By Jeff Brown
Paying off a mortgage early is a financial strategy people either love or hate, with views often hinging on the prospects of alternative investments like stocks and bonds.
Making extra payments on “principal” – the outstanding debt – reduces the interest paid over the loan’s lifetime, since interest charges are figured each month by multiplying the interest rate by the remaining principal.
Pay an extra $100 in year five of a 30-year, 6 percent mortgage and you’d reduce interest charges over the loan’s life by $344, according to the BankingMyWay.com calculator.
That one extra payment would snowball the same way interest earnings compound in a savings account. Since the monthly payment stays the same for the life of the loan, requiring less for interest means more of each payment goes to principal.
If you paid an extra $100 every month on a $100,000 loan at 6 percent, you’d pay the debt off in 21 years instead of 30, saving nearly $40,000 in interest. (These examples assume a fixed-rate loan, as opposed to an adjustable-rate mortgage.
As appealing as these numbers are, making extra principal payments isn’t always the best strategy. Here are some things to keep in mind.
Alternate investments may be better. In effect, the extra payments described above are earning 6 percent a year, since every $100 in payments would save you $6 a year in interest charges. If your mortgage charged 8 percent, your extra payments would be earning 8 percent, and so on.
But if you could earn 10 percent in a mutual fund, stock or other investment, that would be the more profitable choice.
Compare apples to apples. In weighing the alternatives, remember that the return on the principal payments is guaranteed. It’s like putting cash in a federally insured bank account. Other investments, like stocks or stock funds, could be more profitable, but would probably be riskier.
Fixed-rate investments like certificates of deposit offer the same level of safety and guaranteed return as mortgage prepayments. But with the average five-year CD yielding just 2.34 percent, according to the BankingMyWay.com survey, a mortgage prepayment might well be more profitable. The 30-year fixed-rate mortgage rate averages 5.1 percent.
Keep tax issues straight. The 6 percent return described above is a pre-tax return. Most homeowners get federal income tax deductions on mortgage interest payments. A 6 percent loan therefore only costs 4.5 percent if you are in the 25 percent tax bracket – and the after-tax investment return from a prepayment is therefore 4.5 percent..
A bank CD paying 6 percent would really earn 4.5 percent after taxes were paid at a 25 percent income tax rate. But a municipal bond yielding 6 percent actually would put 6 percent in your pocket, since muni bond interest is exempt from federal taxation. A stock paying a 6 percent dividend would yield 5.1 percent on an after-tax basis, since dividends are taxed at a maximum of 15 percent.
Consider liquidity Money you “invest” in your mortgage is not easy to get back. Reducing your debt means increasing the equity in your home, since equity is the market value minus outstanding debt. But to get that money you would have to sell the property or take out a new loan, such as a home equity loan. Money put into other investments, such as stocks, bonds, mutual funds and bank savings, is much easier to get at.
Prepayments can be made at any stage of the loan term, though the snowballing effect makes it most profitable if you start early. If you’re in the market for a new mortgage, look at our survey for current rates. Be sure to look beyond the big lenders like Bank of America (Stock Quote: BAC ) and Wells Fargo (Stock Quote: WFC) for the best deal. Then put the best rate into the BankingMyWay.com calculator to see how much you could save with prepayments.