Suppose that I have a loan of 260,000 in a 10-year payment plan at 7.2% interest. The monthly payment is $3045. Let’s say I can make the monthly payments, and I have an extra $2500/month lying around. Is it more beneficial to use the extra $2500 to prepay the principal every month, or to put it into stock/savings?
So, let’s assume that I am in the 28% tax bracket, and that the average annual inflation rate for the next 10 years is 2.7%. I tried some preliminary calculations using online calculators and come to the (possibly faulty) conclusion that if my stocks/saving earn about 6.5% interest per year, then both scenarios are roughly equivalent after 10 years. However, that was before I considered tax deductions on the loan interest, and also capital gains tax on the stocks/savings. So, I pose this question to the Dope. Is it better to prepay or to save in this scenario?
First, you have to look at risk and evaluate what levels are tolerable. Paying off the home mortgage is a guaranteed return, and leaves you with smaller financial obligations. Therefore, even if an investment plan yielded broke even compared to paying off the mortgage, you’d have to do more than break to justify the added risk.
Second, (and more directly related to your question) future tax rates and deductions are a wild card right now. There are proposals on the table to increase upper tax rates, to eliminate/reduce the benefit from mortgage interest deductions and to increase the capital gains rate. It’s very hard to know what Congress will do. I’m not sure any projection past two years is worth the paper it’s printed on; you might run several scenarios or perhaps do a worst-case scenario to try to evaluate the best option.
If you want to take taxes into consideration using current rates:
With your mortgage, then treat the effective interest on the mortgage as 28% less. (But keep in mind as the interest gets low that the standard deduction means there is no benefit to the mortgage interest once your total itemized deductions are below the standard).
With the tax on your earnings, that would be either 28% (for interest or short-term capital sales) or 15% (for long-term capital gains). Capital gains are taxable until you sell, but it might be simplest to assume they’re taxed each year. In any event, you subtract that from the rate being paid.
Personally, I wouldn’t even bother with the math. Get a rainy day fund established and then pay off the mortgage. Money invested needs to be money you can afford to lose.
Exactly. You can view the difference in the payments as the cost of an insurance policy that protects you against changes in interest rates. Over the lifetime of a typical home mortgage, that’s a pretty significant protection.
You shouldn’t just compare the rates; you should consider risk.
You can get a risk-free 7.2% return by paying extra on your loan. The stock market might have average returns higher than that, but the risk is much higher. If you compare this return to other risk-free investments (say, T-bills), you can see that 7.2% is a huge return for a low risk investment.
Another way to think about this is, if you didn’t have a loan, and someone offered you one for 7.2%, would you take it and put the money in the stock market? It’s the same financial tradeoff.
A variation on the OP - instead of investing in stocks/savings how about taking the extra money and putting it into a retirement account such as an IRA or Roth fund? If the money put into the fund is pre-tax dollars does that change the conclusion?
One aspect you didn’t mention is: 1) How is your mortgage contract set up? Some contracts (at least by German banks) don’t allow premature pay-off at all, only the fixed rate. Some allow with a penalty, some allow you to pay additional whenever you want.
1a) If you can do additional premature payments, is it the same ratio of debt: interest as your normal payments or does it only reduce the debt? The quicker you reduce the debt itself, the less interest you have to pay.
1b) If your contract does not allow any premature pay-off, you should look around if a better contract is available and if you can switch. Depends on the current interest rates and other conditions of course.
If you dump $10K into paying down the principal today, you can’t easily get that money back 4 years later when your plans change. OTOH, if you store the $10K in some investment with a similar return, you can change your mind 4 years from now and redeploy the capital (plus gains) elsewhere.
Paying down the mortgage is low risk but nil liquidity. Investing elsewhere usually has high liquidity but *may *involve risk.
My investments are easily beating the 3% after taxes (1% after taxes and inflation) I’m paying on mortgage interest. For me, paying down principal early makes no sense. I get a better ROI invested elsewhere *and *have better almost-guaranteed liquidity.
Yes, there is some non-zero counter-party risk that I’ll lose principal. OTOH, I’d rather walk away from a half-paid-for house eaten by a tornado than a fully-paid-for house eaten by the same tornado. Counter-party and other bolt-from-the-blue risks are real; the hard part is being both honest and thorough about assessing *all *such risks for both the pay-off and the hold-wealth-elsewhere scenarios.
You can try doing a very detailed analysis of your net cash flow over 10 years:
Total payments out (including prepayments), minus the tax impact. Add up how much that is.
Then compare that to the amount you’d have on hand if you invested that extra couple hundred dollars a month and got X rate of return (look at it both as an IRA and as a standalone investment to get the best picture).
If you’ll have more wealth (including the equity in the house) with the mortgage not prepaid, than you would if you did prepay the mortgage (and again, include the value of the house), then don’t prepay.
As others have noted, you’re looking at a 7.2% guaranteed rate of return, at the tradeoff of less liquidity. Only you know whether it’s worth it.
Why not split the difference? Put half of that prepayment money toward the mortgage, invest the other half.
Oh - and as others have noted: the interest rate on a 10-year mortgage is a LOT lower than 7.2%. I’d seriously consider refinancing. You might even get a no-closing-cost mortgage where they basically include the costs in the rate (or add to the loan balance) - zero cash up front, likely a substantial reduction in payments.
Then continue making your current payment, and you win all around :).