CERTIFIED PUBLIC ACCOUNTANTS AND ADVISORS |
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SHOULD YOU PREPAY MORTGAGE IN A DOWN
MARKET? Disenchanted with stock and bond returns, some homeowners
are diverting their investment money into their home mortgage. But many
financial advisors think this is not always as good an idea as it might first
appear. Here are some points for you to consider before you decide whether to
prepay your home mortgage. It’s easy to see why diverting investment money into your
home instead of stocks or bonds might look attractive these days. When you
prepay your remaining mortgage with a lump sum, or accelerate the payoff through
monthly extra principal payments, you reduce your long-term interest costs. On a
30-year, 7.5-percent, $200,000 mortgage, paying an extra $200 a month would save
$112,625 in interest charges. Thus, paying off a mortgage carrying seven to
eight percent looks like a smart move compared with investing in stocks, which
have been on the skids since March of 2000. It also looks smarter compared with
ten-year Treasury bonds currently yielding a modest 4.5 percent, or even the
more anemic returns of money market mutual funds, savings accounts and
certificates of deposit. For conservative investors who don’t invest in stocks, or
perhaps even bonds, prepaying your mortgage might make financial sense, say many
financial planners. You’ll probably earn more than low-risk alternatives and
you’ll reduce your debt, which is usually a good thing, especially in tough
times. And paying off the mortgage early provides peace of mind . On the other hand, the financial value of paying off a
mortgage early is not necessarily as strong as it appears, suggest experts.
First, you should compare after-tax returns when weighing your options.
Homeowners who itemize can take a mortgage-interest deduction, which effectively
reduces the return gained by paying off the mortgage early. For example, let’s say you will be in the 27-percent federal income-tax bracket next year. Thus, the real cost of that 7.5-percent mortgage (which is the same as the return you would get prepaying the mortgage) is 5.47 percent. Someone in the top 38.6-percent tax bracket next year is actually paying only 4.6 percent on their mortgage (this doesn’t take into account any state taxes saved). Compare this with the after-tax return of an alternative
investment. A stock returning 7.5 percent annually provides an after-tax return
of 6 percent assuming a 20-percent long-term capital gains tax. In dollar terms,
putting $200 monthly toward stocks earning 7.5 percent annually would earn
$271,174 in 30 years, versus the $112, 625 you saved in interest payments by
prepaying the mortgage. Experts also point out that the interest savings gained
from prepaying a mortgage are overstated because of the time value of money. Due
to inflation, the interest payments you make in the latter years of your
mortgage are made with much cheaper dollars than the ones made with the early
payments. So prepaying means you’re using up dollars that are more valuable. Another argument for continuing to invest in stocks instead
of diverting the money into the mortgage is that stocks overall might be
considered a “bargain” these days because they are so beaten down. The
assumption is that stocks, while returning poorly now, will eventually recover
their losses, and much more, in the long run, so it’s a good time to buy them
while they are cheap. Since 1926, stocks have averaged annually 7.9 percent
after taxes and inflation are taken into account—well above the return
you’d earn paying off a mortgage early. It also makes less sense to divert money from tax-favored
retirement accounts—especially if your employer is providing matching funds.
And at the least, if you remain too nervous to invest in stocks or bonds, you
would probably be better off putting excess money into paying off high-interest
credit cards or other higher-interest consumer loans (whose interest you can’t
deduct) instead of a lower-interest-rate mortgage. Prepaying a mortgage also means you are tying up money that
could remain in more liquid accounts, such as an emergency fund. (Remember,
prepaying does not lower your monthly mortgage payments unless you pay the
entire amount off.) If you were to lose your job, for example, it would be
harder to get money out of your home than to simply take out cash from your
emergency fund or even sell stocks, if necessary. November 2001— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by McGuire & Co., LLC, a local member in good standing of the FPA. |
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