Oct. 26, 2011— -- "Sending in a little extra saves you a lot." That was my argument in last week's column about the beauties of mortgage prepayment. I showed you how by sending in just $50 extra per month on a $200,000 fixed rate mortgage of 7 percent, you will save $36,427 over the life of the 30-year loan. That's impressive, but there are still plenty of people who argue against mortgage prepayment.
In these tricky economic times, I understand the fear. Who wants to pay extra toward a house if you're under water in it, as so many Americans are? I'll give you that. If you owe more than the house is worth or you plan to sell soon, maybe this strategy is not for you. But at least let me lay out the arguments the naysayers make and my responses, because mortgage prepayment continues to be a sound strategy for many of us.
1. Their Argument: "You can make more by investing the money."
My response: Yup, you can. But you can also lose more money. When you invest in the market, your investment has the potential to go up, but it can also go down. There's risk there. Mortgage prepayment has a guaranteed return. No other investment does. And the higher your mortgage rate, the more competitive an investment it is.
I'm not sure why, but whenever financial whizzes debate this topic, they always frame it as an absolute, like you either have to put all your money in the market or all of into prepaying your mortgage. Why can't you do a bit of both? Prepaying your mortgage could be one of many investments you make, a way of diversifying your "portfolio." Or you could switch back and forth over time, putting your money in the market when it's hot and in your mortgage when it's not.
There's also the discipline factor. Yes, if you have extra money, you can make a greater return by investing it, but many of us will just spend the money instead. Investing takes will power and effort. You have to hire a financial advisor, find a stock to invest in and hope it's a good choice. Any idiot can prepay their mortgage –and I mean that as a good thing!
2. Their argument: "You should save for retirement and college first."
My response: OK, go for it. You should at least make sure you are contributing enough to get your company's 401k match, if it offers one, because that is a 100 percent return. There are great college savings plans with lucrative tax benefits as well. But, remember any amount - $100, $50 or even $25 - you send in to pay your mortgage off early makes an impact. Besides, you have to pay your mortgage off eventually. It's a debt you took on. You can either pay it early –and save a lot of money—or pay it later and save nothing.
3. Their argument: "You lose part of the mortgage interest tax break."
My response: Yes, you do. When you spend less on interest, you have less to write off. But, please, people, by prepaying your mortgage, you are slashing tens of thousands off of your interest payments. By contrast, the mortgage interest tax deduction only saves you a fraction of those thousands. It's always better to save the whole thing than part of the thing.
Keep in mind there may be prepayment penalties, but they usually only apply to paying off the whole balance or more than 20 percent of the loan in any one year. As for keeping records, your mortgage holder is required to provide a full statement at least annually, and it's a good idea to retain your bank statements indefinitely.
4. Their argument: "You should save up 6 months worth of living expenses first."
My response: Good idea. Do that…and then consider prepaying your mortgage. After all, if you lose your job but you have paid your mortgage off early, those living expenses will be next-to-nothing because you won't have a mortgage payment to make.
5. Their argument: "Money prepaid into a mortgage is not liquid."
My response: This is the most compelling argument against mortgage prepayment. I suppose it is the one risk of prepayment as an "investment." A couple of thoughts: I always believe in taking the sure savings over the possible problem. You may never have an emergency that forces you to tap the cash that is stashed in your house. If you suddenly do, you will have to refinance or take out a home equity loan and your chances of approval are much greater if you have substantial equity in the home --which you can get by, you guessed it, prepaying your mortgage.
6. Their argument: "What if the homeowner doesn't plan to keep this house anyway?"
My response: That's fine. There is no rule that says you can't sell a home that is already paid off. It gives you more equity to put toward the next one.
7. Their argument: "Real estate prices have fallen."
My response: "That's irrelevant. The amount of money you invested in your house was determined back when you bought it. If values have fallen, you still owe the same amount, whether you pay it now or pay it later when you sell. Furthermore, by prepaying your mortgage, you can save thousands in interest payments and at least cut your losses.
8. Their argument: "You could lose your equity through foreclosure."
My response: If you get behind on your house payments and you have no equity, that's when you are forced into foreclosure. If you get behind on your payments and you have equity –especially the extra equity you gain by prepaying—you can sell the house before the bank forecloses.