JLP’s Question of the Day – Prepaying Mortgage

October 17, 2006

Here’s today’s Question of the Day:

Should people prepay their mortgage (pay it off early)?

Or, should they pay their regular payment and invest the amount they would have used to prepay?

This is one topic that is heavily debated because at issue isn’t just the math, which depending on the mortgage interest rate, makes more sense financially to take as long as you can to pay off the house. However, there’s also the emotional side, which says that the warm, fuzzy feeling you get from having your house paid off early will more than compensate you for the money that it takes from your net worth. My friend, Foobarista, is clearly in the first camp, while FMF likes the emotional side (read the last paragraph of his post).

As for my thoughts: as long as your mortgage rate is less than the rate of return you can get in the stock market, taking as long as possible to pay off your mortgage will add to your net worth IF (and ONLY IF) you invest your extra money in the market (like an index fund). Is this without risk? No, but paying off your mortgage early also isn’t without risk.

Now it is your turn to weigh in. To help you with your decision, try out my calculator.

42 responses to JLP’s Question of the Day – Prepaying Mortgage

  1. What about taxes? Mortgage interest deductions are a huge advantage of owning a home. If you pay your mortgage off early you dont have that HUGE deduction anymore

  2. There is no one right answer and it depends a lot on each individual’s situation in life and risk tolerance. After all, if it’s better to make just the basic mortgage payments, then maybe it’s better to get an interest only mortgage and not make any payments at all. After all, the 30 year amortization that the mortgage company gives us is just an arbitrary number. Maybe a 50 year amortization is what’s right for one person, while 10 is right for another, or never paying a mortgage off and investing everything in the stock market is right for someone else. There was just an article on CNN Money where someone asked if it made sense to take out a second mortgage to invest in the stock market. Of course the advisor said it was a terrible idea, but was it really? If it makes sense to invest in the market instead of building equity, why does it not make sense to get your equity out and invest that in the market as well? It’s really the same thing.

  3. The mortgage interest deduction can sometimes be not as much as one would think. It depends on how much interest you are paying and how much other deduction you have. Because of the standard deduction, you only get to deduct the mortgage interest to the extent it plus your other deductions exceed your standard deduction.

    Consider this example. Suppose you have other deduction worth of $2,000 and your standard deduction is $9,000 (I haven’t looked at the current number). If you pay mortgage interest of $10,000 this year, you real deduction from the mortgage interest is only $3,000, not $10,000. Because without a mortgage, you get to deduct $9,000. With a mortgage you get to deduct $12,000.

    So, the mortgage interest deduction is not what it cracks up to be for a lot of folks, especially in low state tax and low housing price areas.

    Rob in comment #2 hits the issue squarely on its head. Not paying off early is equivalent to borrowing more and invest it. It’s a leveraged investment, which could be good or bad. But you can’t say borrowing more is bad but not paying off early is good because they are the same thing.

    Just curious, why do you say “paying off your mortgage early also isn’t without risk”? What risk is there?

  4. While there probably isn’t a real right or wrong answer to this one, I definitely fall into the warm/fuzzy camp of paying it off early. The emotional freedom of having no debt hanging over my head is very appealing. I want to own my house.

  5. For us, this came up a few years ago when the amount in our taxable investments went over the balance due on our mortgage. A person we knew was trying to convince us that it was better to pay off the mortgage, even though our investments have averaged about 10%/year for a long time (they’re a combination of stocks and some partnerships we’re in).

    This was “the second scenario” in my discussion: investment growth allowing the possibility of early payoff. In our case, we ran the numbers and early payoff would forego over $350K of investment appreciation over the 30 year term of the mortgage.

  6. Opportunity risk is a type of risk; this is why even taking your savings and burying it in the ground is risky. You can never completely escape from risk…

  7. Foobarista,

    Thanks for the risk answer.

    One other “risk” is the risk that the value of the house may decline, which could reduce the amount of equity. Sure, this risk is unlikely, but it is still a risk.

  8. FinanceBuff,

    True, you do have to itemize your deductions in order to take advantage of the mortgage interest deduction.

    My point is that as long as the interest rate you are borrowing at is lower than the rate you can reasonably get in the market, you would be better off to invest rather than pay down the mortgage.

  9. Foobarista,
    Good point, I can definitely see now why in that scenario it would be better to continue leveraging the house. Thanks for the clarification.

  10. If you are disciplined and invest the money well, you may come out ahead. If you are like many people that would rather spend than save, well . . .

  11. Not wanting to start an argument here. As you said this is heavily debated and has been argued over and over on forums like Vanguard Diehards. I’m tb00957 there. I really like your blog and I started a blog myself recently. Of course in the end it becomes “it depends” otherwise it wouldn’t be heavily debated over and over.

    You have to already itemize your deductions without the mortgage interest in order to deduct the *full* amount of the interest. Easy to do in California with state tax and property tax, not necessarily easy in say Kansas. If you can’t itemize without the mortgage, your mortgage interest is only partially deductible.

    The “house value may decline” comment is irrelevant unless you are thinking of defaulting on your loan and letting the bank repo your house. Your house doesn’t know if you have a mortgage. It will decline the same way and reduce your equity by the same amount whether you prepay or not. The ability to default on the loan is a put option. It has some theoretical value, although most of us probably don’t want to exercise that option.

    When you compare to returns from investment, you have to compare to returns with similar risk factor. 10% or 8% or whatever you estimate from investment is not a sure thing. Otherwise the people who loan you the money wouldn’t have done so. They would’ve invested the money themselves. The perspective from the mortgage holder is very interesting. As you know, most mortgages are packaged up and sold to investors. These investors hold the mortgage to your house and receive the payment stream. They pay the bank a “loan origination” fee when they acquire the mortgage portfolio. They also pay the bank an ongoing “servicing” fee for processing your monthly payments. They also take on the default risk. A certain percentage of mortgages will default every year. They will take a hit when they pay someone to auction off your house for less than what’s owed to them. After paying those fees and writeoffs, they are still happy with the interest income from you. ***Are they crazy or what?*** Aren’t they better off investing their money and not getting into this mess? Apparently the market determined that the interest they are getting adequately compensates them for the stuff they got into and they are neither better off nor worse off when they are getting paid by you vs investing elsewhere (the stock market, treasury note, oil futures, etc). The flip side must also be true. When you prepay your mortgage, there is no origination fee, no servicing fee, no writeoffs for deadbeats. When you prepay your mortgage, you are also neither better off nor worse off, or perhaps slightly better off absent those fees and writeoffs.

    Bottom line comes to the question of how much risk you want to take with your incremental cash. The market already drew the efficient frontier for you. All points on the efficient frontier are equally efficient. Picking the exact spot on the efficient frontier is up to you.

  12. I think what makes the most sense is to make regular mortgage payments and deposit any “extra” mortgage payments in a Roth IRA, if you are eligible.
    Some may feel that paying off the mortgage is a less risky strategy. I disagree. If an major emergency arises, you can withdraw your contributions from a Roth to get you through the crisis. On the other hand, if you have made extra morgage payments, you’ll need to either sell the house or take out an equity load to tap into your equity.
    If you make your extra payments into the Roth IRA and it grows at a rate greater than your mortgage rate, you will accumlate in the Roth funds to pay off your mortgage in full more quickly than by making the extra paymewnts to the mortgage. With the Roth strategy, you can pay off the mortgage in full after you reach the age of 59 with tax free withdraws.
    In the meantime, you can continue to take the full mortgage interest deductions.
    I don’t see any downsides to this Roth strategy, provided that you are sufficiently disciplined to actually do it.

  13. My view is that if you invested in bonds that had an equivalent post-tax interest rate as your mortgage rate (less the tax advantages of interest deductions), then it does not really matter if you pay off the house or invest in bonds because investing in bonds (at the same rate)will grow to the amount needed to pay off the house when it would have been paid off with accelerated house payment.

    Now, the question is, are you a bond investor (for safety) or equity investor (more risk for the upside)? Where is our retirement savings being invested? If you pick equity then you may want to put the extra cash into your investments. If not, then choose bonds or pay off the mortgage.

    As for those who say people will spend the money if they did not pay off the mortgage first, what about when the mortgage is paid off where will the extra money go then? People need to learn to save on their own, not through a forced biweekly payment plan.

    For those who like the feeling of being debt free because if you lose your job when it is paid off then it would be better financially, what about the 15-25 years before you pay it off early? Those extra payments do not buy you any cushion on when the next payment is due (or risk default), yet if the payments are invested (either in CDs, bonds or equity) you do have a bigger emergency fund with the option to pay off mortgage when the time comes.

    Prepaying the mortgage is just extra savings without the option on where to invest. And, yes some invest in bonds (e.g. due to risk as one gets closer to retirement). Thus, if young and risk taker, look at stocks. If older, then you would have invested more conservatively anyways, so paying off mortgage is equivalent to investing conservatively in bonds.

  14. Just wanted to weigh in on the tax deduction aspect. As many others have noted, there’s no one “right” answer. Say you got a really low rate when they were dropping and live in a low or, like I do in Texas, no state income tax state. So basically, all you’ve got to itemize is mortgage interest, property taxes, sales taxes (if Congress renews it …) and charitable contributions. Will all that come to more than $5,510 if you’re single? That’s the 2006 standard deduction. If you’re married, which many homeowners are, then you’ve got to have mortgage interest etc. exceeding your standard deduction of $10,300.

  15. The keys for me boil down to:

    1. Paying off any debt is a guaranteed return (avoiding the interest costs) whereas investing returns are not guaranteed.

    2. “Taking as long as possible to pay off your mortgage will add to your net worth IF (and ONLY IF) you invest your extra money in the market (like an index fund).”

    90% of the people don’t have the discipline to do this. (To be honest, many don’t even have the discipline to simply spend less than they earn.) The money almost always is spent on other (generally consumable) items. I’ve never seen anyone successfully implement this strategy over a long period of time in my 15 years of helping people with their finances. So while it may be a great idea “in theory”, practically, it’s dead in the water.

    3. I’d simply rather have no debt. Owing nothing to no one is a great feeling.

  16. I would rather take a middle of the road strategy. I would build up a cash reserve which I would invest in the stock market to make returns substantially over my mortgage rate but any additional money I would put into paying off my mortgage. That way I would have some money for emergencies. Also any capital gains I make with the investment money I would plough back into the mortgage.

  17. I’m a little late to the party, but I tried to tackle this topic a couple of days ago with my Do-It-Yourself Mortgage Accelerator Plan.

    I’m big into math and not emotions. I would lean towards investing the money and if debt really causes you sleep problems, you could always use that invested money to pay off the home. You just have to be careful with how you invest and what your risk tolerance is. Hmmm, use math, not emotion, note your risk tolerance, I’m starting to sound like a financial planner or something. Yikes!

  18. In response to Paul D re: Roth strategy

    It’s great in theory and suitable for most folks, but if you make too much (AGI over $160,000 joint) funding a Roth is not an option.

    JLP, Re: your #8 response, there are some curveballs. If you’re on the cusp of having your itemized deductions reduced (AGI exceeding $145,950 or so joint) then any incremental income will get you there that much faster. Also, any other credits that are dependent on AGI may be reduced.

    Given all that and everyone’s comments, it obviously depends on the math of one’s circumstances, their emergency fund status, etc. Personally, I can’t wait until our mortgage is repaid. Besides the peace of mind (“neither a debtor nor lender be…”) it’s another opportunity to reduce our life insurance amounts…

  19. Taxes would definately be an important consideration while deciding about paying off a Mortgage. I really think one can make good use of that money by investing in some Profit Making Avenues and paying the Mortgage in instalments. Also, it may be beneficial in terms of having liquidity at a given point of time

  20. There are a couple of points I’d make which haven’t been covered.

    1. In general, it’s not an “all or nothing” decision. You can pay ahead a little or a lot. If you pay ahead, you can use money from your current income or you can dip into savings.
    2. As a specific example, for me, I consider the economic environment when I think about whether to pay ahead. From 1999 until around 2001, I paid ahead quite a bit on my mortgage because I thought the markets were overpriced and not worth the risk. Then I quit paying ahead when I thought the markets were fairly priced or undervalued. Now I am paying ahead again. Yes, this is a little bit of market timing which theory says you can’t do. What can I say, my intuition has served me well so far.

  21. This has been a great discussion and many of you have brought up outstanding points and great ideas. One thing we can probably all agree upon is that any decision is entirely dependent on each individual and his or her circumstances, risk tolerance, and emotions about debt. This is the beauty of personal finances because there is no cookie-cutter solution for everyone. Otherwise we’d have nothing to blog about! As a financial planner that is what makes my profession fun and challenging.

    The only thing I will add is that the issue of taxes can lead some folks astray because they get fixated on the mortgage interest deduction. Let’s assume that the full amount of mortgage interest is tax deductible and that a person is in the 25% federal bracket. Based on that,some people conclude that they MUST have a huge mortgage just for the sake of getting the tax break, as if it were some great deal the government offers and it just can’t be passed up. They will purposely keep the mortgage high just for the interest deduction, even if paying off the mortage or at least of chunk of it clearly makes more sense in their situation. What they forget is that they are spending $1.00 for every $0.25 of tax benefit. That never makes sense as a strategy in and of itself. All else being equal, a person is always better off keeping the dollar of interest expense and foregoing the 25 cent tax break. Readers of AllFinancialMatters wouldn’t fall into this mental trap, but I’m amazed at how people do.

  22. If you are conditioned and invest the money wisely, you may need no solution to avoid Mortgage risks. If you spend without considering the effects, then I suggest read something on Mortgage Basics

  23. Appreciate a little help with this. Question along the same lines – should i pay off my mortgage?… although my situation is a little different. I own a number of rental homes, a few of which have a bunch of equity in them. I am think of refi’ng one of the rentals, taking the cash and paying off my current mortgage. Using current mortgage payment savings to invest in the market, as my investment allocation is heavy in real estate versus other vehicles. Rental house would be cash flow even if i did this with $100K remaining equity. I have enough cash reserves in case of emergency as well. should I do this? I’m 40 and have set a goal to be mortgage free by the time I am 47. I can reach it earlier if I pull the trigger. Thoughts?

  24. I listen to Dave Ramsey a financial talk show host. And he always recommends paying off the mortgage early but that’s only after all debts are paid, you have an emergency fund and you’re saving for your retirement and kids’ college fund. Both ideas are right, mathematically it’s best to keep the mortgage but psychologically it’s best to get rid of the stupid thing.
    He gives an example: $200000 mortgage at 5% interest will give you a deduction of $10000. If you make $70K/year you would pay taxes on $60K. If you have no mortgage you pay taxes on $70K and at a 25% tax bracket the $10000 difference is $2500. So you’d rather give a mortgage company $10000 than give $2500 to U.S. You could have a paid for house and if you want deductions, give to charity.
    Bottom line is once you’re debt-free without a mortgage payment you could dump all kinds of money into savings and investments.

  25. Thanks for the reply Reco.
    Yes, I’m thinking the deduction isn’t worth the overall interest payment. Further, I think most of my taxes will be reduced/deferred because of my other rental props. which show a paper loss. I’m probably going to do it.

    Thanks again.

  26. Dave Ramsey’s plan works best, baby, because of the risk that comes with debt. The quicker you deep-six your debt, the less time you have the risk of a mortgage. You’ll save big-time dough on the interest that you’re not paying, and you can invest like crazy when you have no house payment.

  27. I agree that the situation will be different for everyone. However, the mortgage pay-down seems to only apply if you plan on living in your house for the long term, 12+ years. What about younger, upwardly mobile people whose incomes/education/assets may be rising and will purchase more than 1 house in their lifetimes?

  28. Paying off your mortgage makes more sense if you think about it. Here’s why:

    For example (with mortgage and without mortgage scenario):
    1) your mortgage is $75000 @ 5.5% interest (fixed)
    2) assume you’re in a 25% tax bracket
    3) assume your income is $60,000/yr

    $75000 x 5.5% = $3,937.50 (interest paid to bank)
    $60,000 – $3,937.50 = $56,062.50 (your taxable income)
    $56,062.50 x 25%tax = $14,015.63 (tax due to government)
    your total tax payment and interest paid is:
    $14,015.63 + $3,937.50 = $17,953.13

    Now without any mortgage payment (no decduction) calculation:
    $0.00 mortgage (no deduction)
    $60,000 – 0 deduction = $60,000
    $60,000 x 25%tax = $15000 (tax due to government)
    Your total tax payment is:

    A person who has a mortgage payment gets to deduct to the interest payment he paid to the bank but still is paying more money if you add the tax he owes the government and the interest payment he made (tottal of $17,9533.13).

    Now, the person who does not have a mortgage payment has no mortgage tax deduction, and so, has to pay more tax of $15,000. But he does not have any mortgage interest payment.

    You do the math on this. Paying off your mortgage early makes more sense. Also, never go for a 30 year loan mortgage, only 15yrs at the max.

  29. In addition to my comment (above or below), payoff your mortgage early only if, and only if (very important now):

    1)you have a 6-month emergency fund,
    2)you are maximizing your retirement investment accounts(e.g. 401k and roth IRA (if your earning is less than $150,000 for married couple)),
    3)you are maximizing your kids college funds (e.g. 529 Plan),
    3)no car payment, and
    4)no outstanding credit card balance.

    Once you have these items taking care off, go ahead and pay as much as you can in paying off your mortage.

    We’ve paid off my mortgage on my rental property in 9 years. And now, our house we built in 2002, with a 15 yr mortage, is only 3 years away from being paid off (only 8 years total). My wife and I, however, are diligently investing in the stock market while paying down our mortgage.

    On the down side, we do not drive new and expensive cars.
    We are driving 1992 honda accord (15 yrs old), 1996 toyota tacoma (11 yrs old), and 2000 toyota sienna (7 yrs old).

    We look like we are broke driving these older cars compared to our next door neighbors who are driving expensive european cars, but we are almost debt free!!! Our neighbors are looking good but are dead broke with credit card bills, etc…

    The key is being decipline and being blessed.

  30. Ed (#29) the thing you are missing is the 75,000 that is used to pay off the mortgage would be invested if the mortgage is retained; and if the after-tax return on that investment is greater than $2,953.13 (approx 4%) then you’d be better off keeping the mortgage. Of course you also need to consider the risk profile of the investment, but if you could get a risk-free return higher than the mortgage rate, it would be a good deal.

  31. billyw (#30): you are correct that you should retain your mortgage if you could get a guaranteed higher rate of return compared to your mortgage interest rate. The main problem I see is this…. i know couples who’ve decided to just pay their monthly mortgage payments and promised to themselves to invest the available funds they have (only because of the idea that they can get a much higer rate of return in the stock market), is that they do not maintain the course in investing, as they promised. These couples were tempted to spend their money in frivolous things and, sadly, lost their focus in investing (which is very easy to do, in my opinion). As a result, they have nothing to show for.

    You have to be discipline in maintaining the course for this to work. And balance is the key… invest and pay down your mortgage at the same time.. provided you have covered all items in #30 above.

  32. billyw (#30): you are correct that you should retain your mortgage if you could get a guaranteed higher rate of return compared to your mortgage interest rate. The main problem I see is this…. i know couples who’ve decided to just pay their monthly mortgage payments and promised to themselves to invest the available funds they have (only because of the idea that they can get a much higer rate of return in the stock market), is that they do not maintain the course in investing, as they promised. These couples were tempted to spend their money in frivolous things and, sadly, lost their focus in investing (which is very easy to do, in my opinion). As a result, they have nothing to show for.

  33. As a society we have been taught that all debt is bad. I feel that this is at least in part due to Depression-era thinking. In 1930 most mortgages were 5 year notes. As you could imagine no family was able to pay off their mortgage in 5 years. Keeping the family home was thus entirely dependent on being able to refinance! Well in the event of a liquidity crunch like the Great Depression refinancing was impossible. The following lesson was learned: Even if you pay all your mortgage payments the bank can still take back your house. This simply isn’t the case anymore. Mortgagors have far more protection than in the past.

    My basic point is that I think there are some ideas ingrained in many of us that are outdated and cloud are ability to think about mortgage debt in an analytical way.

    I have so much more to say on the topic but I don’t want to hog the message board!

  34. David Scubadiver March 15, 2007 at 3:34 pm

    “Nobody ever got rich paying off a mortgage”

    I could prepay $1,000 a month on my mortgage at 5.5%
    Or I could sock away $1,000 a month and invest it in various mutual funds or whatever.

    After many years, assuming my investments are somewhere near 5.5%, I will have a huge pile of cash which I can easily spend for expenses, including retirement expenses. Heck, I could use it to pay my monthly mortgage while reserving the bulk of it for an emergency or keeping it invested.

    The question for me is, would I rather have a HUGE pile of cash and small mortgage debt (after all I have been paying it down a little each month for so many years), or a tiny pile of cash and no mortgage at all? The answer for me is simple. Give me the cash because I can buy stuff with it without having to take out a home equity loan, etc. Even if I wind up with less on a net worth basis, I have easier access to the cash if the money is invested in something liquid rather than my house — and if I do well investing, I will be on the positive net, and if I want the warm fuzzy feeling I can simply pay off the entire mortgage once my investment balance equals my mortgage balance.

  35. I would say prepay your mortgage. The sooner you can be debt free the better. Finanical advisors, banks, loan companies, etc. want you to keep this debt. Invest your money to make more money. Why do they say this? Because if you didn’t invest they would lose out! Put money in stocks and bonds, and watch them grow. Can they guarantee that? Nope. One terrist attack, and you have nothing. No house equity and no retirement funds. You don’t want to live life owing people or businesses. You want to own everything, and not have to worry about the stock market, or if your paying to much on finance charges from investors or others. Have a mortgage save money on a tax deduction. Your going to pay the same taxes no matter what! Your investments at 12% are taxed, and whenever you pull out money on your 401k your taxed (even during retirement!). My plan would be to pay off my smallest debt first, and then move to the next largest (snowball effect), until you are completely debt free. After that use CD laddering for furture savings.

  36. The first assumption is that additional money is required to pay down a mortgage early. While you may choose to make an extra payment over the course of a year (which happens on a bi-weekly payment plan,) you can pay the same amount each year but switch to a twice a month payment plan to reduce the amount of mortgage interest you pay out by $15-$20K or more and shave a couple of years off the loan without spending any more money than you already are spending now.

    We went through 6 months of cash reserves and incurred debt following a prolonged period of unemployment after 9/11 and some unexpected health expenses in 2002. We were able to hold on until we both became employed again in 2003.

    In the process of negotiating reduced payments on unsecured debt, a couple of our debtors chose to instead charge off our accounts and eventually sold the debt to attorney collectors who initiated legal proceedings. During a recent debtor legal action, we became painfully aware that any money we put in our cushion fund is liquid and therefore at immediate risk of being appropriated. Without that cushion we are at risk of going back into debt at the slightest financial setback.

    For the next couple of years, we are getting ahead and lowering risk by maxing our 401Ks at work and making bi-weekly mortgage payments. We are limiting how much money we put into liquid cash and investment accounts until we have settled with unsecured debtors and are back on our feet. At that time we will redirect extra monies to investments that pay more than our mortgage interest costs us. Until then we are increasing the equity in our home which–unlike cash and investment accounts–can’t be taken away from us so long as we are current with our mortgage payments.

    You can accelerate your mortgage when it makes sense to do so, and revert back to usual payments for maximized tax benefits when that makes sense. It is not necessary to make additional payments during the life of the mortgage when you can realize investment returns that exceed your mortgage interest rate, but it’s hard to ignore the fact that you can get ahead just by making the same amount of house payments on a twice a month instead of once a month plan.

  37. Well, TODAY we took %170,000 out of our savings, and paid off our house! IT FEELS WONDERFUL! This lovely house is all ours. NO ONE but God can EVER take it away from us!

    We had a house foreclosed on us in 1995. It was the most horrible thing. There we were..broke, out in the street. Kicked to the curb.

    We vowed that we would come back..rise from the ashes, and never again would we go through that hell. We bought this house in 2000 for $550,000. There is a second house on the property we use as a rental, $1500 a month.

    No matter what happens to the economy, or to us, RIGHT HERE is where we will be. No “investment” nor stock purchase ever made us so happy. We feel secure, and very damn proud of ourselves. Sure, there will be taxes and insurance and repairs, etc., but they were there, anyway. The rental house income will cover whatever.

    OH, HAPPY DAY! :) :) A dream come true. OUR house: Free and Clear. Ahhhhhhhh, what a feeling!

  38. OK, so you do not have high interest credit cards and you are fully funding your Roth. Then if you want to GET RID OF YOUR MORTGAGE FAST, here is what you do. Use the equity you DO have to pay off the equity you don’t have yet. Take out a HELOC and start treating it like a checking account. Deposit your income into it and pay your bills out of it. By cashflowing through it you will achieve a lower EFFECTIVE rate on it than on your mortage. HOW? Ask yourself this… if you borrow $1 from a heloc (a revolving line of credit with interest calculated on the average daily balance), how much does it cost you in interest? 10 cents if you pay it back exactly a year later, but only 2.5 cents if you pay it back in 3 months. So your EFFECTIVE interest rate is just 2.5%). Now by achieving a lower effective interest rate on your heloc, than your primary mortage, you can monitor your cash flow (there is an algorithm based software program you can buy for this) and then borrow the equivalent of your discretionary income 3 months in advance and put it into to your mortgage (making sure you will be able to pay it back quickly enough with your paychecks and cash flow to keep the effective rate low). Then when the heloc balance gets close to zero… do it again. The heloc should be used only as a TOOL to do this. You can do this as a guessing game, or use software, but this is math, not horseshoes or hand grenades. If you DO do this right you can knock a 30 year mortgage down to half the time or LESS, without changing your budget or scrimping or saving. You must be very disciplined to do this yourself, but it has been done for years with excellent results. Making these transfers as quickly as possible is key… want to know why? Go put a $5000 principle payment into your mortgage (use an extra payment calculator on the internet) with the first months payment… then do it instead 6 months later. On a $200,000 mortgage at 6% you will see that you save an EXTRA $787.94 by putting the money in 6 months earlier. But what does it cost you to borrow it from the heloc? Making monthly payments at 10% interest it costs you at most $180. but if you cashflowed through the heloc with your income you may have achieved an effective rate of as low as 1-3%. Regardless.. that is an advantage of, at LEAST, an extra $600 in interest saved over the life of your mortgage. Short term, controlled borrowing from a heloc is a simple way to accelerate a mortgage painlessly. If you do it really well you can end up with an EFFECTIVE interest rate, for BOTH your primary and heloc. of as low as 1-3%. And PLEASE do not stress over losing your tax deduction! All we do with that is give the bank $1 and get back 15-25 cents at year end (depending on our bracket). As someone here said.. that is called negative cash flow. Wouldn’t you rather have the dollar? Also… a savings account strategy loses here also… as the money earned on a savings account is accrued, and TAXABLE, while the lower effective rate on a properly managed heloc is tax deductable. Do the math on that and you see that paying down the mortgage in THIS fashion (with heloc) beats trying to save chunks, even with a 5% savings account. Advance TIMING of prepayments makes a HUGE difference on an amortized loan! Got questions… call me 407-697-8869 Sue :)

  39. With this on-going recession and low bank interest rates, I would rather pay my house which I have rented out than put my money in risky investments. I’ll finish paying the house next year (within 2 years only) and then keep as savings the $950 I receive every month from the renters. Which bank nowadays can give me $950 a month CD interest for my $142,000 (my house cost in San Antonio)?

  40. No one has mentioned a recast. You can pay down a lump sum, like $5000 or $10,000 toward principle, and instead of ending the mortgage early, lower the payment. This makes it easier to save up for the next paydown, etc, so you still end up finishing earlier if you want to.

    The thing I don’t like about paying down early the traditional way is that it does nothing for improving cash flow. I can pay down early, but then lose my job, can’t make the payment, and lose it all. But with each recast, I increase my liklihood of being able to keep up with the payment in hard times.

Trackbacks and Pingbacks:

  1. Your Money Matters » Blog Archive » Prepaying Mortgage – No, it is cheap debt! - November 3, 2006

    […] Over at the popular personal finance blog, AllThingsFinancial, JLP had a question of the day – Should people prepay their mortgage (pay it off early)? The result was a string of comments and varying opinions. To summarize and add some clarity to the matter, I will simplify and provide some guidelines surrounding this topic. […]

  2. financial zen » Blog Archive » Pin this up on your wall. - March 24, 2007

    […] 7. Pay ahead on your mortgage. I’ve seen this contested. Pay more because you can afford to (and you own your house faster), or take that extra money and invest it. JLP at All Financial Matters has covered this. I’m no expert, but the feeling of paying off a property would give me that overwhelming relaxation of getting that monkey of your back (I can see why some people hesitate – it’s all a matter of income and how much you buy your house for – I’m looking in the $160k range, some people talk of $300k+ for something that I’m living in now!) […]