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Mortgage Prepayments: A Good Investment?

Clients occasionally raise with us the question of whether or not to make prepayments against the principal on their mortgage.  Unfortunately, we don’t have a one-size-fits-all answer to this question.  Below are some pros and cons and a discussion of factors to consider in determining whether to prepay on your mortgage.

b2ap3_thumbnail_mortgage_20150325-140623_1.jpgAlternative Use of Funds:  The most significant consideration is to what use you would otherwise put the money.  If, for example, you are considering prepaying a modest amount (e.g. rounding up your mortgage payment to the next hundred) that you would otherwise use on clothes, eating out, etc., then prepaying would allow you to build a bit more equity in your home while decreasing your monthly personal expenses (a double bonus for any financial plan!).  If, however, you are considering prepaying a more substantial monthly amount that you would otherwise save and invest, then you might be better off investing.  If faced with this enviable problem of extra money at the end of each month, consider first whether you have an adequate emergency fund, whether you are maxing out your retirement plan contributions, and, if you have young children, whether you are saving for college tuition or even a taxable investment portfolio.  If the answer to any of those questions is “no,” start there.  If you feel comfortable about your savings toward each of those goals, you might still be better off investing extra cash flow in a non-retirement investment account, which would have potentially a better return and certainly more liquidity than prepaying your mortgage.

Interest Rate vs. Expected Returns:  One advantage of prepaying your mortgage is that you will pay less interest on the loan over time.  However, with current interest rates near historic lows, mortgage rates are considerably lower than the expected long-term return from investing in a balanced portfolio.  For example, an investor might expect annual returns of approximately 8 percent from a 60-40 portfolio (60% in equity, 40% in bonds) over the long term but pay only 4 percent interest on a 30-year fixed mortgage. 

Personal Profile:  An individual’s attitude toward debt and stage in life can also be a significant factor in the prepayment decision.  Certain individuals are extremely debt-averse and would be much happier without a mortgage.  Others are approaching retirement and would appreciate the simplicity and security of having their mortgage paid off before ceasing work, especially if they are going to remain in their homes for the foreseeable future and will not receive a pension.   If, however, one is not particularly averse to debt and/or is planning to move (and therefore obtain a new mortgage anyway) in the near term, then making prepayments might hold less appeal.  


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