NEW YORK (MainStreet) -- Making extra mortgage payments is a strategy that thrills some homeowners and leaves others cold. Unfortunately, that means most people choose a side and stick with it, while the best approach is to switch back and forth as conditions change.
Homeowners who rejected prepaying when they were young (and used extra cash for other investments) might find it more appealing as they get older. The value of pay-downs changes as the expected returns on other investments rise and fall, and since older investors are wise to be more conservative, that makes owning a home outright more appealing.
The basics are simple: Make extra principal payments on a regular, intermittent or one-time basis, and you can save a bundle on interest charges in the long run. For every $100,000 borrowed at today’s average interest rate of 4.2% on a 30-year fixed-rate loan, you would pay about $76,000 in interest for the life of the loan, according to the BankingMyWay Mortgage Loan Calculator. Paying an extra $50 a month would reduce interest costs by more than $14,000 and retire the loan in 25 years instead of 30.
But there are some downsides to the practice. For one, that $50 in extra principal payments is tied up in the home and thus not available for other purposes. To get it back in liquid form you’d have to sell, refinance or take out a home-equity loan or reverse mortgage.
Even if tying the money up is not an issue, the cash could probably be invested in more profitable ways. In effect, the extra principal payments are equivalent to an investment with an annual return equal to the interest rate on the mortgage. So, in this example, if you could earn more than 4.2% on an alternate investment, prepayments would not make sense.
Many advisers would point out that 4.2% earned on a prepayment, where the return is guaranteed, is very good compared to earnings on other rock-solid investments. The average one-year certificate of deposit, for example, yields just 0.331%.
But this is where factors like the homeowner’s age come into play: People in their 20s, 30s and 40s typically emphasize stocks in long-term investments, because there’s plenty of time to ride out market downturns and enjoy stocks’ high expected returns in the long run. U.S. stocks averaged about 10% a year in the 20th century.