Should You Pre-Pay Your Mortgage?
Paying Off Your Mortgage It's Not as Attractive as It Sounds
Save, Save, Save
A critical component for developing future security is the practice of "paying yourself first". One popular way to accomplish this objective is to pre-pay your mortgage, reducing the total interest owed and eliminating future payments.
If you have a home loan, you'll inevitably be offered an opportunity to "save money" by enrolling in a bi-weekly payment program. In one recent example, a borrower could save nearly $31,000 by eliminating five years and five months of payments on a loan amount of $197,500.
The logic behind this savings program is simple. Many people get paid every other week. Based on this schedule, each time a paycheck is received, half of the mortgage payment would be paid on the borrower's behalf. During the two months when three paychecks are received, two extra half payments would be made, equating to one extra mortgage payment each year.
Others may choose to pre-pay their mortgage in different ways, but the benefit is basically the same. Some individuals make lump sum pre-payments when they get a bonus or a tax refund check, while others simply add a little extra to their payment each month. Another option is to take a shorter term loan such as a 15-Year Fixed Rate. Regardless of the method chosen, prepayment does appear to save the homeowner money. The question is, do prepayments make the most of your investment dollars?
Hold That Check
The Federal Reserve Bank of Chicago recently released a paper, The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings, which demonstrates the benefits of not prepaying your mortgage but choosing to fund your retirement instead.
Many homeowners may think they're already making progress towards retirement by paying down their mortgage at a faster rate. After all, a penny saved is a penny earned, regardless of where it's placed. Besides, the objective is to pay off your mortgage as soon as possible so mortgage payments don't have to be made during retirement.
The key factor to keep in mind though is something called arbitrage. The Merriam-Webster Dictionary defines arbitrage as "the nearly simultaneous purchase and sale of securities or foreign exchange in different markets in order to profit from price discrepancies." While we're not discussing securities here, we are talking about money. So, here's an example to help clarify things. If you were to borrow money at 4.00% and invest it at a return of 12.00%, this would be considered arbitrage. Banks do this every day.
How is this relevant to you? Well, the IRS allows you to contribute a portion of your earnings each year into a Tax-Deferred Account (TDA), such as a 401K or Individual Retirement Account. The benefit of doing so is that you forgo taxation today, when you're most likely being taxed at a higher rate. When you withdraw the funds in later years, your earnings and your tax rate will probably be lower. In addition, you'll benefit from having a compounded rate of return on the non-taxed funds, allowing them to grow to a higher balance until the time comes to draw on the account.
Analyzing the Difference
In the report by the Federal Reserve, the authors stated that by choosing to accelerate mortgage payments in lieu of funding a TDA, American homeowners may cost themselves as much as $1.5 billion a year! This doesn't even take into account the money that many homeowners withhold from their company-matching 401K plans.
Furthermore, by choosing to fund a TDA, the resulting savings to the individual homeowner could yield 11 to 17 cents per dollar, depending upon the choice of assets in the TDA. While the reasons for choosing to pay off a home loan early can vary from person to person, it is estimated that about 38% of U.S. households are costing themselves a lot of money simply by making the wrong choice of where to direct their money.
What to Do Now
If your company offers a 401K program and you aren't participating, then enroll yourself as quickly as possible. If you're unable to enroll this year, plan on doing so next year. Contribute the maximum amount you can without causing financial hardship. If your company offers a matching plan, take advantage of the full amount available. This is a 100% return on your money! If you don't have the ability to participate in a 401K program, consult with a Financial Advisor about starting an IRA. For those of you who are self-employed or employed by a small business, there are several programs you can investigate. A call to your Financial Advisor would definitely be worthwhile.
If you're participating in a bi-weekly mortgage program or making advance principal payments against your home loan while not fully funding your retirement accounts, STOP doing so. In addition, if your current home loan is set at a term of less than 30 years, you may want to consider restructuring your loan to allow for higher retirement fund contributions.
For a simple analysis of which options may be best for you, place a quick call to your Mortgage Professional or Financial Advisor. These experts will help you to achieve financial security in the years ahead. With home loan rates approaching their lowest point of the year, this is a great time to investigate how you can make your home, and home loan, work for you.