Should You Prepay your Mortgage?

Admittedly, this is probably not a question that many homeowners find themselves asking these days, given the recession that continues to ravage the US. Even regardless of the economy, it’s not an easy question to answer, as I shall explain. The most important consideration is whether you can afford it. That is, if you commit to contributing an extra $50 per month or making one extra payment per year, can you be certain that it won’t negatively impact your financial situation.

As to whether it makes financial sense to repay- this involves a much more complicated calculation. The general idea is that if you can afford to prepay your mortgage, you should make sure that the money you save (by effectively shortening the term of your mortgage) exceeds the return you would have achieved by investing those hypothetical repayments. Thus, you should begin by comparing the rate that you pay on your mortgage to the rate of return that you think that you can reasonably achieve as an investor.

This basic calculation, however, ignores the tax-deductibility of mortgage interest, which must be accounted for in your mortgage rate. In other words, while your mortgage rate is technically 6%, it might fall to 4% on a tax-adjusted basis, after accounting for the 33% you don’t pay, via your marginal tax rate. At the same time, you need to consider that your investment profits will be taxed by the IRS, at a rate that depends on the type of investment. If you put your money in a savings account, it might be taxed as normal income, whereas if you invest in stocks, you will be taxed at the long-term capital gains rate, and will in effect come out ahead in the tax arbitrage game.

Moreover, you should be aware that there is a connection between the risk and return of what you invest in. While a mortgage rate may not fluctuate much over the life of the mortgage (of course it won’t fluctuate at all if it is a fixed-rate), your rate of return might vary from year to year. Interest rate cuts and stock market declines will certainly erode your ability to achieve your projected return.

Ultimately, if you have the cash to spare, it’s probably advisable to repay. Situations where you are reasonably sure that you can achieve a much higher return than your mortgage rate are probably going to be rare. If you were lucky enough to lock in a 6% fixed rate mortgage while your savings account is currently paying interest at 15%, well that’s a different story. While everyone certainly has a different risk-reward matrix, it’s probably still better to build up additional equity in your house rather than gambling in the stock market.

Before prepaying, make sure that there isn’t a prepayment penalty attached to your mortgage. Fortunately, such penalties have become increasingly rare, and if you do have a penalty, chances are it will no longer apply after two or three years. One final piece of advice- make the repayments directly to your lender, rather than through a third-party, which will charge a fee for managing a process that simply doesn’t need to be managed.