Prepaying your mortgage vs. investing the extra cash

Mortgage Prepayments When You Expect to Sell

by Gary Foreman


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Hi Gary,
We've read some stuff about prepaying mortgages lately. We prepay ours. Every month we round it up to the next hundred which adds about $75. Does it make any sense to prepay if you know you're not going to stay in your house until the mortgage is paid off? We're not planning to be here 30 years or even 15. I can see 5 or 6 more years at the most.

I thought about it, and it's not like the $75 we pay is getting us anything except $75 extra returned when we sell the house. But, if we invested $75 a month and didn't prepay, we'd be better off....right?
Nancy

Nancy is like most of us. We have a hard time comparing two dissimilar things. So let's see if we can't find a way to compare mortgage prepayments to investments.

Let's begin with some assumptions that we can use to create some illustrations. We'll say that Nancy took out a 30-year, 8% fixed mortgage for $100,000. Let's also assume that it's a brand new mortgage.

We begin by using a mortgage calculator from Bankrate.com. It showed that Nancy would be making a payment of $733.76 per month.

What happens if Nancy prepays $75 this month. How much will she earn? In one year her one prepayment of $75 will have reduced the principal amount due on the mortgage by $81. That's because she's borrowing less money next month and every month thereafter. So less of her next payment goes to covering interest and more goes to reducing principal.

The $81 represents an 8% return on her $75. Not surprising since that's the rate of the mortgage. So lesson #1 is that when you prepay your mortgage you will always earn the interest rate on your mortgage. If your mortgage rate is 7%, then that's what you'll earn.

Suppose that she sells her house in five years. What will Nancy's one-time $75 prepayment be worth then? After 5 years her principal would be reduced by $111. So if they sold the house at that time they'd walk away $111 richer.

OK, now let's compare. What happens if Nancy invests the money? In part, it will depend on what she invests the money in and how much that investment earns. Let's consider an example.

Remember that she gets a guaranteed 8% return on her prepayment. So we'll pick something safe like a certificate of deposit. If she could buy a $75 CD with a five year maturity it would earn about 6.5%. That would mean that she'd get back $103 when she redeemed it. So she'd actually be $8 ahead ($111 minus $103) by prepaying the mortgage.

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Next let's see what happens if she puts away $75 every month for five years. By prepaying the mortgage she'll end up with a loan that's $5,511 less than it would be without the monthly prepayments.

On the other hand, if she invests the same amount and earns 6.5% she'll have accumulated $5,300 in five years. But realistically, Nancy won't be able to buy a $75 CD each month. She'll either need to settle for money market rates or put it into a mutual fund that's not guaranteed.

We won't get into predicting how mutual funds will do. But just for a moment let's assume that she chose one that earned 10%. That's about the long-term return on the stock market. Her nest egg would be $5,807 after five years.

If we consider taxes Nancy would be about $5,300 ahead when she sells in 5 years after the prepayments. If she invests at 10% taxes would drop her return to about $5,550.

So what's the bottom line? It really depends on your personality. If you're a cautious person who likes getting a guaranteed return, then prepay your mortgage. You won't find a safe, guaranteed rate that's as high as your mortgage rate. You'll also be happier knowing that your mortgage is facing early retirement.

On the other hand, if you don't mind a little risk in your life you might want to put the money into a mutual fund that invests in stocks. Over the long haul you could get a higher return.

In either case, it really doesn't make any difference how long you'll own the house. If you prepay you'll get that rate of return however long you have the mortgage.

In fact, if you plan on selling your home fairly soon, prepaying your mortgage could be an excellent choice. There's a good possibility that you'll need some extra cash when you buy a new home. When you sell your old one the 'savings account' represented by the prepayments will automatically be available to you.

One cautionary note. Whenever you prepay your mortgage be sure that you clearly note that the money is meant to prepay principal. If it's not noted your mortgage company could just apply it to your next monthly payment which will have almost no positive effect.

Hopefully Nancy will enjoy her home however long she has it and will be able to continue her savings plan.


Gary Foreman

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter. Gary is also available for audio, video or print interviews. For more info see his media page.

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