| Topic - Should I Prepay? | Education Center |
YOU'VE GOT SOME EXTRA CASH? Should you invest it, or use it to pay down your mortgage? Look at it this way: When you prepay part of your mortgage, you end up paying less in interest. But in the bargain, you also lose part of your mortgage-interest tax break. Your true savings, then, can be expressed as the difference between your mortgage interest rate and the rate at which you take your deduction (a function of your total marginal tax rate). If that net percentage figure is less than the amount you could make investing the cash, you're better off investing it.
Here's an example: Suppose you have $10,000 in cash, a 10% mortgage and a 40% total marginal tax rate. If you prepay, you'll save roughly $1,000 in interest payments this year (10% of $10,000 compounded monthly). But you'll lose your $400 tax deduction (40% of $1,000). Consequently, your true savings will be $600, or 6% of $10,000, meaning you "earned" 6% by prepaying. Now, if you could invest that $10,000 and earn more than 6%, you're probably better off with the investment.
As for your investment-return assumptions, one warning: Remember that the rate you earn by prepaying is a guaranteed return. Investing your money otherwise carries all the attendant risks. The higher the assumed return, of course, the greater the risk. As you range above 8%, this is definitely something to consider. The same is true if the spread between your prepayment return and your assumed investment return is small. Our recommendations should be taken with this caveat in mind.
And here's another caveat. If you do decide that prepayment is the way to go, don't get suckered into a "biweekly prepayment program." These programs -- where you pay your lender or a third party for the right to prepay your mortgage -- are lousy deals. Typically, you pay a set-up fee somewhere in the range of $350, plus a monthly service charge of about $5 dollars. But here's a tip: With most mortgages, you can prepay anyway -- at no charge.
If you want to prepay, it's wiser just to add a little bit extra to your monthly mortgage check. But first, make sure there is not a prepayment penalty associated with your loan. Fortunately, only about 20% of loans have one, and the vast majority only penalize you if you prepay more than 20% during your first five years.