Pre-Paying a Mortgage - Is it Wise?

Many homeowners believe that it’s smart to prepay their mortgage loan and often ask whether or not prepaying is right for them.  The surprising answer is no, unless your overriding goal is to get out of debt quickly regardless of economic consequences.

From a financial perspective, prepaying a mortgage loan is actually more costly than taking the longest mortgage loan possible and repaying it on schedule.  The main reason is that none of the accelerated repayment schemes take into account the time value of money.

Mortgage Loan Payments and the Value of a Dollar

Homeowners frequently are told that by making larger mortgage loan payments (switching from a 30-year to a 15-year loan, paying extra toward principal) or paying more frequently (biweekly rather than monthly mortgages), years of debt and bushels of interest will be shaved off the back end of the mortgage loan.  On the surface, these statements are perfectly true.  If someone takes a 6.5%, 30-year, fixed-rate mortgage loan on $100,000 in December 1998, and puts an additional $100 toward principal in the first three years, the debt will be retired nearly three years earlier (that is, in February 2026 rather than December 2028) and the homeowner will save a whopping $27,312 in interest charges over the life of the mortgage loan.  However, the interest savings are realized at the back end, 27 years hence, while the prepayments are made at the front end, beginning this year.

Determining the Real Savings of Prepaying Your Mortgage Loan

To find the true value of the savings, we must assume what is called a discount rate, which is how much less today's dollars will be worth in subsequent years.  One way to perform a present-value calculation is to use the rate of inflation to discount those future dollars, but financial analysts prefer to use a constant 8%, which takes into account both the effects of inflation and the potential return from having invested the money for growth.  At an 8% discount rate, the $27,312 in savings is worth only $2,880 in today's dollars, or $720 less than the $3,600 it costs to prepay the mortgage principal.  Further, the homeowner would lose the tax benefit of deducting $27,312 in mortgage loan interest over the years.  In short, it's better to pay only the required amount on the mortgage loan and hang on to that $100 a month.

Indeed, if the same $100 a month for three years went into a stock mutual fund yielding 8% and was left there until December 2028, when the mortgage loan is repaid, the $3,600 investment would have increased to $38,380, which is over $11,000 more than the benefit of prepaying the mortgage loan.

All these calculations assume that the homeowner will live in the house for the entire 30-year life of the loan.  In reality, most Americans move long before their mortgages are paid off.  When this happens, the long-term, back-end benefits of prepayment become illusory at best.

When Mortgage Loan Prepayment Makes Sense

On the other hand, anyone who dislikes being in debt and feels a sense of dread at the prospect of having mortgage loan payments cascade across decades may prefer to pay down the mortgage loan more rapidly than necessary, regardless of the economic disadvantages, simply for the peace of mind it brings.

The information contained here is for your reference only.  It is not intended to render legal or financial advice.