The Age-Old Quandary: To Prepay Your Mortgage or to Invest

As the market has exited from our worry screen at least temporarily, let's take a moment to ask the burning question: "Should you pay off your mortgage early?"

This is not only an investment decision, it is also a subjective personal decision about our home. And that's what makes it so difficult. We're talking about where we sleep, eat, interact, and entertain and are protected from cold, heat and storms. Our home may be the only environment that we can totally control. The decision is so personal that only you -- no financial advisor -- can make it.

The investment part of the decision is easier to map: Do you think the return on your investments will exceed the money you could save paying down the mortgage, and is that return worth the market risk? You will probably end up wondering whether you can make more in the market, and with days like Tuesday, you'll conclude that you shouldn't pay off the mortgage. At this level, the discussion is much like the one we had in my earlier column on taking on a bigger mortgage to invest.

There is a difference, however, and for most people, it's a practical one. Most people already have a mortgage on a home -- it's not a matter of taking on more debt. Once the mortgage exists, the question then becomes whether we can pay it off early. At some point in our lives, we are hopefully making more money and can afford to start paying off the mortgage at a more rapid rate. Should we do that, or should we invest the money elsewhere? The investment side of the equation presents several points: Refinancing at a Better Rate

First, you need to look at the issue of refinancing your existing mortgage (not to take on more debt, like we discussed last month, but to get a better rate). The cheaper your mortgage, the more it makes sense to invest rather than prepay.

If you qualify and the numbers work out, you should refinance. Fraj Lazreg of Money Concepts, a New York financial planning firm, says, "Most people are still carrying rates above today's market rates, especially people that got mortgages between 1989 and 1992." It's possible to get a new 30-year mortgage at 6.75% and a 15-year mortgage at 6.5%. If you have an existing 8% mortgage, here are the comparisons:

Cheaper Mortgages are Better Years Rate Amount Monthly Payment Total Paid 30 8% $100,000 $733.76 $264,155 30 6 3/4 100,000 648.59 233,492 15 6 1/2 100,000 871.11 156,799

Source: Fraj Lazreg, Money Concepts

There are refinance charges that range from 2% to 2.5% of the amount refinanced. It can take 18 to 24 months before you work off that cost. Shop around and you might even get a better deal. Systematic Pay Down

The "pay down your mortgage" strategy generally involves a systematic payment that can take several forms. The two most common seem to be an annual payment on principal or a monthly payment that pays the equivalent of the next month's principal. By paying monthly, you will essentially convert a 30-year mortgage to a 15-year mortgage. The results are impressive: A 30-year 7% mortgage for $100,000 adds up to $239,509. By prepaying the next month's principal, the total comes to $161,789 -- a guaranteed savings of $77,720. Don't Forget the Taxes

The investment decision boils down to two numbers: the mortgage interest rate and the investment rate of return. You need to factor in the after-tax rates for both. A 7% interest rate on a home mortgage is tax deductible. If you are in a 28% tax bracket, that means you will save approximately 2% in taxes, reducing your cost to about 5%.

The same tax may apply to investment return. So if you make 7%, you'll net 5%. I said "may apply" because if you have a long-term capital gain, the rate may be 20% and you could net 5.6%.

Some people argue that as long as you make more than 7% on your investment, you should invest the money and not prepay your mortgage. My conservative bent always comes out on an issue like this, so I take the position that you should net 7% after taxes on your investment. That means you should make about 10% on your investments using a 28% tax bracket.

Can you make 10% or more in the stock market? If your answer is yes, then don't prepay your mortgage. If it is no, then prepay it. Some of you will want to use the 5% net argument and say you only need to beat the 7% number. It's your decision. But remember that we are comparing a guaranteed savings on the interest vs. a nonguaranteed investment in the market. Keep the following statistics in mind:

Out of the 63 10-year periods since 1926, large-cap stocks have returned less than 7% during 16 of those time periods. In other words, 25% of the time, the return was less than 7% per 10-year period.

The flip side of that is that 75% of the time, the large-cap stocks returned more than 7%.

There were 33 10-year periods out of 63 since 1926 that were up more than 10% per year. That is 52% of the time.

In case you're wondering what the large-cap stocks did during your lifetime, here are some examples:

Returns on Large-Cap Investments Year Born Age Now Lifetime Returns 1968 30 12.1% 1963 35 12.2 1958 40 12.3 1953 45 12.4 1948 50 13.2 1943 55 13.3 1938 60 12.5 1933 65 12.7 1928 70 10.6

Source: Ibbotson

When you see market figures like I've just given, remember that actual results for investors are generally different. Because people may pull out of the market during down times, their returns are often less than market returns. Here are some summary guidelines for making a decision about paying down your mortgage:

The higher the interest rate on your mortgage, the greater the reason to pay it off early. It is harder for an investment to beat it.

The lower the interest rate, the greater the possibility an investment will beat it. Check out refinancing your existing mortgage if you're paying over 8% interest.

If your job situation is uncertain or unstable, you may want to pay it down while you can.

If you're preparing for retirement, you may want to pay it off so you don't have those mortgage payments hanging over your head.

If the investment part of your decision is positive but you'll "feel" better paying it off, pay it off!

Just in case you were wondering what I would do, I would not refinance to invest in the market nor would I prepay my mortgage at a 7% or lower rate, which is what I have. That is my breaking point -- anything over 7%, and I start paying down.

Many of you have sent me terrific emails about my column on refinancing. Thanks, and I'll try to answer them soon! I want to share one email from Mark Caestates, who makes points that we all should keep in mind.

I bought my house in February 1997 for $334,000. My neighbor sold his house for $443,000. I am 35 years old. My wife and I saved 20% for a down payment. We are paying an additional 20% for each monthly. We are refinancing from an adjustable of 7.8% to a fixed 7%, no points. Given my business degree from UCB and our options, our plan is to be debt-free in four years.

The San Francisco Bay area housing market is too hot. Many of my friends, the ones who can afford housing, are refinancing their homes with the purpose of using their equity to buy other homes or to put it in the stock market. This act of leverage will break a lot of financial hearts when things go south. When the stock market or the real estate market goes down, it will pull down all those leveraged positions and we will see a real recession or depression. If this happens, I want to be debt-free!

Please send me your thoughts, too.