Saturday, February 24, 2007

Prepaying your mortgage to do or not to do

Interesting article over at called Prepaying mortgage not a no-brainer here is what they said along with my comments. morgage motrgage

Dear Dr. Don, I have heard so many debates on paying off the mortgage versus not paying off the mortgage, but to me it's a no-brainer. I want to pay off my mortgage! Here's my plan: I have $40,900 as a principal balance and about 20 years left on my mortgage. The total principal and interest each month is $323.38. I think you should also consider how close you are to retirement. A general rule before you retire is to be debt free. If you are 50 and still have 20 years left on your mortgage you should think about getting rid of your debt before retirement. In this case prepaying your mortgage probably makes sense. morgage motrgage

According to the amortization schedule I printed out, the total interest I would pay if I continue to pay on this mortgage would be $35,038. Adding that to my principal, I would pay a total of $75,938.76 over the next 20 years if I continue my loan. It is really impressive that she is financially savy enough to do the amortization schedule and calculate the total payments over the 20 years. Most people don't know what an amortization schedule is or how they are calculated. If you need help on this please review my posts on top financial calculators.

If I pay off the loan now, I would be saving that $35,000 of interest, plus I could contribute an additional $323/month to my 401(k) at work ... which would also grow over the years, giving me, as far as I can see, a huge savings that I would not have had if I hadn't paid off the mortgage. I realize there's a tax write-off for mortgage payments, but it can't add up to the amount I'd have saved at the end of those 20 years if I pay off my mortgage! Do you agree? I'm no financial expert, but as I said, it seems to be a no-brainer to me! The key point here is that she will contribute the additional funds to her 401K. In some cases it may make more sense for a person to max out the 401K contributions first prior to paying down the mortgage. Especially if you have a low interest, like below 7%. You have to remember that if you contribute $323 to your 401K the entire amount comes off of your taxable income. Meanwhile, if you pay and extra $323/month on the mortgage you don't get any additional tax benefit. It is a difficult balance in trying to figure out what you should do.

Dear Deborah,What makes it a "no-brainer" in your case is that you're going to prepay the mortgage and then use the money you would have spent on the mortgage payment to make additional contributions to your 401(k) plan. The tax advantages of that strategy make it easier to justify prepaying your mortgage.

What's missing from your analysis is consideration of how the $40,900 used to pay off your mortgage is invested. You only look at how it generates interest savings and the ability to invest the mortgage payment. The $40,900 needed to pay off your mortgage, invested over 20 years at an after-tax rate of return of 6 percent, will grow to $135,387. The lost tax deductibility of the mortgage interest does have a cost, assuming you can use it in calculating your income taxes. I assumed that you could use it in calculating your income taxes and estimate the value of investing that tax savings over the 20-year period at 6 percent after-tax as about $20,000. So combined, the value of not paying off the mortgage early and keeping the $40,900 invested and taking the tax deduction has a future value 20 years from now of $155,387.

Since 401(k) contributions are made with pretax dollars, an after-tax sum of $323 per month can buy more than $323 per month in contributions to the 401(k) plan. I'm going to assume that $323 per month buys you $430 per month in 401(k) contributions at an 8 percent pretax rate of return. That contribution stream is worth $253,279 (pretax) 20 years from now or $189,959 after taxes at 25 percent. If your contributions are matched by your employer, the forecasted results are even higher.

Without the extra $107 per month in contributions to the 401(k) and the advantage of deferring taxes on the additional 401(k) investment, the comparison would be a lot tighter and not the "no-brainer" that you suggest.

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