To pre-pay (your mortgage) or not to pre-pay . . . that is the question.

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Most people would agree that living without a mortgage payment would be a nice thing . . . but is it worth pre-paying your mortgage to try and get the balance paid off? 

The answer: Yes . . . but probably, No.

A lot of people are overly consumed with the idea of paying off their mortgage.  Many sending in an extra few dollars each month, rounding up their total payment to the nearest hundredth or even adding $100 or $200 to their payment, hoping to make a dent in what is most probably their largest debt.  Investors, keying in on the consumer’s drive to do this, have come up with ways to “help” (and I use that term very loosely) by offering bi-weekly payments — sometimes called “Equity Power Program” or something of the like — selling the payment plan as a smart-fix to paying off your mortgage early. 

Essentially, making payments every 2 weeks is the equivalent to making 26 half-payments per year, which is the same as make 13 payments per year.  So, if you want to avoid the “administrative fee” of signing up for the “Equity Power Program” (usually $50 to $295 — ouch!) and if you want to avoid the transaction fee usually associated with this type of plan and charged at each half-payment (usually $1 or $5 per period), you can accomplish the EXACT same thing by sending in one extra payment per year or by sending in an additional 1/12th principal-and-interest-payment each month.  But . . . you probably shouldn’t even do that.

So . . . back to the question at hand.  Should you pre-pay your mortgage?  The answer depends on a few things.

# 1.  Do you have any other debt (credit cards, student loans, car loans, a home equity line of credit)?  If you do, you should pay those off completely before adding $$ to your mortgage payment.

# 2.  Do you have cash in the bank?  Most financial experts would advise you to have four to six months worth of living expenses saved in some type of liquid asset account (checking, savings, money market, etc).  If you do not have this type of reserve account, you should save for this first.

# 3.  Are your 401K contributions at work maxed-out?  If you have numbers 1 and 2 under control, money growing in your 401K should pay a better return than the tax-deductible cost of your mortgage.

# 4.  Are your other retirement and college saving plans being utilized fully?  If not, put more money here to make sure you are on track to meeting your goals, more so than paying down your mortgage.

# 5.  Assuming that 1 through 4 are in order (and even if you don’t have them in order, but you are just dying to pre-pay your mortgage), then the final question is possibly the most important.  Do you have a fixed rate mortgage or an adjustable rate mortgage (ARM)?  And if you have an adjustable rate mortgage, does it have an automatic recast option (most interest-only ARMs do have this options; most others do not).

Here is why this is important:

On a fixed rate mortgage, pre-paying the mortgage does not change next month’s payment — it does not “save” you interest in the same sense as it would if you prepaid a credit card or car loan (most credit cards and car loans have interest calculated daily based on the outstanding balance).  On a fixed rate mortgage, the amortization schedule is set the day that you close on your loan, so additional payments that you make towards the principal save you interest simply because you are saving yourself having to make the 360th or 359th payments (for example). 

On an interest-only adjustable rate mortgage (for most investors) the amount of monthly interest charged recalculates based on the outstanding balance.  This feature is called re-casting, or automatic re-casting — so, as you pay down the principal balance of the mortgage, the interest charged is reduced.  So, prepaying the mortgage really DOES “save” you interest.

Here is an example.  You and I both buy houses and mortgage $200,000.  You get a 30 year fixed at 6.5% and I get a 10/1 interest-only ARM at 6.375%.  Because of the lower interest rate and the interest-only payment, my payment is $202 less than yours (yours, though, includes a principle and interest payment).  If I take the additional $202 per month and pay down the mortgage (assuming that it is automatically recasting each month) who will pay more interest over 5 years?  10 years?

Hmmm . . . I’m working on a spreadsheet to calculate the savings.  Check back soon to find out the answer.  

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5 Responses to “To pre-pay (your mortgage) or not to pre-pay . . . that is the question.”

  1. Chad Says:

    Another point…and this may be covered somewhere else on this site. The interest and property taxes that can be itemized on the income taxes are only beneficial to the point where the impact on the total itemized deduction exceeds the standard deduction. In my case, I would need to have an outstanding principle balance on my mortgage greater than 125K to receive any benefit from an itemized deduction.

    In my opinion, any mortgage less than 200k or 300k should be payed off ASAP.

  2. hillsidelending Says:

    Good point Chad. Mortgage interest is only “beneficial” tax-wise assuming that it allows you to itemize deductions on your Federal tax returns. Depending on your filing status, the dollar amount needed to exceed the standard deduction varies — for 2006, the standard deduction is $10,300 for married couples filing joint and $5,150 for individuals.

    One thing to keep in mind though is that many people will have deductions in addition to their mortgage interest and property taxes that will also fall onto the Schedule A (Itemized Deductions) — ad valorem tax (car-tag tax in the state of Georgia), gifts to charities, and unreimbursed employee expenses, just to name a few.

    For example, if someone had even a $50,000 mortgage at 6.25%, they would pay $3,108 in interest the first year. If they also paid $1,000 in property taxes, paid $100 in ad valorem tax and gave $1,000 to charities (gifts of cash or goods), they would exceed the standard deduction for an individual.

    A mortgage balance of $125,000 at 6.25% would equate to $7,771 in interest in year one. Add to that property taxes, other taxes and gifts to charities, and you would exceed the standard deduction for married couples filing jointly.

  3. Darren Says:

    Bi-weekly payments are a semi-good practice for homeowners who want to pay off their mortgage sooner. However, it doesn’t help those who don’t have extra money to make an extra payment. Besides that, you still pay a lot in interest to the bank, regardless of how often you’re making payments. On a 30-year fixed 6% mortgage, the first year you’re actually paying 500% interest. Most homeowners only keep their home for 1-5 years. Even at five years, they’re still paying a 100% interest rate. The 6% doesn’t come into play until the mortgage has been kept for the full 30 years. A way for homeowners to actually pay off their mortgage in half the time, without changing their monthly payment, is to get a Cash Flow account. By paying less in interest to the bank and more in principle, and by having the principle actually earning interest, after 15 years your Cash Flow account has enough money to pay off the home. If you held the account for the full 30 years, you can have over $1 million with which to pay off your home and retire comfortably. There’s a free site (http://www.just10steps.com) that shows homeowners how to do this. With a typical mortgage or bi-weekly payments, you’re still paying a lot in interest, and after the mortgage is paid for, you’ve actually paid twice the value of your home, and don’t have anything to show for it but a paid off home. Isn’t it better to pay off your mortgage and actually have money left over? Of course it is.

  4. hillsidelending Says:

    Darren,

    Thanks for the comment. The “Cash-Flow” Mortgage that you are describing (and the small print on the website you referenced confirms it) is an MTA-interest-only loan. This loan is a one month adjustable rate mortgage based on the Monthly Treasury Average index — a slow moving index, but an index that is moving up, nonetheless.

    Because of its monthly adjustment feature and the way it compares rate-wise to other intermediate adjustable rate mortgages — 5/1 ARM, 7/1 ARM or a 10/1 ARM (and often negative-amortization feature), I rarely recommend this type of financing to my clients.

    All that being said, I do think the idea of an interest-only loan and saving the $$ net savings difference in an interest-bearing investment account is a great idea.

  5. To pre-pay (your mortgage) or not pre-pay | The Mortgage Blog Says:

    […] think. This topic was previously discussed on this blog, and you can find the full post at this link. To hit the highpoints of that […]

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