It's Always Smart to Prepay Your Mortgage

onsidering that the word "mortgage" has its roots in mort, the French word for death, is it any wonder most of us view a mortgage as one of life's darker burdens? We look forward to the day we've paid off the debt and own our home free and clear.

If you want that day to arrive sooner rather than later, mortgage prepayment holds high appeal. You can prepay in various ways: by adding a little extra to your regular monthly payment; by making one extra payment a year; or by paying biweekly rather than monthly (making half a monthly payment every two weeks), which comes out to one extra full payment each year.

Prepaying can pare years off your mortgage and reduce your total interest. For example, by paying $25 extra each month on a fixed-rate, 30-year, $100,000 mortgage, at 7% interest, you'd save $18,214 in total interest and shorten the term by more than three years.

But before you get carried away thinking about saving thousands of dollars, look deeper to determine if prepaying is a wise move for you.

    Most financial experts
    say paying a company
    to set up a biweekly
    payment plan for you
    is "money down
    the drain."

Prepaying
your mortgage
is never
a good idea
if you have
consumer debt.

First things first
Anyone is eager to get out from under a debt. So prepaying your mortgage has to be a good idea, right? Not necessarily, financial experts say. Often, prepaying is "much more of an emotional than a financial decision," says Don Chou, a certified financial planner (CFP) in San Juan Capistrano, Calif. "But in our experience, in today's environment, prepaying might not be the best financial decision for you."

Emotions aside, you need to consider several factors before deciding to prepay. "It's never a good idea if you have consumer debt," says Phil Storms, a Denver CFP. "Consumer debt should always be the first thing you pay off .... I've seen people with $30,000 of credit card debt who were happy because they were down to $15,000 on their mortgage." That's a perfect example, he notes, of how emotions often rule, blinding consumers to the fact that they can do more with their money by paying off higher rate credit cards than by prepaying their mortgages.

Also, be sure prepaying won't cramp your ability to save for other financial goals. "Sometimes people end up house poor," Chou says. "They have the house, and it's paid off, but they haven't saved for other goals, whether it's retirement or their children's college education. They end up having to refinance their house or perhaps even sell it in order to get the capital they need to meet those other goals."

Another factor to weigh is your liquidity needs. By prepaying your mortgage, you could end up strapped for cash to cover regular bills or emergency expenses. Experts recommend building a cash reserve equal to at least three months' salary—more if your job future is unpredictable.

"I've seen people in financial trouble, even though they've paid an extra $5,000 or $10,000 [on their mortgages] over the years," Storms points out. "If you pay down that mortgage and then lose your job down the road, unless you have liquidity to keep making those mortgage payments, you're still delinquent after missing a payment."

Number crunching
Tax consequences also must weigh into your prepayment decision. Usually, consumers think about putting extra money into the mortgage during their peak earning years, between ages 40 and 60. "So you're in your highest tax bracket," Chou points out, "and you're getting rid of your largest tax deduction" by prepaying your mortgage.

For instance, if your mortgage rate is 7%, putting money into your mortgage is like investing it at 7%—or so it seems on the surface. But you also must consider the tax effects, Chou says. Say you're in the 28% tax bracket. By giving up your tax deduction on mortgage interest, you lose 28% of your "earnings" on your investment. That means you only get 72% (100% - 28%) of that 7% interest rate, or 5.04% (.72 x 7%).

Now, compare that with what you could earn by placing your money somewhere besides your mortgage. Say you were to invest in a mutual fund earning 10%. If you're in the 28% tax bracket, you lose 28% of that to taxes. In other words, you earn 72% (100% - 28%) of that 10% interest rate, or 7.2%. The upshot in this particular example is that you're ahead by more than two percentage points if you put your money in the mutual fund instead of your mortgage. You'd be even further ahead if that money went into a tax-advantaged plan, such as an individual retirement account (IRA) or 401(k).

On a simpler level, you might think of the tax situation as a "wash"—that is, the lost tax deduction for your mortgage interest is countered by the taxes you'd have to pay on earnings from your mutual fund investment. Then you could view prepaying your mortgage as the equivalent of investing that money at a rate equal to your mortgage rate.

But you also need to think about the flexibility you sacrifice by prepaying, Storms points out. "If you offered most people the chance to buy an investment that pays off at the end of 20 years, bears interest at 7%, and is totally illiquid, I would guess nobody would buy that investment," he says. "But that's what you're doing when you prepay a [30-year] mortgage."

    Often
    mortgage prepayment
    is more
    an emotional
    than a financial
    decision.

"I've seen
people with $30,000
of credit card debt
who were happy
because they were
down to $15,000
on their mortgage."

Right for some
That's not to say mortgage prepayment is never a good idea. If you're free of consumer debt, have saved amply for retirement and the kids' education, have a healthy cash reserve fund, and won't get boosted into the next tax bracket by losing your tax deduction, then prepaying may be the right move. If you're risk-averse and prefer to invest conservatively, you'll usually be money ahead by prepaying your mortgage rather than by investing in certificates, for example.

Whenever you pay an extra amount on your mortgage, be sure to tell your lender to apply it to the principal. Check first to find out if there's a prepayment penalty (such mortgage penalties are rare, especially in credit unions).

Besides making extra payments spread over time, another approach is to set up an escrow or investment account to accumulate assets, and then pay off your mortgage in one lump sum at retirement, when you'd prefer to have no mortgage payments hanging over your head. "Presumably your tax bracket will be lower, and you won't need the tax benefits," Chou explains.

Experts generally advise against using companies that offer to set up a prepayment plan for you in the form of a biweekly payment schedule. "There's a fee, usually $200 to $400, plus a monthly service charge," Storms says. "As far as I'm concerned, that's money down the drain."

The advantage these companies tout is the built-in discipline to assure you make the payments. But you can create your own prepayment plan, of whatever type you choose. If you need help devising a plan, talk to someone at your credit union.