Should You Prepay Your Mortgage?

If you are one of the million Americans who own a home you need to ask yourself if prepaying your mortgage is a wise financial strategy.

We live in a society that is not averse to taking on debt, but real estate debt is a secured investment and that asset can be taken away in foreclosure in the case of default. This is what prompts many homeowners to prepay their mortgage, the lure of a secure financial asset and shelter.

A desire to see your mortgage balance fall is natural but this is an emotional decision and may not be the best strategy. Today's interest rates are at an all time low. If you haven't refinanced to take advantage of that, do so immediately. If you already have locked in a low interest rate on your fixed mortgage, congratulations you are a wise investor.

Wise investor's also know that the first five years of mortgage are mostly interest and tax deductible. If you have a thirty year mortgage, that may seem like a very long time. But patience may be best. The question is what will you gain by decreasing that period?

In economics there is always an opportunity cost. Money is finite. If you have ten dollars and spend five, you are left with five. Pretty simple. You can't spend the same dollar twice. Now apply that same principle to your mortgage. What is the opportunity cost of prepaying?

Let's say you have a $200,000 30-year fixed mortgage at an interest rate of 5%. Your monthly payment is $1073.64. The payment is fixed throughout the loan but the interest paid decreases over the life of the loan. In the first month's payment, $893.33 goes to interest. In the last month $4.45 goes to interest. Paying early doesn't translate to a significant cut in interest paid.

Prepaying your mortgage can shave years off of your loan. For example, making one extra mortgage payment for year on the above loan takes five years off the life of the mortgage. Making two extra payments takes 8 years off the end. The question is what is the opportunity cost?

Say you have an extra payment worth of dispensable income per year or $1073.64. This money could be allocated to 401(k) and matched by your employer. That's an instant 50% return and as that account grows the return will far exceed that of prepaying your mortgage. This is especially true if you lock in a low interest rate on your mortgage.

If you are self-employed and don't have the opportunity of investing in an employer matched 401(k) there are other options. Consider taking that extra mortgage payment and using it to fund a health savings account or HSA.

Health savings accounts are fairly new but their popularity is growing. They are connected to a high-deductible health insurance plan. A health savings account is a flexible spending account which allows consumers to make tax-advantaged contributions to pay out-of-pocket health care expenses.

Funds accrue from year to year and can offer a comfortable nest egg for medical expenses later in life, when these tend to be higher. You don't pay federal income taxes on contributions, earned interest or withdrawals for qualified medical expenses. Plus, employers may also contribute and these funds do not count toward your gross income.

The big benefit of these accounts is that they double as a tax-advantaged retirement account. There is no penalty for unused contributions and unspent funds can be used for purposes unrelated to your health after the age of 65. In other words, the healthier you are in your younger years the more tax sheltered money you will have in the health savings account for retirement.

If the incentive to prepay on your mortgage is to live better later in life, you might want to consider the other options. Homeowners who take advantage of low interest rates stand to lose by prepaying their mortgage rather than maximizing contributions to strong retirement accounts. On average you stand to gain $0.11-$0.17 per dollar by redirecting mortgage prepayments.

Maximizing contributions to retirement accounts, like 401(k)s or HSAs, means you're are taking advantage of "free money," the matching contribution from your employer and the tax-advantages. These accounts are more difficult to borrow from in an emergency, but the equity you build in your home through prepaying the mortgage is not guaranteed. A dip in housing prices could wipe out the equity. And although you may fear losing your house if not paid off you should know that a 401(k) retirement account gets more protection than a home in the event of bankruptcy.

If you still feel the urge to prepay on your mortgage just be sure to specify the extra payments to principal, not interest. This will help you achieve your goal of shaving years off the life of the loan. It is a difficult temptation for debt wary consumers to have a large, life-time loan. It's only natural. Perhaps the best approach is to prepay just enough to appease your emotional side. That's what this author does.