Debunking the Mortgage Prepayment Myth
by Jeffrey Yeager
How Mortgage Prepayments Work
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Yesterday was one of life's great milestones, as my wife and I made one lump sum payment to pay off our home mortgage, a full fifteen years before we had originally planned. I don't need to share with readers here how we did it (a concerted savings plan, frugal lifestyle, and a constant focus on getting this debt off our back), but I would like to weigh in on the fallacy of the "conventional wisdom" provided by many professional financial planners on the subject of prepaying your home mortgage. Namely, most financial planners advise you not to do it!
Their argument against retiring your home mortgage early is twofold. First, they point out that you will be losing what is for most people their largest tax deduction, their mortgage interest payments. But the proper way to look at this issue is that for every dollar in interest you pay to your mortgage lender, you recover about 28 cents of it in tax savings (depending on your tax bracket), which is a net loss of 72 cents on every interest dollar you pay. Simply put, the financial planner's argument is analogous to saying that gambling is a good investment, since 28% of the time you win!
But, in fairness to financial planners, the real basis for their traditional advice is the legitimate, but oversimplified point that mortgage loans are just about the cheapest money you can borrow. With mortgage rates near record lows and factoring in the above tax savings (which in essence lowers the effective rate for borrowing the money by another 28% or so), the conventional wisdom would be that in a case like mine, where I have banked the lump of cash necessary to pay off my mortgage, I should instead invest that cash. After all, any idiot should be able to earn more from his investments than the 4% or 5% in mortgage interest rates (after tax saving) that you pay these days, shouldn't he?
Well, I've always said that I'm not just any idiot, but that's another story! As we all know, the reality these days is that even a 4% or 5% rate of return on investments is far from being a shoo-in. In fact, you'll fall well short of that level unless you're willing to take at least a little risk and/or lock up your money in relatively long-term investments like five year CDs. As Americans are beginning to remember (and as most of us are now trying to forget), it's very possible to lose value on your investments. In hindsight, looking back over the past few years, how many of us wouldn't choose the guaranteed 4%-5% rate of return we would have had by prepaying part or all of our home mortgages, instead of the gut-wrenching losses we sustained with our any-idiot-can-do-it investments?
An even more compelling point in favor of prepaying your home mortgage, and one which financial planners rarely ever mention, is the whole notion of cash flow. As any business owner knows, cash flow is king. And when it comes to most family's cash flow, their single largest monthly expense is their home mortgage payment. Once that monthly demand for cash is no longer, your options and financial security skyrocket. If you lose your job tomorrow, your chances of making ends meet and hanging on to your house until you find another job (if you even need to!) are excellent now that you own your home outright and don't need to keep the cash flowing out to your mortgage lender every month. And assuming that you don't confront a worst case scenario, then being mortgage-free allows you to focus all of your attention and resources on your other financial priorities going forward, such as saving for retirement, funding your children's education, or helping others more needy than yourself.
This last point about the cash flow argument in favor of prepaying your mortgage is particularly important as it relates back to the financial planner's advice about investing the cash you might otherwise use to pay down your mortgage. What many planners fail to fully consider is the timing factor. In order to have the best chances for realizing investment rates of return greater than the 4%-5% guaranteed by prepaying your mortgage, you generally need to "invest for the long haul."
Most of us know that the U.S. stock market, over a period of decades, has returned rates averaging around 10% annually. But what if you need to get your money out of stock investments tomorrow because you lose your job and need the cash to make the monthly mortgage payment? Particularly in the investment climate of the last few years, there's an excellent chance that having to liquidate your long-term investments on short notice will result in a net loss of principal. In other words, the financial planners are expecting that you'll always have the luxury of being able to buy and hold investments until the best possible time to sell, when in fact that's not always the case.
The argument for reducing your monthly cash flow requirements by prepaying your mortgage is an extremely important and under appreciated consideration for most Americans in the current economy. And, what's more, by prepaying your mortgage, you are making an investment, an investment in real estate that's likely to continue to appreciate in value. While any appreciation in value will be the same regardless of how much equity you have in your home, your ability to borrow against the appreciated value of your home, if you should really encounter a worst case scenario, does depend on how much of your home you actually own.
Financial security and flexibility, a guaranteed rate of return, and 100% ownership of an asset which is likely to continue to appreciate in value over time. What's not to like? Did I mention peace of mind? I'm going home now.
Jeffrey Yeager has spent his career of more than 20 years in senior management positions with various national nonprofit organizations based in Washington, DC. "When you work for a nonprofit organization, you're frugal for a living, so it's easy to be frugal in your personal life." Yeager is an honors graduate of Bowling Green State University in Ohio and was a Rhodes Scholar nominee. His most recent book The Ultimate Cheapskate's Road Map to True Riches is available at Amazon.com.
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