The Cost of Prepaying
We prepay our mortgage. I’ve written about before about my thinking on the matter. Basically, for me the psychological benefit of having the mortgage paid off outweighs the potential financial cost. But, as Lazy Man commented on that post, there is a possible cost.
I figured out our cost in real dollars for paying off our mortgage early. Assuming a $200,000 mortgage at 6% and $200 extra per month going either to investments paying 8% or the mortgage balance, it costs $77,671 to prepay(tax consequences have been neglected, mostly because I’m too lazy to include them). I pay off the mortgage nine years early, but at the end of 30 years, I’m poorer by $78,000.
Or am I?
The assumptions in this example are important. The key one is the rate of return. Just recently, I figured out and wrote about the effect of volatility on return.
Basically, it’s not completely realistic to assume a steady 8% return from investments in things like stocks. You can do that with fixed-rate instruments like CDs and savings accounts or retiring debt (like a mortgage or credit card). But you really can’t just assume a smooth 8% (or any other percent) return on equities.
This is something Suze Orman and I actually agree on. The return on investment from prepaying your mortgage is a sure thing. Not so with stocks. ‘Long term,’ yes, stocks average better than my 6% mortgage. It just depends on how long you have to wait for that average.
So thanks go to Lazy Man for making me consciously think about and calculate the effect of our prepaying our mortgage.
August 22nd, 2007 at 9:57 am
Another item I think you can make a point on is what you will be doing with the extra money after you’ve paid off your mortgage. I don’t currently own a home but am trying to pay off my car a couple years early. My plan is once I have the car paid off to take the $300 a month payment and put towards a house or savings or retirement. I haven’t done the math but I feel like I can catch back some of the “losses” for prepaying that way and I will feel better about not having the debt on my mind.
August 23rd, 2007 at 5:52 am
over the long term and 20-30 years is a long time, 8% isn’t unreasonable. Even then, I would also point out that the equity in a house is not appreciating and is in fact decreasing according to inflation. If you want to tap equity in the house you either have to sell the house or take out a HELOC. To me, paying interest to tap equity in the house doesn’t make sense; whereas, if you kept the difference in payments liquid, you wouldn’t have to take a hit on interest. If you sell the house, are you going to be able to afford to buy a house at retirement or even when you are working? There are plenty of people with lots of home equity that cannot tap the equity by selling the house. The house may not be in an appreciating market, it may be in a flat or depreciating market. In the latter two cases, you lose at worst inflation in the equity of the house.
August 23rd, 2007 at 8:45 am
I just don’t get the piece of mind from having the house paid off that makes it worth having less money at the end of the day. I know that piece of mind is often worth paying for, but in the case of a mortgage, I don’t get the piece of mind, so I don’t want to pay for it.
I just think the house being paid off is an old fashioned and societally programmed goal for middle agers. It’s not a big deal. They’re not going to come kick you out of your house just because you owe money on it. As long as you can meet the payment schedule, it’s just money coming and going from the account like any other bill. You’re still living in the house and living your life and you’ll probably never even meet anyone that has loaned you the money. Alright, so you have a bunch of money freed up earlier than 30 years. Big deal. You could’ve had some of that money freed up way earlier if you hadn’t just voluntarily given it to the mortgage company so they could do more with it than making 6% off of it by loaning it to you.
August 24th, 2007 at 11:33 am
[…] Personal Finance ponders the cost of prepaying a mortgage. At the moment, we do not currently pay extra towards our mortgage because our mortgage rate is […]
August 24th, 2007 at 2:00 pm