Prepay My Mortgage?

Should I prepay my mortgage? The WealthAdviceMadeSimple answer would offer the following guidelines:

1. Make sure you have ample emergency reserves in the bank to deal with unexpected cash flow needs.
2. Pay down any credit card debt that is currently being carried month over month. The interest rates on these are often high and they are not tax-deductible.
3. Pay down auto loans if the rate is higher than your after-tax mortgage rate (if your mortgage rate is 4% and your marginal tax rate is 25%, then your after-tax mortgage rate is 3%).
4. Run the same calculation as #3 for any outstanding school loans you have.
5. Be sure you are receiving any employer match in your company retirement plan. This is free money you should not pass up.

Beyond these basic guidelines, the answer gets a little murkier. You will often hear things like “with rates as low as they are, it’s essentially free money.” Or “I should be able to invest my money and beat the rate of interest I am paying on the mortgage.” These are both valid comments, but at the end of the day, you’re still paying someone else interest, rather than collecting it yourself (the inverse of bond where you collect interest). Your appetite for risk is a driving force behind this decision. Yes, the historical rate of return for stocks is somewhere in the 9-10% range and your mortgage is likely less than 4.5% (more like 3.38% after-tax). However, simply opting to invest in stocks with your idle cash rather than pay down the mortgage may be easier said than done. Paying down debt offers a certain outcome immediately. Investing in stocks almost always requires a long-term view, patience, and at times some intestinal fortitude due to the volatile price swings you will likely experience.

If you are the type who sits on a great deal of cash in the bank, far beyond any logical emergency reserves, then paying down debt is a good use of that money. Think of it this way – you are just transferring your low-interest savings to a different vehicle. Keep in mind this vehicle is much less liquid than your savings, but if your income is stable and you have been carrying a heavy cash balance for a long-time, then paying down debt may be a good use of capital.

If you are a bigger risk taker, maybe investing for the long-term is a better use of your capital. Hypothetically, let’s say you have an excess savings balance (beyond your emergency reserve requirements) of $25,000. You could pay down your mortgage and save the interest expense (4% for example) or you could invest for the long-term in a portfolio of stocks of target something close the historical return of stocks (9% for example). However, it’s likely you would invest in a balanced manner, say 50% stocks and 50% bonds rather than all stocks. In this case, it might make sense to buy $12,500 of stocks and use the other $12,500 to pay down the mortgage, and replace the investment in bonds with the debt reduction. After all, a mortgage is the inverse of a bond.

My clients who are positioned to have the best outcomes during retirement usually share a few characteristics. They have ample guaranteed income (social security, rental income, public or private pension), they live within their means, and they arrive at retirement debt-free. If you are on track to have mortgage debt when you reach your planned retirement age, paying down debt should be a higher priority for you.

Beyond the basics, no one size fits all but I have never seen anyone regret paying off their mortgage.