One question frequently contemplated by individuals as they work towards financial independence/security is, “Should I prepay my mortgage?” The question has a number of different components that need to be considered before making a decision.
The first and most important question is, will it impact your liquidity? Liquidity is the measure of your ability to use cash to handle your obligations today. You can have all the net worth in the world, but if you can’t pay your bill when its due then you’re not liquid. Some of the major collapses during the economic crisis, Leman Brothers for example, were not brought on by a lack of assets but rather a liquidity crunch. You should always have some source of emergency money, this can take many forms including a savings account, checking account, I-bonds, CDs with early withdrawal clauses, Roth IRAs, and depending on your faith in the issuing company even a Home equity line of credit. I personally use a mix of I-bonds and and cds with minimal withdrawal penalty. You should investigate options for the best return in this area.
Peace of Mind
Once you have your liquidity covered, you can proceed with a decision on whether to prepay. Two factors play into this question. The first is your peace of mind. Paying off debt can have a powerful impact on your way of life. It can make you feel more self sufficient, help you to see the light to your end goals, and even provide a safety net to build upon by lowering your net monthly cash flow impact.
The second factor however is much more financially based. Having peace of mind is fully legitimate, but if your goal is maximization, it may need to take the backseat. In order to determine if a mortgage is financially worth paying off, you need to determine the opportunity cost of paying off the mortgage versus using the money elsewhere. Opportunity Cost is defined as the cost of forgoing something else in favor of your choice. In the case of paying the mortgage off early, there is an opportunity cost that is soft (or not real money) in your psychological impact of peace of mind. There is also a real impact in terms of dollars of other investments you could use. Combined, this provides guidance on the best choice for you.
Mortgage as a Bond
I personally look at the mortgage payments as the equivalent of my bond portion of my investment portfolio. I previously talked about asset allocation and investment portfolios. To summarize, I view the mortgage the same as investing in a bond of similar length, risk, and payback net of taxes. For example, I would consider a mortgage comparable to bonds of general low risk like a Municipal General Obligation, CD, or Treasury backed security. Unless I plan on going bankrupt which I do not see as an option, there is no way I can lose my money by putting it into my mortgage. The amount I owe is fixed whether the value of the home changes or not. In much the same way, these other investments are relatively safe.
One additional way to look at it is as matching your liabilities to your assets, or matching your payments to your incoming cash by matching time frames. If both the bond and Mortgage have equal returns then putting money into the bond will you cost you the same amount as putting money into the mortgage. As long as you won’t raid the bond or mortgage for spending, they are equivalent.
Mortgage as a Source of Leverage
FinanciaLibre and others have recommended using a mortgage as a source of inserting leverage into your portfolio. While inevitably a stock market allocation leveraged has a much higher return then your mortgage, it also magnifies your risk. Leverage simply magnifies both the potential up and downs of stock movements. There is no guarantee stocks will have returns in the same way in the future. As such, I’m not comfortable personally with taking that size of a risk. Therefore, my view of mortgage prepayment is purely based on a conservative investment comparison. However, that doesn’t necessarily mean you should prepay it.
Comparing to Risk Free Returns
How do you know if the mortgage rate is the same or greater than the rate of the safe investment? It is important to look back at your mortgage rate. I do not mean your interest rate which is typically measured as a continuous interest rate, i.e. your interest builds on itself continuously. A continuous interest rate results in a higher interest rate per year, which is a number shown as your APY or annual percentage yield. It’s important to use APY when comparing to your bond as this makes the numbers comparable. Note, if your bond pays coupons more than annually, you should also look at their APY.
The numbers are still not comparable because if your interest payment is high enough on your home, you can deduct it on your taxes. Also, if your bond is outside a tax deferred account like a ROTH IRA, 401K, HSA, ECT then the bond will require tax payments on the interest.
Let’s assume for a moment that both your mortgage and a CD have a 4% APY and you are in the 25% tax bracket. What this means is 1/4 of any interest (25% is your marginal or additional tax penalty for additional money, not your overall tax burden) will go to taxes for the CD. Your return is thus APY*(1-tax rate). It also means you will get 1/4 of what you pay in interest on the mortgage back due to the mortgage deduction. This means the CDs return is 4%*(1-.25) or 3%. The mortgage cost meanwhile is 4%*(1-.25) or 3%. So in this case they are still functionally equal.
If I purchase an EE Bond, which currently returns 3.5% when held for 20 years in a taxable account, would paying off a 20 year mortgage at 2.7% still win out financially? Well, the EE earns you 3.5%*(1-.25) or 2.6% and the mortgage still costs you 2% after the tax deduction. The EE is also tax free if used for education. The EE is thus the better financial move as the funds out of the bond will exceed the cost of the mortgage interest. However then you have to ask the question is that 1/2-3/4% difference in return worth more then your peace of mind.
|Mortgage Pretax||EE||Mortgage Post Tax||EE Post Tax||Winner||Net Difference|
|Mortgage Pretax||CD in Roth Account||Mortgage Post||Winner||Difference|
Assumes 25% tax bracket
Do you prepay your mortgage?