Mar 13th, 2009
Does a Mortgage Prepay Make Financial Sense? A Discussion on Interest Rates
On Twitter (gee, I seem to be saying that a lot), one of my buddies and I had a quick exchange on the pros and cons of prepaying a mortgage, which I thought I’d expound on here.
This discussion assumes that you don’t have an exotic, difficult to deal with mortgage like an adjustable rate mortgage. If you do, you’d likely be much better off finding a fixed rate mortgage than worrying about paying beforehand. It also assumes you don’t have a mortgage with a prepayment penalty–yes, there are mortgages that will sock you with fees if it’s paid off early!
The question that was at the heart of the discussion is whether paying off a mortgage early made financial sense. The answer, as almost always, is, “it depends.”
In particular, it depends on the interest rate of your mortgage and the rate of inflation. Let’s take a quick look here.
Pretend you live somewhere (like Hawai’i) where the interest paid on the mortgage for your primary residence is deductible on both your federal and state taxes. Also pretend that inflation is in the “normal” 2-3% range. And let’s also pretend your mortgage rate is 5% (which is a pretty decent rate).
Start with your mortgage rate–right off the bat, you can deduct the inflation rate–you are paying off the mortgage with future, cheaper dollars. So 5 (your mortgage rate) minus 2.5 (right in the middle of the 2-3% “normal” inflation rate) equals 2.5.
Then consider you are deducting the interest you’re paying from your federal and state taxes, which might (depending on how much interest we’re talking about) give you the equivalent of about another 1-1.5% discount on that rate. That leaves us somewhere about 1.25% interest on that loan–we’re talking pretty cheap money. Financially, this would suggest that prepaying is not so hot of an idea–your money would better be spent in even a pretty low rate certificate of deposit if you wanted a “sure thing” or, given historical returns, the bond or stock market.
However, remember that the inflation rate is a key part of this! Right now, inflation is essentially zero, if not negative. So it’s hard at this particular time to give yourself that 2.5% part of the equation, although over time it’s likely to be true. If you can’t count on the inflation part of this scenario, the effective interest rate becomes considerably higher–an argument to prepay.
Alternatively, looking at a different part of the scenario: if you prepay the mortgage at 5%, it’s like investing your money at a guaranteed 5% rate, which is pretty darned decent these days–although about half the traditional return of stocks. If, however, you are a conservative investor, you could consider this similar to being like investing in a fixed income security such as bonds or CDs–in that case, it may be worthwhile to prepay the mortgage with the money you may otherwise use for fixed income investing. But be careful with that, because while you eliminate debt faster, you aren’t building any wealth.
And of course, the 5% mortgage rate is key to this; if your rate is, say, 7%, you just added two more points onto the equation, which would make the argument to prepay much stronger.
So, a few things to consider when thinking about prepaying your mortgage. This is, while much more comprehensive than what could be done on Twitter, just the beginning of a long discussion on some mortgage issues.
