Dan Marchiando's Mortgage News Blog

Prepay Your Mortgage or?

February 6th, 2009 2:01 PM by Dan Marchiando


Last issue I discussed most of the different strategies that are available to accelerate the payoff of a home mortgage. You may recall that it is the simple payment of extra money on a mortgage, not some magical system or program, which pays off a real estate loan more quickly. But before you commit to this course of action—accelerating the payoff of your mortgage in the hopes of saving interest—please consider the following ideas.

Home Mortgage Interest Deduction

The home mortgage interest deduction is considered by many financial experts to be the best and biggest tax break given to average middle-class taxpayers. (The interest deduction for credit cards and car loans was repealed years ago.) The argument is this: If you claim mortgage interest as an itemized deduction on your income tax return, then the federal government and the State of California are not charging you taxes on the money that you spend on mortgage interest. For example, a homeowner with a 6.50% loan and a combined federal and state marginal tax rate of 30% is effectively borrowing at a rate of 4.55% (calculation: 6.50% x (1.00-0.30) = 4.55%). Homeowners who do not itemize their deductions cannot realize this savings. Consult a tax expert for more details.

Other Financial Goals

Before accelerating the repayment of a mortgage, ask yourself what other financial goals are important to you and whether you have a plan to achieve them. Am I saving enough for retirement? What if I need to make a major purchase? If you anticipate needing extra cash in the future to pay for a car, a college education, a wedding, or a home improvement project, and you have no plan to save for these extraordinary outlays, you might want to hold off making extra mortgage payments.

Opportunity Cost

Economists use the term “opportunity cost” to describe the impact of not making an alternative financial decision. To continue the example above, let’s assume the homeowner has a daughter but chooses not to establish a wedding fund for her, and that such a fund might have an expected return exceeding 4.55%, say, 6.55%, after taxes. Thus, the homeowner’s opportunity cost of prepaying the mortgage would be foregone interest of 2.00% and a very unhappy daughter!

Inflation and Appreciation

Inflation is another factor that must be considered, according to Jeffrey Sears, a Certified Financial Planner™ in Santa Barbara. “The concept of inflation is pretty simple,” remarked Sears. “Since a dollar today will be worth less tomorrow, inflation is the ally of the borrower but the enemy of the lender. Regular mortgage payments are made with future dollars of lesser value. Instead of prepaying a mortgage, why not save or invest the more valuable dollars today?”

Long-term, real (inflation-adjusted) appreciation in the value of residential real estate has greatly increased the wealth of many local homeowners. Depending on your age, the amount of your mortgage, and the extent of your retirement savings, there may be no need to worry about accelerating the payoff of your mortgage as you approach retirement.

Consider a Santa Barbara couple who purchased a home in 1982 for $100,000 at the age of 40. Today they are retiring at 65 years old, and they have been paying on various mortgages for the last 25 years. Their mortgage balance is now just $28,000—about the cost of a car today—and their home is now worth $950,000. Their monthly payment is $560. They could lower it even more by actually extending it through a refinance into a new 30-year mortgage loan, or make the payment go away using a reverse mortgage. The important point is that, over longer periods of time, inflation and real price appreciation will make a typical mortgage somewhat inconsequential or trivial eventually. Many home-owners gain much more equity in their homes through appreciation, than they do from paying off their mortgage.

Equity Locked Up in Home

Homes tend to appreciate over time, and the equity that builds up through loan payments and appreciation is not useful unless you are prepared to sell or refinance to withdraw some of that equity. Fortunately, with the advent of reverse mortgages, extracting equity in retirement is becoming less of a problem for home-owners. Call me if you have questions about reverse mortgages.

Setting Important Financial Priorities

Financial planners, including local Certified Financial Planner™ Jeffrey Sears, encourage home-owners to consider mortgage prepayments in the context of a larger financial plan. The following list of priorities is commonly set forth in a financial plan.

1. Establish an emergency fund equal to 3-6 months of your income, which will come in handy in case of a lost job, a medical emergency, or other major expense such as a car or home repair. Self-employed people and people in vulnerable industries (e.g., Hollywood writers) may want to put away even more.

2. Address financial risks and, if necessary, mitigate them with insurance. Health, auto,
liability, disability income, life, and long-term care insurance may be appropriate solutions.

3. Pay off consumer debt, such as credit cards balances and car loans, the interest on which is not tax-deductible. These types of liabilities will usually have higher interest rates than home mortgages.

4. Fully fund all retirement plans, especially 401(k) plans where there is an employer match. Employer matches are “found” money that should always be pocketed. Fully fund an IRA account every year in addition to your employer-sponsored plan. If you are unable to “max-out” your retirement accounts because you are funding multiple priorities, start by setting aside a percentage of your income, with an eventual goal of at least 10%. Retirement accounts provide two significant benefits over prepayment of a mortgage: 1) they can reduce current taxable income; and 2) their earnings compound tax-deferred or, in some instances, tax-free.

5. Contribute to tax-advantaged college savings plans, if appropriate. Contrary to actual practice in the U.S., saving for retirement should always come before saving for college. While prospective students or their parents can always borrow if college savings are inadequate, prospective retirees have only one option to borrow for retirement – a reverse mortgage.

Putting Your Equity to Work

Many people use the equity in their homes to make investments in other areas, whether in more real estate, a business venture, or the stock market. Financial author Douglas R. Andrew has made a career out of promoting this very concept, and has written a few books on the subject, for example Missed Fortune 101. Although his ideas run contrary to conventional thinking and won’t appeal to everyone, especially to risk-averse traditional savers, he certainly presents some interesting and insightful ideas about saving and investing for retirement.

The Bottom Line

At the end of the day we all have to choose a financial path that guides us, that reflects our personal goals and risk tolerance, and that makes us comfortable. But we shouldn’t determine our destination before considering all our options, some of which may be novel.

Thanks for your interest,


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