Is it Worth PrePaying Your Mortgage?

As mortgage rates continue their unabated decline, many borrowers have naturally decided to refinance. A growing contingent of borrowers, however, are skipping the refinance and simply prepaying their mortgages in full. But is this really the best move?

In a related post in March of this year, I concluded that, “There is a strong emotional benefit to repaying your mortgage early, as long as you can afford it. While it’s possible that you will come out ahead by paying off your mortgage normally and investing in the interim, there is added risk and no guarantees associated with such a strategy.” Since then, interest rates have continued to fall, stock prices have risen, and the economy is still struggling to escape from recession.

In other words, the opportunity cost of pre-repaying your mortgage has risen, while the cost of outstanding debt has fallen (but only if you refinance!), and the emotional benefits of being debt-free are probably greater, especially for those dealing with economic/financial hardship. For those who are risk-averse, that means that there is a greater likelihood (but no guarantee) that you will come out ahead if you continue to make payments as usual and instead invest your spare cash.

In fact, according to a 2006 National Bureau of Economic Research paper, “About 38% of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice. For these households, reallocating their savings can yield a mean benefit of 11 to 17 cents per dollar…In the aggregate, these mis-allocated savings are costing U.S. households as much as 1.5 billion dollars per year.” At the same time, the researchers conceded that such “inefficient behavior” is also  driven by non-financial considerations, such as the psychological desire to be rid of debt.

In addition, those whose financial situations are somewhat uncertain are probably advised to save their cash and/or pay down higher-interest debt first. In addition, prepaying one’s mortgage should not endanger one’s emergency savings accounts, such that an illness or job loss would force you to tap into home equity, thereby offsetting any gains from prepayment.

On the other hand, a recent Wall Street Journal analysis determined that by making partial pre-payment of one’s mortgage, one can start pay off the mortgage earlier and at that time, begin to make substantial contributions to one’s retirement accounts. However, the example that served as the foundation of the article assumed a mortgage with a long duration and high interest rate. If you assume a short-term mortgage and a low interest rate, the benefit of prepayment would shrink, if not disappear. Although, for those that are finding it difficult to refinance, prepayment might be the next best thing, as long as you can you can afford it.

Personally, I’m pretty conservative, and I like the idea of being debt-free more than earning an extra 1-2% (a pittance when adjusted for risk) on my savings. Whether you feel the same way should dictate whether it makes sense to consider mortgage prepayment. Either way, just make sure your assumptions are realistic. Right now, CD and Treasury rates are still well below mortgage rate. Over the long-term, the stock market tends to return 8%, but we all know that this hasn’t been the case for the last 10+ years.

To see how partial mortgage prepayment (i.e making a monthly payment larger than required) will affect you, you can use our Prepayment Calculator. Simply plug in the parameters of your loan and your planned prepayment, and it will computer overall interest savings and the number of years trimmed from your mortgage.