paying off their mortgage seem to be more in love with their house and the idea of having it paid off than the goal of building wealth. These people are also blind to the risks that come from investing too much of their finances in a single residential structure. I think that for the majority of people the “right” decision would be to keep the mortgage and invest the extra money.

Image credit: Oracio
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Updated January 12, 2012 and originally published February 21, 2008. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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{ 34 comments… read them below or add one }

avatar ro

Hmm… how about a second mortage with 7.5%?

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avatar savvy

While I think your analysis has valid points, it seems like you assume it’s either all or none – prepay the mortgage or invest. I do both. while I know that I’m likely to get a better rate of return by investing rather than pre-paying my mortgage, I also want to be mortgage-free by retirement. That will greatly decrease the cash flow needed in retirement. Of course, I have a healthy emergency fund so that in the case of job loss or other issues, I am still able to make the mortgage payments.

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avatar Adfecto

Paying off your mortgage before retirement is a laudable goal. If you invest your whole life you should be able to easily pay cash for a house immediately before you retire. Until retirement, I do see it as clearly beneficial to hold a mortgage the entire time. I will allocate [all] my money to where it will have the better return, stocks.

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avatar Jason

When you pay an extra $300 in principal on a 30-year fixed mortgage, at around 5.5%, you can save about $600-$800 in interest, especially at the beginning of the loan.

$300 earning you $600… and, in the short and long run, real estate bought with a sound mind in a good area is easily at least as safe as the stock market … that’s a pretty awesome, real return on your money. It’s a 200% return that you’ve controlled and locked-in.

The only reason we don’t hear about this strategy on every other commercial is that no one has figured out a way to bottle up this advice and sell it yet.

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avatar sean

A 200% return…. which you don’t get until 30 years have gone by. A 7% yearly return on $1000 over 30 years is $7114.

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avatar Jason

Nope, actually, if you’re pre-paying a 30-year mortgage you’d have it well paid off before 30 years. You missed on that one, bud.

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avatar Zack

Nice post! This is a very common topic for PFBs and most fail to mention asset allocation and diversification.

We are prepaying our mortgage until we hit the 20% equity mark so that we can then dump the PMI. For us, this was the mathematically correct move.

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avatar VK

I think the most important point made in this post is “improper asset allocation”. Home and mortgage are typically ignored when determining the correct asset allocation. If Home is being considered as an investment, it NEEDs to figure into asset allocation computations and should affect a person’s decision about how much exposure they want to different asset classes.

One point though, if we are being picky about returns, one still needs to consider the tax efficiency of the investment, for example despite the fact that stocks may return higher rate of return, at the time of realization of capital gains a stock sale will be taxed at 15% (atleast currently), while a home sale can have upto 250,000 free of capital gains.

Typically, borrowing money to put it into another investment for a potential higher return, involves assessment of a person’s risk profile and I would not recommend it for anyone unless you have a very aggressive style. But as I stated earlier it should still pay a role in determining the correct asset allocation.

So I don’t think there is a true black and white answer, but if a person does know and consider their home and mortgage as part of determining their correct asset allocation, then they would come up with the right choice for their risk level.

VK

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avatar razmaspaz

“Every dollar that is put into a residence is not necessarily money you will get back when you sell.”

Thats simply not true. If your house falls in value you are still on the line for the difference between the loan balance and the sale price. So if the outstanding balance is smaller, it decreases your loss. Paying extra is paying yourself no matter what (unless you get foreclosed on).

As to the overall argument, I get it, but I don’t necessarily agree. I have a 2nd mortgage, and its for 10% of my home value. If I pay that off early thats $300/mo I don’t have in expenses. Every dollar I decrease my monthly expenses makes it that much easier for my wife to stay home with kids one day. It should be a laudable goal to build wealth, but a pile of money isn’t everyone’s top priority in life.

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avatar KC

I’ve been wrestling with this issue for years and finally come to the conclusion that no one answer is right. I can come up with valid arguments for all three sides (pay it off, don’t pay it off and invest, do a little of both). Everyone’s situation is different and everyone’s outlook is different. Times like these (possible recession, housing values decreasing) make me think owning your home is the ultimate hedge against the economy. But the past 15 years you would have been far better off putting it in the market and letting it run. But…and I know a lot about the market and one thing is for sure – past performance is not an indicator of future performance. I can sit here and contradict myself all day – that’s why I’ve concluded everone’s decision (and comfort level) is different. Personally I’m in the do a little of both camp, but I could make valid arguments for any direction I chose to go. Do your research, get the best rates possible and do what makes the most sense to you.

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avatar Terry

You leave out a important point, if you do not prepay your loan and invest the money, you will miss out on cutting your interest to the bank which can be a great deal over thirty years. Should you half the money. invest and prepay, both will save in the long run. True you can take interest of taxes but not to the extent of what you are paying in interest to the bank. I saved over $70,000 of interest over a 30 year loan.

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avatar rewards

PPINAIOFP (past performance is not…. future performance) applies to both stock market and home value.

razmaspaz: Adfecto’s argument, if I understand correctly, would “favor/put on equal footing” paying off a 10% mortgage (primary or secondary) but not a 5% mortgage (primary or secondary). Your point is valid, however, on the consequences of debt.

I think that one of the underlying assumptions is related to the time horizon to pay off the mortgage vs the risk of losing your home. 30 years of 5% vs 9% SP500 returns is different from 10 years of 7.5% vs 9% SP500.

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avatar Allison

I have a mortgage on a duplex and I live in one half and rent the other. I pre-pay my mortgage and get peace of mind by doing it. I’m a single female in my mid 20s and would like to purchase a single family within the next 10-15 years in addition to the duplex that I currently own. I won’t purchase another home unless this mortgage is paid off since the house that I would want to purchase wouldn’t be affordable by on only my income. I would rather not have to worry about having a mortgage down the road especially if I get married and have kids. The income produced from the duplex will help out and possibly help me stay at home or at least give me flexibility.

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avatar Scott

I’m a little lost on the definitions. The 9.34% over every 30 year period — is that actual returns, or inflation adjusted. If you don’t count inflation in those averages, then that quickly drops below what my mortgage rate is.

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avatar Adfecto

@ Scott

The 9.34% is the gross annualized return (which is before inflation). However, I think you may be considering the numbers in an awkward fashion.

If you subtract inflation from the 9.34% to get the real rate of return you would also need to subtract inflation from the interest rate on the mortgage to get the real interest paid. You must compare apples to apples. I hope that answers your question.

Here is an example:
Lets say you have $200 per month to either pay toward your mortgage or invest in stocks. You have a $150,000 mortgage @ 5.75% interest. Under a normal 30 year amortization schedule, the payment would be $875 a month for interest and principle. After a full 30 year term you will have paid $315,000. If you add $200 a month to the payment you will pay $248,196 and own your house in full in 19.24 years. You can then invest $1075 a month for 10.76 years @ 9.34% and end up with $223,142 in investments. The third option is to pay your mortgage as normal and invest the $200 every month the whole time. In 30 years the house will be paid off and you will have $348,618 in investments. Regardless of what the inflation rate happens to be, you end up with more wealth by not making prepayments on your mortgage.

Taxes were omitted from this simple example. If tax friendly methods for investment such as a 401(k), IRA, or even index funds or ETFs there will be minimal taxes incurred from investing. There would also be a tax benefit for those who itemize and deduct the mortgage interest. In other words, taxes should also favor investing rather than pre-payment too.

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avatar Robert

You are not comparing apples to apples when you cite the S&P 500 as the comparison for home equity. If anything it would be most comparable to speculation on a real asset with stable value (gold, etc.), and less so to bonds (due to similar rates of return). So if your investment goal is to build wealth (as opposed to peace of mind through paying off the house) AND your risk tolerance is high enough to merit putting the extra principal in the S&P 500 AND you are factoring in the extra risk of living under the possibility of foreclosure for a longer period of time and that is a non issue to you (because if it is your risk-adjusted rate of return for the house would then increase) then list the 9.34% as the other option. Just listing off that number is irresponsible.

On another note, the true rate of return on the mortgage must also subtract the tax benefit you obtain through interest. Prepayment thus effectively lowers the rate of return on prepayment.

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avatar BfskinnerPunk

There is yet another assumption here.
You are assuming that money *not* put into a mortgage will be diligently invested in the stock market.
I submit that many of us, like myself, don’t like to watch my life savings fluctuate like a bank account with schizophrenia.
So lets assume that somebody pays off their mortgage *and* that they would have only bought CDs or money markets as the only viable alternative to mortgage payoff.
Is paying off one’s house such a bad idea given that scenario?

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avatar Kripal Singh

nice post . One point to keep in mind is that mortgage is a forced saving plan . Most people can ( and will) pay mortgage every month but can’t buy that s&p index fund every month for next 30 years ( hard to save to invest rather than paying mortgage )

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avatar Scott

thanks Adfacto. I guess that makes sense to me. I was considering the $200 I have now and should I apply it to my mortgage or invest it. Since short term investments are usually so low, and everyone seems to recommend not buying stocks unless you’re in for 5 to 10 years, my thoughts were: $200 now to the mortgage is worth $200 at whatever rate. My $200 invested, which I won’t touch for 10 years, is exposed to inflation. I wasn’t looking at the overall term or a long plan, just reflecting that every month, I need to decide.

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avatar NoDebtPlan

We’re working on our 2nd mortgage first — 8.125% — and it is a low risk return. We’ll take it.

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avatar kmgeb2000

Clearly your first statement may not be true for many people who purchase a “house” and is purely the subjective view of a short sighted, 20-something engineer – “I view a person’s choice of housing first as a financial decision and second as a lifestyle decision.”

We view our purchase as that of a “home” not purely an investment decision. It is molded into our lifestyle and as others pointed out you missed the main benefit of a home purchase that being the tax deduction from interest. Something that should not be overlooked so easily.

Don’t get me wrong the financial aspect is a consideration, but it is a house or a “home” that one is factoring into the equation. If its just a house, sure go for the financial equation first.

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avatar Adfecto

I’ll address the tax deduction issue since it has been raised a couple of times. Before, I intensionally ignored taxes because in really they do not have much of an effect for most people. The value of the mortgage interest deduction is grossly overstated and the taxes on investment are overblown too (if the investor holds equities/indexes/ETFs for the long term).

First, you only get a benefit of deducting the mortgage interest over and above the standard deduction. So for the first $10,700 for married couples, $7,850 for head of household, or $5,350 for singles there is NO benefit. That amounts to about the first $180,000 of a married person’s mortgage which will generally not be deductible. Sure you can have other deductions that can contribute to getting you over the hump, but my itemized deductions only gave me about a $300 tax break based on ~$9000 in interest and property taxes. I would not have gotten ANY benefit if I did not have other expenses I could itemize in addition to just the house.

Also, as you pay down your mortgage you are paying less interest and more principle. This post is about prepayment which further minimizes the tax benefits of owning a home. In only a few years I’ll be back to getting zero tax benefit from the house (and so will most people)!

A majority of people get a very a modest benefit (or none at all) from deducting the mortgage interest over the life of the loan. In fact, this deduction rewards people who pay their loan down as SLOWLY as possible.

If your goal is to maximize your tax deductions you should take out the largest loan possible on an interest only basis. Common sense should tell you that this is not the best plan for long term wealth building. This is because you’d be getting a tax break but you’d also not be investing for growth. Invest as much as possible (and housing is not an investment)!

@ kmgeb2000

I want to respond about being called short sighted about my view of housing. To give you a little background, the average home is sold every 5 years. Most people do not spend a lifetime in one place. We also will have multiple careers and move several times in our lives. I think I am a realist who understands realities of the modern economy. If you want to build your life around a place, that’s your call. For me, it is the people and not the building that makes something “home.”

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avatar kitty

Just wanted to address tax deduction. This really depends where you live and your income. In a high tax state, a lot of people can get more than standard deduction on state income taxes and property taxes alone. I don’t know which percentage of people live in high tax states – there aren’t that many states with income taxes over 5%, but they are among the most populous ones: NY, California, etc.

In terms of prepaying – I generally agree with the original post, but a lot depends on age, mortgage interest, other personla circumstances and preferences. I wouldn’t prepay a 4.5% interest – in 30 years or so the chances are good even a regular CD rate and government bonds will be higher. Imagine buying a house in early 70s and then hitting a period of two-digit inflation and rates on government bonds and CDs twice as high as your mortgage rate. I did pay off my mortgage, but it was at 7% and I am still second-guessing myself if I should’ve refinanced instead; but a) I am in my 40s, not 20s b)I simply signed one big check (gains on the sale of another property) rather than making additional payment, so I immediately reduced my living expenses c) this was a couple of years after the internet bubble burst when the gains that could’ve also been used to repay the mortgage evaporated. d) at the time lots of software engineers were getting laid off and there was a lot of fear of our jobs all going to other countries, so not having a mortgage made me feel more secure. Sure, having this money in a bank would’ve also meant extra security, but not at the stock market. Anyway, I am still not certain this was the right thing, but at 20-something and with low mortgage rate I agree that there is no reason to pre-pay.

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avatar ian

“The bank will not give you credit for the extra payments made to pay down the debt if you start to struggle further down the line.”

My car loan does; if I make 2 payments, it pays for this month and next month. Are there no mortgages that do this?

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avatar BfskinnerPunk

That’s not the “credit” originally referred to.
When you pay down your mortgage, you do indeed get credit in the sense that you will owe less if you pay more than your minimum payment.
If your house gets foreclosed upon, then you do *not* get credit for any additional payments…you lose the house and all money that you have put into it.

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avatar NickFadz

I would argue that if you were only looking at housing as a financial decision, you should really consider renting. In many parts of the country, housing prices have risen much more quickly than the rate of inflation while rents have increased at a more modest rate. YMMV of course but renting shouldn’t be left out of the conversation.

On the other hand, my wife and I are looking to buy a home for ourselves and our two young children and have some very specific lifestyle issues (school district, location close to family, etc) that we must take into account. As always, your personal situation and the market in your area determines the appropriate choice, financially, lifestyle or otherwise.

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avatar Dave

I decided to pay off my mortgage after reading this Scott Burns column back in 1999. Burns, a financial columnist for Dallas paper and graduate of MIT, points out that imputed income i.e. shelter services generated by a paid-off home, gives home owners a risk-free return very close to stock market returns.

Here’s the link

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avatar James

Dave…That Scott Burns column is out to lunch. The “12%” return from living in your house doesn’t depend on owning the house, you still capture that return even on an interest-only mortgage. You also capture the appreciation even if you never pay down your principal. The only real effect of paying down your principal is that it saves you interest and PMI payments. All you have to do is calculate whether the interest+PMI you save is greater than the returns from investing those extra principal payments in the stock market. Usually it isn’t.

For example, suppose you bought a 200K house with 3% down and a 5.5% 30yr fixed, and you decided to pay an extra $500 a month toward principal. This would allow you to pay off the house in only 15 years, and save a lot of interest. However, if you had invested that 500/month in stocks for a gain of 10% per year, you would be able to use the investment proceeds to pay off the house after 15 years…with $56,000 to spare.

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avatar Bfskinnerpunk

What needs to be compared is this:
1. You pay off your house. OK. So now what will you do with the money formerly sent to pay down the mortgage? What if you invest it at 10% as well?

2. Not paying it off, as suggested, and investing it for that lovely 10% yearly.

Surely, if you can make 10%,you would be better off if you never paid off your mortgage. In fact, you would be better off maintaining an interest only loan for life if you can get 10% yearly!

That 10% is a big **if**.

On the other hand, if you want to make a sure bet 6% (like I pay on my mortgage), without sweating the stock market, enjoy the debt free life, **and** invest some or all your former “mortgage money” in stocks… that could be a viable option as well. It limits your profit potential, but that always comes with a low risk decision.

I haven’t decided for myself. I am told that paying off a mortgage with today’s dollars is not a good thing. (Inflation somehow does a number on your mortgage payoff money).

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avatar Vin

I am actually in the process of purchasing a home and now have to look at the mortgages that are good for me. For someone who is looking to pay-off his mortgage earlier, would it be cost-effective and safer to get a 20 year mortgage at 4.65%, which would make your monthly payments higher, but you will pay-off the house in 20 years. Or get a 30 year mortgage at 4.85%. The difference per month between each scenario is $500.00. The mortgage companies I have looked into so far do not penalized paying off your mortgage earlier.

My thought process would be to get the 30 year mortgage and try to pay off the house in under 25 years. Having a 30 year mortgage at a good rate of 4.85% gives me the flexibility to save some money one month to put towards personal use/repairs on the home, pay more to the principal/interest and/or invest. Even though it sounds great to pay-off the home in 20 years, I would be worried that my monthly payments would be high resulting me in some months maybe just making it since I have to consider every day life expenses such as gas, car, food, etc. And by having some extra flexibility, it can help me is repairs are needed to my car and also to my home. Roofs, Heaters, A/C, etc don’t come cheap and if you want to get the most out of your home, maintenance is crucial.

So, here is my thought..I wonder if most would agree

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avatar Dean

I faced the same quandary about 8 years ago when I bought my first home. The way I looked at it was I was willing to pay a small amount extra in interest each month (in your case about $50) to have the option of not paying the $500 difference that you WOULD HAVE to be paid each month if something comes up. You can pay an extra $500 in principle if you want to, but you don’t HAVE to. Call it “cash flow insurance.” I planned on paying significant amounts of extra principle each month, but wanted the option to use my monthly cash flow for other things if need be. We now only have 3 payments left on our house, and I am glad to have gone with the 30 year option. Three times in the last 8 years things have come up when we didn’t pay extra and used the money to buy other investments that came along the way and we also bought a car for cash when we needed one.

That being said, if you don’t have the willpower to put money in savings or investments each month and need an iron fist chasing you demanding you to put money into an account, then the 20 year option would be better.

I enjoy the freedom of liquidity with my income so I can decide each month where to put my money depending on personal and economic circumstances.

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avatar Spence

I’m 36 yrs old with 7 kids. I’m about to buy a home at the incredible rate of 4.125% on a 30 or 3.7% on a 15 yr. Home will be purchased for $490K. I have cash to buy the home outright, but I’ve planned to putting down only 50% and keeping more cash in the bank. I’m in a rather high tax brackett. I’ve always been a fan of paying off the home, but this article has me rethinking the whole idea. Would any input on a better strategy than my plan of paying it off.

ALSO: I heard recently that there is a danger to owning a home outright. If you are ever sued, your home is now an assett that can be more easily taken in a suit than if it were owned by a bank. Can anyone confirm this is truth?

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avatar Harry

What a bunch of baloney! Please explain how paying a $1,000 monthly mortgage payment, $900 of which goes to interest, is even close to the 6% interest listed on the loan. That’s 900% interest! Don’t let the “financial experts” fool you. Loans are amortized for a reason: to take advantage of the consumer. The only way to not be a slave to our backwards economy is to educate yourself and use your common sense.

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avatar Nate

“I view a person’s choice of housing first as a financial decision and second as a lifestyle decision.”

Your home is NOT a investment, it is NOT a “deal”. It is not “logic” vs “emotion” – it is the fact that you act like your living place is just like a stock, just trade it around all the time.

Your home is an *expense*. It is not a place to “store wealth”. Too many people have looked at homes as something to make money off of, and we ended up with the giant disaster that was 2008.

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