By Simon J. Lau, CFA
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Prepaying Your Mortgage: Smart Strategy or Costly Mistake?
Deciding what to do with extra cash is one of the most important financial choices homeowners face. Should you funnel it toward paying down your mortgage faster, or could that money work harder for you elsewhere? With rising interest rates on savings and investment accounts, many are rethinking their strategies. What was once a no-brainer—prepaying the mortgage—might not be the best move in today’s financial landscape.
Recently, I received a letter from a reader grappling with this exact dilemma. He’s been diligently prepaying his mortgage but is now questioning whether it’s the best use of his funds given the current economic environment. Let’s dive into his question and explore whether prepaying your mortgage is a smart strategy or a costly mistake (edited for clarity):
Dear Simon,
My wife and I own our home, and we’ve been prepaying our mortgage by making an additional $500 payment toward the principal each month (or $6,000 a year). We were fortunate to lock in a favorable mortgage rate of 3%, but we’ve noticed that interest rates on money market accounts have climbed to over 5%. This has left us wondering whether we should continue prepaying our mortgage or if it would be better to invest the extra money instead. We want to make the most financially sound decision—can you help us weigh our options?
Sincerely,
Conflicted Homeowner
Dear Conflicted Homeowner,
This is an excellent question and one that many homeowners grapple with at some point. Before diving into the specifics, let’s discuss the core principle that should guide your decision-making process:
Opportunity Cost
When deciding whether to prepay your mortgage, it’s essential to consider the concept of opportunity cost. Simply put, opportunity cost is the potential benefit you miss out on when choosing one option over another. In your case, the decision is between prepaying your mortgage or investing your money elsewhere.
When Not to Prepay
The primary factor in this decision is the comparison between your mortgage interest rate and the return you could earn by investing that same amount into a money market account (or equivalent low risk investment) instead. In your situation, with a mortgage rate of 3% and current market conditions where money market accounts offer higher returns, the numbers suggest that investing your money rather than prepaying the mortgage would be better. Here’s why:
- Higher Returns: If you can place your extra funds in an account or investment that yields more than 3%, you’re earning more on that money than the interest you would save by paying down your mortgage. This difference in interest rates translates to higher overall earnings over time.
- Liquidity: Money market accounts and other investments often provide greater liquidity, meaning you can access your funds more easily than if they were tied up in your home equity. This flexibility can be crucial in emergencies or if other investment opportunities arise.
- Tax Considerations: Depending on your situation, you might also benefit from mortgage interest deductions on your taxes. Although these benefits have been reduced in recent years, they can still provide some financial relief, making prepaying even less attractive.
When Prepaying Might Make Sense
This approach should generally only be considered if and when your mortgage rate is higher than the interest rates one can earn in a money market account. In these cases (which don’t apply now), you may want to consider prepaying for the following reasons:
Risk Management: Prepaying your mortgage can also serve as a form of risk management. If market conditions are uncertain or if you’re uncomfortable with the potential volatility of other investments, paying down your mortgage can provide a stable, predictable financial outcome.
Debt Reduction: Reducing your overall debt can also lead to greater financial peace of mind. Without the burden of a mortgage, you may feel more secure and financially independent, especially as you approach retirement or other significant life events.
Focus on Long-Term Goals: For those with a short-term focus, such as an impending retirement or a need to reduce monthly expenses, prepaying the mortgage can lower your fixed obligations. This can be particularly beneficial if you anticipate a decrease in income or a need for increased financial flexibility in the near future.
Making the Numbers Add Up
By leveraging our Prepayment Calculator, we can quickly see how much you (Conflicted Homeowner) can save in interest in the first year and compare it to how much you would have earned if you had placed that money in a money market account earning 5%.
Scenario 1: Prepaying the Mortgage
Mortgage Rate: 3%
Extra Monthly Payment: $500
Total Extra Payments in One Year: $6,000
Interest Savings Calculation: By prepaying the mortgage, you would save approximately $97.50 in interest in the first year.
Scenario 2: Investing in a Money Market Account
Money Market Interest Rate: 5%
Total Investment in One Year: $6,000
Interest Earned Calculation: If you invested the same $6,000 in a money market account earning 5% interest, you would earn $162.50 in interest over the year.
Conclusion
You should invest your money in a money market account rather than prepay your mortgage. The numbers make this decision clear: the interest earned from investing in a money market account ($162.50) is 67% higher than the interest saved by prepaying the mortgage ($97.50).
Not only do you generate more interest income by investing, but you also maintain liquidity. This liquidity can be a crucial financial resource, whether used as part of an emergency fund or to prepay your mortgage later if interest rates on money market accounts fall. By keeping your money in a liquid investment, you capture the net benefits of higher returns without any significant downside risk. In contrast, money used to prepay a mortgage is locked away in your home equity, making it less accessible and reducing your financial flexibility.
Additionally, depending on your circumstances, you may benefit from a higher mortgage balance through mortgage interest deductions on your taxes. Mortgage interest is tax-deductible for many homeowners, and maintaining a higher mortgage balance means paying more interest, which can increase your tax deduction. This deduction can effectively reduce your taxable income, offering additional financial benefits that further enhance the attractiveness of investing over prepaying.
This strategy not only enhances your financial position but also preserves your flexibility, ensuring you’re ready to seize future opportunities or navigate challenges that come your way.
All my best,
Simon
Disclaimer: The information provided is for informational purposes only and does not constitute financial, legal, medical, or professional advice. Users should consult qualified professionals for advice tailored to their specific needs. The author and publisher are not responsible for any errors, omissions, or damages arising from the use of this information. By using this content, you agree to hold the author and publisher harmless from any claims or liabilities.
