To pre-pay (your mortgage) or not pre-pay

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To pre-pay or not pre-pay… that is the question.

I’m often asked this question by clients, and the answer isn’t as straight forward as you’d 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 post…

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 since the rates on those loans may be higher than your mortgage rate.

# 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 can pay a better return than the tax-deductible cost of your mortgage. This is a better conversation to have with your financial planner.

# 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. Again, consult your financial planner on this one.

# 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…. How long do you plan to remain in the home? If the answer is only a few years, then you probably won’t pay off the balance anyways. You should instead use the money for items 1 through 4 above. If this is your forever home, then you can argue it makes more sense to pay it off in full. That said, I would make to at least have 1 through 2 resolved before paying down extra on my mortgage.

I’m sure there will be plenty of people who disagree with this post, and I’m not saying it is a huge mistake to pre-pay your mortgage. What I am saying is this… with rates at historically low levels, does it make sense to pay down a mortgage with a rate of 4% when credit cards are closer to 20% and a car loan may be around 5-7%. Once all other debt is gone AND you have a 4-6 month emergency reserve account, then that would be the time to consider making extra payments on your mortgage.

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