Do Not Prepay Your Mortgage on Your Real Estate!

Haven't you hear from almost everybody that paying off your mortgage early is what you should do? For years, banks and financial advisors have been recommending that you pay extra cash into your mortgage to cut down the huge interest amount and reduce the period over which you pay back the loan. While that sounds good, if we dig a little deeper, it may not be the best thing for you to do.

For example, if you borrow $100,000 over 30 years at a rate of 5%, your monthly repayments would be around $537. Over 30 years, you would actually pay $537 x 360 (months), which is $193,320. That's $93,320 you are paying in interest!

The financial experts tell us that if you could pay an extra $123 a month, your mortgage payment would come to about $660. If you did this over 20 years, your mortgage would be paid off. You have just cut 10 years off the life of the loan. That sounds wonderful. At first blush, it does sound great. However, this advice totally ignores the concept of the time value of money.

Anybody over the age of 10 understands that money is worth less today than it was when they were younger. Let's take the mortgage payment of $537 and project it out to 30 years when the mortgage is paid. That $537 would only be worth about $218 in today's money.

The concept is basic to all business; a dollar now is always better than a dollar in a year's time, and definitely better than in 30 years!

We will put some figures to this to help us understand it. You need to calculate what's called the Present Value of a mortgage.

The Present Value of a 30 year mortgage with repayments of $537 at a 5% interest rate is $100,033.

The Present Value of a 20 year mortgage with repayments of $660 at a 5% interest rate is $100,033.

Surprised? Yeah, I thought so. The two payment plans are the same.

Since there is no advantage in Present Value to paying off a mortgage early, let's do something different with that extra $123. Take this money and invest it in a mutual fund. The return varies, but historically it is about 10% a year. At the end of 20 years, you would have about $93,400. We need to subtract from that the effects of inflation; we'll take a 3% inflation rate. Your $93,400 would be worth about $51,300 in today's money.

The question remains, why do banks and financial people suggest you pay off your mortgage early? They understand the time value of money knowing that a dollar today is worth more than a dollar tomorrow. They know the extra value of that extra $123 a month you are giving them. They also know the shorter the time you take to repay the mortgage, the lower their risk, and the sooner their money comes back to them to be loaned out again.

There are some great arguments for paying off your mortgage early. Your equity does grow faster, but be aware that every dollar you give the bank is a dollar you can't invest to earn 10% or better.