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Should You Prepay Your Mortgage in a Down Market?

By: Investor Solutions

By: The Financial Planning Association

Disenchanted with stock and bond returns, some homeowners are diverting their investment money into their home mortgage. But many financial advisors think this is not always as good an idea as it might first appear. Here are some points for you to consider before you decide whether to prepay your home mortgage.

Its easy to see why diverting investment money into your home instead of stocks or bonds might look attractive these days. When you prepay your remaining mortgage with a lump sum, or accelerate the payoff through monthly extra principal payments, you reduce your long-term interest costs. On a 30-year, 7.5-percent, $200,000 mortgage, paying an extra $200 a month would save $112,625 in interest charges. Thus, paying off a mortgage carrying seven to eight percent looks like a smart move compared with investing in stocks, which have been on the skids since March of 2000. It also looks smarter compared with ten-year Treasury bonds currently yielding a modest 4.5 percent, or even the more anemic returns of money market mutual funds, savings accounts and certificates of deposit.

For conservative investors who dont invest in stocks, or perhaps even bonds, prepaying your mortgage might make financial sense, say many financial planners. Youll probably earn more than low-risk alternatives and youll reduce your debt, which is usually a good thing, especially in tough times. And paying off the mortgage early provides peace of mind.

On the other hand, the financial value of paying off a mortgage early is not necessarily as strong as it appears, suggest experts. First, you should compare after-tax returns when weighing your options. Homeowners who itemize can take a mortgage-interest deduction, which effectively reduces the return gained by paying off the mortgage early.

For example, lets say you will be in the 27-percent federal income-tax bracket next year. Thus, the real cost of that 7.5-percent mortgage (which is the same as the return you would get prepaying the mortgage) is 5.47 percent. Someone in the top 38.6-percent tax bracket next year is actually paying only 4.6 percent on their mortgage (this doesnt take into account any state taxes saved).

Compare this with the after-tax return of an alternative investment. A stock returning 7.5 percent annually provides an after-tax return of 6 percent assuming a 20-percent long-term capital gains tax. In dollar terms, putting $200 monthly toward stocks earning 7.5 percent annually would earn $271,174 in 30 years, versus the $112, 625 you saved in interest payments by prepaying the mortgage.

Experts also point out that the interest savings gained from prepaying a mortgage are overstated because of the time value of money. Due to inflation, the interest payments you make in the latter years of your mortgage are made with much cheaper dollars than the ones made with the early payments. So prepaying means youre using up dollars that are more valuable.

Another argument for continuing to invest in stocks instead of diverting the money into the mortgage is that stocks overall might be considered a bargain these days because they are so beaten down. The assumption is that stocks, while returning poorly now, will eventually recover their losses, and much more, in the long run, so its a good time to buy them while they are cheap. Since 1926, stocks have averaged annually 7.9 percent after taxes and inflation are taken into account [Vanguards retirement booklet] well above the return youd earn paying off a mortgage early.

It also makes less sense to divert money from tax-favored retirement accounts especially if your employer is providing matching funds. And at the least, if you remain too nervous to invest in stocks or bonds, you would probably be better off putting excess money into paying off high-interest credit cards or other higher-interest consumer loans (whose interest you cant deduct) instead of a lower-interest-rate mortgage.

Prepaying a mortgage also means you are tying up money that could remain in more liquid accounts, such as an emergency fund. (Remember, prepaying does not lower your monthly mortgage payments unless you pay the entire amount off.) If you were to lose your job, for example, it would be harder to get money out of your home than to simply take out cash from your emergency fund or even sell stocks, if necessary.

This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by a local member in good standing of the FPA.