For many, it still makes sense to prepay mortgage
At a time when mortgage rates remain below 7
percent, it seems odd to tackle the subject of when, and when not, to prepay a
mortgage. With mortgage debt being so inexpensive relative to other debt, the
prospect of accelerating repayment is not advantageous for many.
A 30-year fixed mortgage rate of 7 percent is closer to 5
percent on an after-tax basis, after the deduction of mortgage interest from
federal taxes. With mortgage rates so low, even borrowers without other
higher-cost debt are better off diverting long-term investment dollars into
higher-return instruments such as stocks. After all, the long-term average
annual return of 10 percent on stocks, before taxes, still equates to 8 percent
after taxes, assuming the long-term capital gains rate applies.
Nonetheless, there are some instances where borrowers can
benefit by paying down mortgage debt, despite the relatively low cost.
Better retirement
Consider those who are retired, or about to retire. They want to reduce expenses
as much as possible, and their investments tend to be more conservative. They're
also more likely to have been paying their mortgages for many years. For them,
paying a little more now so the mortgage can be eliminated will drastically
reduce monthly expenses. With lower expenses, there is no need to tap retirement
funds for housing, allowing those funds to continue growing tax-deferred or
tax-free.
This advice isn't for everyone: If the level of retirement
income is such that it keeps the investor in a high tax bracket anyway, the
advantage of the mortgage-interest tax deduction remains inviting.
Paying off a mortgage early also makes sense for owners of
smaller properties who don't pay enough mortgage interest to warrant itemizing
their taxes. Without the tax benefit, a rate of 7 percent still costs 7 percent.
Build equity, avoid the market
Consider those who took out mortgages one year ago. They have nothing to gain by
refinancing because rates are similar to today's. Applying excess cash to their
mortgages builds their equity -- the portion of the home the borrower actually
owns -- and may be an attractive investment option for those uncomfortable with
venturing back into the stock market.
This same concept applies to those at the other end of the
homeowner spectrum -- consumers who are looking to sell their homes. They will
need cash to get into their next homes, either for closing costs or for a down
payment. They could put that money into a money
market account, but that creates fully taxable interest. Applying that same
cash to the mortgage balance will increase equity, which can be converted to
cash if needed.
Ducking PMI, ditching jumbos
Borrowers looking to pay down the balance in hopes of getting out from under
private mortgage insurance see a quick return on investment when the PMI goes
away. The same paydown strategy also pays off for people who have jumbo
mortgages, which carry higher interest rates. Paying down the principal and
refinancing to a smaller, conventional mortgage, quickly produces tangible
results.
Finally, for those borrowers able to extract a greater return by
paying down mortgage debt than by investing in other means, prepaying a mortgage
can make sense. There is no advantage in letting cash needlessly pile up on the
sidelines that could be used to retire higher-cost debt. Increasing the equity
position in a home is also a better inflation hedge than cash or fixed-income
investments.
