## To Prepay Your Mortgage Principal or Not?

by Mr Credit CardOne of the juggling acts we have with our personal financial life is juggling our mortgage payments, our need to save for our kids college education and our need to save for our retirement. Yet we have only finite resources and income to fund these requirements. Where do our priorities lie?

My friend (let’s call him Mr X) recently confided in me about his mortgage payments. He has a mortgage that he is very comfortable with, but he wants to pay them off as quickly as possible. His accountant obviously has told him that you get tax deductions on your mortgage interests and that he should not be in a hurry in prepay it.

However, Mr X does not like the idea of being in debt. He had seen his parents get in debt troubles and close to financial ruin when he was a kid. It had left a sour taste with him and his attitude regarding debt. He had to take a mortgage when he bought his house because he did not have enough to pay for a house outright! As far as Mr X is concerned, he wants to be debt free (as in free of his mortgage burden) as soon as possible. Yet at the same time, he does realize that any extra cash that he pays to reduce his mortgage principal every month can be used to save for his retirement or his kids college education. His financial advisors have told him that saving for his retirement is very important and he knows he needs to set aside a certain amount every month for that and also his kids college savings. But Mr X told me he would sleep better if he knew his mortgage would be paid off in 10 years rather 20 years.

What should he do, he asked me? Well, my opinion is that if he sleeps better if he has a lesser mortgage burden, then he should make the extra effort to reduce his mortgage. I outlined the following alternatives to him.

1. Take some of your retirement savings and reduce your mortgage immediately. Pros – Mr X sleeps better and his mortgage burden is reduced. Cons – He is taking away his retirement savings from his no IRA or 401k account.

2. Allocate more money each month to repaying mortgage principal – Pros – he will pay off his mortgage faster. Cons – that money can be used for his retirement savings.

3. Cut his expenses even more! and use the extra savings for his mortage principal prepayment every month. Pros – he will pay off his mortage faster and his retirement and college savings plan is “on track” and unchanged. Cons – he has to live an even more frugal lifestyle.

I actually managed to persuade him to go for choice number 3 because that seems to make the most sense to me. I even adviced him to get the Citi® Home Rebate Platinum Select® MasterCard®. This card would allow him to earn 1% rebates which will be automatically used to pay off his mortgage principle every month. (talk about paying off your mortgage faster on autopilot!).

But this conversation I had with him led me to think that sometimes, the most financially sound advice may not be the right choice for a particular individual. In the case of my friend Mr X, he simply hates being in debt. Had he taken choice number 1 and used a portion of his savings to pay off his debt, you cannot really say that was the wrong decision. After all, that is why we call personal finance “personal”. It simply has to suit you, your particular circumstances and your personal values.

What would you have done if you were Mr X. Take part in this poll and share your comments with us.

[poll=4]

February 7th, 2007 at 16:40

I think that by tracking his expenses he would see that there is some wiggle room in his budget and he would be able to come up with an additional 10% to apply to his mortgage payment each month. I also think that he should apply any bonuses to the mortgage.

February 7th, 2007 at 16:48

Just to touch on this subject, here is a tidbit from the latest Kiplinger’s March 2007 on page 67.

WRONG CHOICE:

“Nearly 40% of U.S. Households that speed up mortgage payments to pay off their debt early would save more—$400 per year, on average—by investing the extra cash in a 401(k) or 403(b) plan, reports the University of Michigan.”

Now after reading that, I am going to need to reevalutate what’s more beneficial, paying excess payments toward principal on my mortgage or investing even more in savings.

I always assumed that paying more towards the principal was the thing to do, as I saved tens of thousands in interest. Just think a $150K house with normal payments will basically cost you $300K over 30 years with the normal payment schedule.

So the tidbit is saying take that extra money and invest it and you will reap more. The hard part is to try and find the break even point. If you were to pay extra on your mortgage towards principal you would not pay off a 30 year mortgage in 30 years. Depending on your interest rate and the extra amount you pay towards principal could change the number by as much as 5 to 20 years or even more or less than that.

So maybe I should sit down and see if I can find out if I’m doing the right thing. If anyone has a formula or calculator for trying to figure this out, I’d be very interested. My brain hurts from just thinking about how to figure this one out.

February 8th, 2007 at 05:47

Ray – no need for a headache as the financial decision is pretty straight-forward. All you’re comparing is:

(1) how much, after tax, you could make by investing your next $1000 over the next year. My experience suggests that 6-9% might be a realistic assumption. Strictly speaking, a risk-free, after-tax rate of return would be in the 3-4% range.

(2) how much, after tax, you’d save in interest with an early mortgage or LOC payment.

Many mortgages are in the 3-7% range — clearly an early payoff makes no sense here, based on current interest rates. However, many LOC’s (and some mortgages) are in the 8-12% (or worse) range — here an effort towards payoff can make sense.

Personal aversions to debt may take you in a different direction, but at least you know the cost of your decision.

Good luck!

February 8th, 2007 at 15:18

James,

There are a couple of things missing though.

At some point you still need to calculate in your interest deductions for taxes which will be slightly less due to the principal being paid down. This might not be enough to add up, but I’m not sure.

Then you have to assume you beat the rate of of return of your mortgage interest rate. I am an investor who is spread across the markets, but year in and year out being able to say that $1000 or so will gain after taxes 6%+ is not a given.

I can only think that since the article addresses only 40% of the people who pay off their mortgage early, that they must be referring to people who have a high interest rate or a variable rate that fluctuates.

At least your know by paying off your mortgage earlier you know how much you are savings. If you save more, you are not guaranteed those savings and you will also pay taxes on those gains.

I’d love to see some numbers from the article to see how they arrived at the referenced numbers.