Today borrowers face an interesting dilemma. The market entices them with low interest rate mortgages and historically low priced homes; however, their ability to obtain the financing to purchase these homes limited. In order to purchase many condos, the building needs to be at least 50% sold, which can defeat the purpose of trying to get in early for the best deal. Furthermore, any home over the conforming mortgage limit of $415,000 also forces the homeowner to put 20% down just to be eligible for a loan.
Saving vs. Real Estate Investing
The lure of cheap financing has many consumers thinking about how they are saving their money. Does it make sense to keep $20,000 in a savings account yielding 1.0% at most or should they use that money to lower their monthly mortgage payment? The debate is no longer around investing in the stock market vs. paying down their mortgage.
Over the past year or two, the volatility of the stock market made many investors wary of the ups and downs in the market. Moving to cash or the money market enables consumers to feel safer, but the safety has come at a steep price. Many consumers wonder if they are even keeping pace with inflation rates. Why not invest to secure living arrangements, lower monthly payments and lock in low interest rates for the next 20–30 years?
Does it Really Make Sense to Prepay the Mortgage?
In the United States, consumers gain several benefits from paying interest on their mortgage. First, the government allows borrowers to deduct interest payments directly from their income. In the first five years of a mortgage, when the majority of the payments go towards interest, consumers see the greatest benefits. Not only does it reduce the total tax burden, but it can often put borrowers in a lower tax bracket, which also lowers their tax rate. In 2008, counting only the tax returns that deducted mortgage interest, the average deduction was $12,221 based on findings by the Tax Foundation.
Given the substantially lower savings rates, consumer might still benefit from paying their mortgage down rather than buying a CD. Let’s start by looking at the consumers in the highest tax bracket of 35%. At the current interest rate of 4.5%, a consumer would net a benefit of 2.9% (4.5% x (1-35%)) on the money invested in their mortgage. On the surface this seems like a very low rate of return. However, compared to current 5 year CD rates of 2.64%, it seems like a better investment. Borrowers might also accrue additional mortgage savings by no longer having to pay PMI or mortgage insurance.
Potential Reasons not to Prepay the Mortgage
The two major issues the analysis above does not consider are liquidity and the volatility of real estate prices. While putting some savings towards the mortgage will lower the monthly payment, it will also lower the liquid cash available to borrowers. If a sudden need for a large amount of cash arises, potentially for a better investment or an unfortunate emergency, borrowers might find themselves hard pressed to recoup the cash from the homes via a refinance.
Additionally, prepaying a mortgage is akin to investing in housing. While the investment could appreciate over time, it could also depreciate. In the scenario above, the investor will earn at least a 2.9% return if the home maintains its value. If the value declines, the investor will earn far less, even with the decrease in monthly payments.
Prepaying a mortgage is a great strategy for retirees or for people expecting to remain in the home for a long period of time. Also, people with lots of disposable income could benefit from the additional security of lower payments. At a minimum, prepaying a mortgage or putting additional money down should be a consideration when thinking about investing and saving opportunities.