In the past few months two homeowners that we spoke to proudly noted that they had been slowly prepaying their mortgage by sending in additional principal payments. Mortgage lenders also offer borrowers the option of automatically paying their mortgage bi-weekly, which effectively means 13 monthly payments per year instead of 12, which is simply another form of prepaying a mortgage. Downtown Investment Advisory typically advises against such mortgage prepayments. While prepaying your mortgage might seem like a smart and prudent financial move that reduces household debt there are several critical reasons why this is generally not a good choice.
First, consider that a mortgage is an amazing product for the home buyer who can get one. Currently, 15 to 30 year fixed mortgage rates are in the 3.5% to 4.5% range (according to bankrate.com). Not only are interest rates at historically low levels, but also the interest expense paid to the bank is tax deductible, further reducing the effective interest rate. The point is that borrowing money for decades at these low, tax deductible rates is highly favorable to the consumer – why pay back such a great loan?
Instead of prepaying a mortgage it would make better sense to keep your cash and invest it prudently. You will have more money in the end -- let's see how by considering the example of a 30 year fixed at 4.50%. If you prepay $1,000 of this mortgage, you now have $1,000 less cash, but gain the benefit of $45 per year in interest expense savings. However, if you instead invest this $1,000 in a bond that offers more than $45 per year in interest, you can keep the difference. We currently see numerous investment grade bonds with 15 to 30 year maturities yielding more than 6%. Assuming you purchased one of these bonds with this same $1,000, let's say yielding 6%, you would earn $60 of interest per year, pay the $45 of interest expense that you still owe by not prepaying the mortgage, and keep the $15 difference. You would have to pay taxes on the $60 earned, but this is offset by the $45 mortgage interest deduction you retained, so taxes would be paid on only the net $15 gain. We would typically advise clients to consider investing the $1,000 in a shorter dated bond with slightly higher risk and similar return, but the above illustration proves our point.
The bottom line is that at least based on today’s available bond offerings (and this has been the case for many years now), an investor can typically earn more by investing this $1,000 than what you save by prepaying your mortgage. Mortgage debt is not the right kind of household debt to reduce – credit card debt, and perhaps an auto loan, make better sense to repay.
The second reason not to prepay your mortgage is that prepaying reduces your overall financial flexibility and security. Prepaying your mortgage does not lower any of your mortgage payments – next month you are still required to make the same payment to the bank (it does improve the mix between principal and interest that is paid each month, but not the actual amount of the mortgage payment). The prepayment only shortens the number of years you have to make your full mortgage payments. In the meantime though, you are “out” this $1,000 today. However, you may possibly need this money at some point in the future for some unforeseen reason. But of course the bank won’t return your prepayment. By instead keeping the $1,000, not only can you earn excess investment income, but you also still have your $1,000 to use as you wish.
Lastly, your mortgage is an important inflation hedge. As of this writing, interest rates and inflation are near historical lows. Although there does not appear to be an imminent threat of an inflation surge, no one can predict what inflation may look like in 3, 5 or 10 years. Given the vast quantities of money the government is effectively printing, many analysts believe that rising inflation is a risk, and inflation typically causes interest rates, including mortgage rates, to increase. However, your fixed rate mortgage will remain at the same rate over a 15 to 30 year period. If inflation and mortgage rates spike, you will be happy to keep your low cost mortgage. You will also be able to invest the cash that you retained by not prepaying your mortgage at these higher interest rates as well. Your mortgage is thus your best hedge against rising inflation as you effectively maintain your primary cost of housing (i.e. your mortgage payment) flat for 15 to 30 years while prices for everything else (and typically your wages) rise due to inflation. By prepaying the mortgage, you reduce this long term inflation hedge.
Our advice against prepaying your mortgage is generally based on a 15 or 30 year fixed mortgage and not necessarily on adjustable or shorter dated mortgages. We generally still advise against paying down the mortgage for financial flexibility reasons, but each of these situations would need to be evaluated separately.
Downtown Investment Advisory (DIA) can help you assess your mortgage situation and advise on the best course of action depending on the specific situation. We are also available to discuss other mortgage questions such as deciding to refinance and which type of mortgage to obtain. As part of our analysis, we can perform "what if" scenarios based on your income, tax, and investment situation. DIA is available to assist with all your financial questions.
Note that this article was written to provide information and education, and is not intended to be considered investment advice, which can only be provided by DIA following a consultation and execution of an Investment Advisory Contract.
First, consider that a mortgage is an amazing product for the home buyer who can get one. Currently, 15 to 30 year fixed mortgage rates are in the 3.5% to 4.5% range (according to bankrate.com). Not only are interest rates at historically low levels, but also the interest expense paid to the bank is tax deductible, further reducing the effective interest rate. The point is that borrowing money for decades at these low, tax deductible rates is highly favorable to the consumer – why pay back such a great loan?
Instead of prepaying a mortgage it would make better sense to keep your cash and invest it prudently. You will have more money in the end -- let's see how by considering the example of a 30 year fixed at 4.50%. If you prepay $1,000 of this mortgage, you now have $1,000 less cash, but gain the benefit of $45 per year in interest expense savings. However, if you instead invest this $1,000 in a bond that offers more than $45 per year in interest, you can keep the difference. We currently see numerous investment grade bonds with 15 to 30 year maturities yielding more than 6%. Assuming you purchased one of these bonds with this same $1,000, let's say yielding 6%, you would earn $60 of interest per year, pay the $45 of interest expense that you still owe by not prepaying the mortgage, and keep the $15 difference. You would have to pay taxes on the $60 earned, but this is offset by the $45 mortgage interest deduction you retained, so taxes would be paid on only the net $15 gain. We would typically advise clients to consider investing the $1,000 in a shorter dated bond with slightly higher risk and similar return, but the above illustration proves our point.
The bottom line is that at least based on today’s available bond offerings (and this has been the case for many years now), an investor can typically earn more by investing this $1,000 than what you save by prepaying your mortgage. Mortgage debt is not the right kind of household debt to reduce – credit card debt, and perhaps an auto loan, make better sense to repay.
The second reason not to prepay your mortgage is that prepaying reduces your overall financial flexibility and security. Prepaying your mortgage does not lower any of your mortgage payments – next month you are still required to make the same payment to the bank (it does improve the mix between principal and interest that is paid each month, but not the actual amount of the mortgage payment). The prepayment only shortens the number of years you have to make your full mortgage payments. In the meantime though, you are “out” this $1,000 today. However, you may possibly need this money at some point in the future for some unforeseen reason. But of course the bank won’t return your prepayment. By instead keeping the $1,000, not only can you earn excess investment income, but you also still have your $1,000 to use as you wish.
Lastly, your mortgage is an important inflation hedge. As of this writing, interest rates and inflation are near historical lows. Although there does not appear to be an imminent threat of an inflation surge, no one can predict what inflation may look like in 3, 5 or 10 years. Given the vast quantities of money the government is effectively printing, many analysts believe that rising inflation is a risk, and inflation typically causes interest rates, including mortgage rates, to increase. However, your fixed rate mortgage will remain at the same rate over a 15 to 30 year period. If inflation and mortgage rates spike, you will be happy to keep your low cost mortgage. You will also be able to invest the cash that you retained by not prepaying your mortgage at these higher interest rates as well. Your mortgage is thus your best hedge against rising inflation as you effectively maintain your primary cost of housing (i.e. your mortgage payment) flat for 15 to 30 years while prices for everything else (and typically your wages) rise due to inflation. By prepaying the mortgage, you reduce this long term inflation hedge.
Our advice against prepaying your mortgage is generally based on a 15 or 30 year fixed mortgage and not necessarily on adjustable or shorter dated mortgages. We generally still advise against paying down the mortgage for financial flexibility reasons, but each of these situations would need to be evaluated separately.
Downtown Investment Advisory (DIA) can help you assess your mortgage situation and advise on the best course of action depending on the specific situation. We are also available to discuss other mortgage questions such as deciding to refinance and which type of mortgage to obtain. As part of our analysis, we can perform "what if" scenarios based on your income, tax, and investment situation. DIA is available to assist with all your financial questions.
Note that this article was written to provide information and education, and is not intended to be considered investment advice, which can only be provided by DIA following a consultation and execution of an Investment Advisory Contract.
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