ALDIE, VA-OCTOBER 23: Parker Collection model home at Lenah Mill on October 23, 2019 in Aldie … [+]
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If you’re one of the many homeowners who make monthly mortgage payments, you may have wondered if you should be taking any action to pay off your mortgage faster than planned. Reducing your debt load can be both a financially and an emotionally beneficial decision, and many mortgages provide the option for the homeowner to prepay.
In concept, prepaying a mortgage is very simple: you make additional payments towards the principal of the loan early. Early payments can be made in a variety of ways: paying a lump sum, contributing a little extra on top of your standard payment each month, or making effectively two mortgage payments in one month for a total of 13 annually. Not all mortgage lenders allow early payment without some type of penalty, but assuming there are no such fees, prepayment should be an easy process.
It may be simple to execute, but it’s much harder to know if it’s the right choice for you. Reviewing the benefits and costs of prepayment will help you determine whether it’s a smart way for you to spend your money.
The Benefits of Prepayment
Prepayment on a mortgage has two attractive effects: you’ll pay less money overall in interest and you’ll pay down the entire mortgage faster. Assuming your prepayment is applied to the principal of the mortgage (which you should confirm with your lender), every dollar that you put towards the mortgage early will reduce the amount of interest you pay over the life of the loan. Paying down the principal faster will also allow you to pay down the loan faster, so you’ll be mortgage-free sooner than the scheduled end of your 30- or 15-year term.
Furthermore, prepaying a mortgage is akin to making an uncorrelated investment with a near-guaranteed financial return. Due to low interest rates and the rally in U.S. stocks over the past decade, U.S. financial assets are expensive right now, so you might be able to generate a better return with less risk by paying down your mortgage. For example, if you have a bond portfolio in which you are generating a lower return than the interest rate you are paying on your mortgage, it’s likely that paying down your mortgage will outperform your bond investments.
The Downsides of Prepayment
While prepaying on your mortgage may look attractive in the long run, it’s important to consider the downsides. If you decide to prepay on a monthly basis, you’re putting more of your salary into your mortgage payment and leaving less liquidity for other needs. Particularly for those with variable monthly income, prepayment may take up too much cash unnecessarily and put you at risk of not being able to cover a surprise expense.
Even if you can comfortably cover mortgage prepayment after you’ve taken care of monthly expenses and savings, it’s still important to consider if that would be the best use of that money. Are you contributing enough to your 401(k) to at least to get your employer match? Do you have a healthy emergency fund? Do you have other debt at higher interest rates, like credit card debt? For many people, mortgage prepayment shouldn’t be the first priority for any additional cash you may have.
Perhaps even more importantly, you may build wealth more efficiently over the long run by not accelerating your mortgage payments. There are good reasons to expect that inflation will be accelerating over the next ten years due to a combination of factors, including an expanding Federal deficit and an increasing reluctance of foreign central banks to finance those deficits. In an inflationary environment, you might want to be a debtor rather than a creditor. As the dollar depreciates over long periods of time, the real value of your mortgage liability should decline accordingly.
Finally, your mortgage interest payments may provide you with tax savings. If you pay down your mortgage, your interest expenses will decline, and, with that, it may be that the value of your tax shield falls with it. Your tax accountant should be able to help you figure out the tax impact of any potential decision to prepay your mortgage.
As with many financial questions, whether you ought to prepay on your mortgage depends on your personal financial situation and your goals. If your primary goal is to pay less towards your mortgage over the long run, you should consider prepaying, refinancing your mortgage at a lower rate, or both. If your primary goal is owning your home as soon as possible, prepay. But if you’re more concerned with your overall wealth, now and in the future, it is likely best to continue with your mortgage payments as they were originally planned.
Disclosure: This article is for informational purposes only and is not a recommendation of a particular strategy. The views are those of Adam Strauss as of the date of publication and are subject to change and to the disclaimer of Pekin Hardy Strauss Wealth Management.