The Mortgage Prepayment Myth

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The earth is round. The sun rises in the east.

Some things are obvious. Givens. Accepted without a second thought.

The wisdom of prepaying your mortgage feels like one of those no-brainers. By paying more than your required payment each month, you pay off the loan faster. You pay less in interest and you own your house free and clear more quickly.

Indeed, the numbers seem compelling.  A 30-year fixed rate mortgage of $250,000 at 4% has a payment of $1,175 per month. Interest paid to the lender over 30 years is just shy of $180,000. Pay an extra $320 per month and you’ll pay the loan off in just 20 years and only pay $114,000 in interest … a $66,000 savings!

Obviously, prepaying a mortgage will make you better off financially than not prepaying. However, the real question though is not prepay versus don’t prepay – the real question is whether prepaying the mortgage is better than some other investment you can make with that prepayment money.

Let’s look at the problem that way.

We could do a sophisticated economic breakdown using technical and wonky concepts like the “time value of money” and “opportunity costs”. Instead, let’s construct a comparison that has two owners spending the same amount of money each month – one to prepay a mortgage and the other putting that same amount of money into an investment account.

Imagine that Bob and Jack buy identical houses for $350,000 on the same day. They both take out 30-year loans of $300,000 at 4.25% with a principal and interest payment of $1,476 per month. The two houses appreciate at the exact same rate. Twenty years later, both houses are worth $500,000 and each is worth $600,000 after 30 years have gone by.

Bob makes his required monthly payment of $1,476. He also sends the lender an additional check of $382 to prepay the principal balance on the loan. At the end of 20 years, Bob has fully paid off his mortgage. He owns his $500,000 house completely free and clear.

Jack makes his minimum required monthly payment of $1,476 each month and starts putting $382 each month in an investment account – a savings account, a 401k at work or a mutual fund. Let’s assume this investment earns 4.25% per year.

After 20 years, Jack still owes $144,000 on his mortgage. Bob, you’ll remember, owns his house free and clear and is better off than Jack in terms of home equity. Jack, however, has an investment account. The $382 he has invested in the account each month for 20 years has grown to (you guessed it) $144,000.

Bob has $144,000 more home equity than Jack but Jack has a $144,000 investment account balance that Bob does not. Financially, it’s a wash.

Isn’t Bob, however, going to be much better off over the next 10 years? He no longer has a house payment. He’s been paying $1,858 per month over the last 20 years. He can now start putting that money in savings.

Let’s play it out. If Bob invests $1,858 at 4.25% for the next ten years, he ends up with an investment account balance of $277,000.

Jack keeps plodding along making his $1,476 monthly house payment and continuing to sock away $382 per month in his investment account. Ten years later, his house is paid off and his investment account has a balance of … $277,000.

At this point, Bob and Jack both own houses worth $600,000 that are free and clear and both have an investment account balance of $277,000. Once again, there is no difference between their two situations.

Prepayment always makes you better off financially than not prepaying. If you have some extra money to invest, you’ll be better off to use it for prepayment than to spend it on beer or big screen TVs.

However, if you have extra money to put towards your house payment, the better question is this one: Is prepaying my mortgage loan the best use for this money? Can I do something with that money that will earn me a higher rate of return?

The guiding principle is this: If you can find an investment that earns more than the interest rate on your loan, that investment will be a better choice than prepaying your home loan.

Can you? Can you find an investment paying more than the 3% to 4.5% you are likely paying on your current home loan?

Warren Buffet says that investments in conservative stock/mutual funds over just about any ten-year period will earn around 7% annually. Of course, some risk is involved but the payoff would be substantially better than mortgage prepayment. Jack would be $56,000 better off than Bob after 20 years if his investment account earned him 7% and he’d be $140,000 better off after 30 years.

Another avenue that many people ignore is putting money into a 401k at work where the employer matches the funds. Say your company puts in 25 cents for every dollar you put into a 401k account. You are earning a guaranteed 25% interest rate by putting money there. Someone would be much better off putting money into that 401k account than prepaying a mortgage at 3.5%.

Using money to start or invest in a business opportunity has the potential for even higher rates of return.

If you are considering mortgage prepayment, it’s worth considering if that is the best use of your money.