This is a guest post from Tali Wee of Zillow, and she’s talking about mortgage prepayment, something that I’ve struggled with in the past – and still am not sure I’m making the right decision about.
Buying a home is likely one of the most expensive purchases in an individual’s lifetime. Although some homebuyers purchase properties with all cash, most finance the transactions. Once the emotional process of shopping, bidding and closing on a home is complete, mortgaged homeowners commit to 15 or even 30 years of monthly costs. These payments include repayment of loans (principal), interest due to lenders for loaning capital, property taxes and homeowners insurance.
Many homeowners opt to pay down their mortgages ahead of their payment schedules to save on interest costs. Once completely repaid, homeowners only owe annual property taxes and homeowners insurance on one of life’s fundamental needs – a home. Some homeowners pre-pay their mortgages because they despise the burden of debt, while others prefer to pay more now to free-up future income for alternative financial goals.
Although these are all major advantages, numerous homeowners decide to pay their mortgages on schedule. Here are a several reasons to avoid pre-paying mortgages.
The interest paid on mortgages is tax deductible. Even though the monthly cost of the mortgage remains the same, the breakdown of principal and interest varies on an amortization schedule. Borrowers pay more interest than principal during the first half of their loan terms and more principal than interest in the second half. Some buyers value the tax break more than rapid principal reduction, especially during the preliminary, high-interest years of ownership.
Jeff’s note: For some, this just does not hold. My wife and I bought a modest house with a great interest rate, and our yearly interest does not even come close to being more than the standard deduction. We do live in a low cost of living area though.
Borrowers should always tackle their highest-interest debts first. If borrowers have credit card debt with 15 to 20 percent interest rates, they should focus surplus income to those debts. Student loans also have high-priced interest rates from 5 to 10 percent. These debts compound rapidly making them higher priorities than current mortgage rates of 4 percent.
Not all lenders allow borrowers to reduce their interest profits, so they penalize borrowers for pre-payments. Additionally, bi-weekly payment programs that coordinate with standard employee payment schedules to pay down mortgages every two weeks come at a cost. Third-party programs charge activation fees ($150-$500) and bi-weekly fees with each payment ($5-$20). These penalties and charges defeat much of the cost benefits of pre-payment.
Vary Investments to Limit Risk
Borrowers diversify their investment portfolios for reduced risk. In the last seven years, real estate values have fluctuated dramatically. It’s risky to lock substantial funds into a single asset with potential for major depreciation. Many borrowers stay current on their mortgage payments while investing in higher-producing, more liquid assets and saving cash.
High-return, low-risk investments are more lucrative than fully paying off a low-interest loan. If borrowers’ employers offer 401k matching programs, retirement investing potentially doubles borrowers’ money. Although still risky, many borrowers opt to invest in stocks and bonds for high-return assets. Home equity is simply too low-producing compared to other investment options without diversified, high-return assets.
Before allocating all savings toward mortgage debt, borrowers should amass an emergency fund. Because emergencies require urgent funds, it’s important to have liquid assets. Emergency funds cover urgent home repairs, unexpected medical bills and job loss to prevent further debt or defaulted loan payments. Before pre-paying mortgages, many homeowners save three to 24 months in emergency savings.
Beyond emergencies, many homeowners do not pre-pay their mortgages because of their alternative financial goals. Beyond mortgage payments, borrowers most often keep deep saving accounts for retirement, travel, emergencies, education, cars, pet funds, hobbies or start-up businesses. If all excess cash is tied up in mortgages, the lack of liquidity can affect borrowers’ quality of life. Homeowners must prioritize their lifestyles and needs before investing completely in their mortgages.
If homeowners are underwater on their loans, it’s beneficial to pursue refinancing options instead of investing completely in an overpriced property without potential for fair returns. Refinancing often results in smaller payments and less total cost to the borrower, depending on pre-payment penalties for the original loan. Refinanced mortgages are typically borrowed at reduced interest rates and terms are generally shorter, limiting total interest paid over the life of loans. In these cases, aggressively paying down underwater mortgages is cost prohibitive. Beyond, refinancing underwater homeowners might consider the benefits of short selling to offload the negative equity.
Ultimately, homeowners must evaluate their financial goals to decide whether mortgage pre-payment is right for them. Is carrying debt more of a stressor than lack of liquid assets? Are college funds for the kids a higher priority than early retirement? Can owners pre-pay their mortgages while saving for their goals and investing? Home equity doesn’t work as hard for owners as other investments, but outright ownership is still preferred by some. Homeowners should consider all of the advantages and drawbacks of mortgage pre-payment before fully investing.
So readers, what say you? Would you rather prepay (given todays rates in 2014) or invest?