### To pre-pay or not to pre-pay that is the question!

Whether ’tis nobler in the mind…okay, I am not a huge Shakespeare guru, but I do fancy myself a mortgage finance guru.

Today I want to talk about whether it is a good idea to prepay your mortgage or not. I will be using some information from an economic study from the federal reserve. For those of you who like to “really get in there” the study was released by the Chicago Fed in 2006 Called “The Trade off Between Mortgage Prepayment and Tax Deferred Retirement Savings” Here is a link.

There are some key concepts that I like to point out when I get asked this question (which is a lot) when helping homeowners make this decision.

**Home equity has a 0% rate of return**(as a matter of fact the value of those dollars sitting idle in the property actually loses value due to market forces such as currency devaluation and inflation). What I mean by that is home equity increases either from you paying yourself back principal or as a function of the property appreciating. Whether you have a $100,000 loan against a property worth $100,000 (100%LTV) or you have a $10,000 loan against the same $100,000 property (10% LTV), if it appreciates by say 10% in a year, the equity gain is the same: $10,000.**Mortgage interest is simple interest and the money you invest is compounding.**What does that mean? Completely ignoring the tax implications for now, let’s say that you are paying 7% on a $100,000 interest only loan (as most HELOC’s are for the first 10 years) The employment cost (more on this in a sec) on that borrowed capital for the first year is $7,000. Now, let’s say that you took that $100,000 and invested it and managed to earn 5% on that money. So you earned $5000. So you end up with -$2000. Not a good deal right? But hang on, in year 2 you are earning that 5% on 105,000 or $5250 and you are still only paying $7000 a year in interest. Year 3 you are still paying $7000, but you earn 5% on $110,250 or $5512.50. The punchline is that if you ran this calculation out for 30 years you would have earned a net(interest earned-interest paid) of over $200,000 (assuming the interest rate stays constant which HELOC’s do not–they are based on the prime rate which is the fed funds rate +3%. The fed funds rate changes as the federal reserve raises and lowers rates). This strategy really works the best if you have a fixed rate for 30 years to take away the interest rate risk. If the loan is amortizing, the interest you pay actually decreases every year while the interest you earn grows every year. You also have to be able to make the payments on the mortgage comfortably. All the compound interest in the world doesn’t do you any good if you cannot afford to make the payments. Please keep in mind, this is a very simplistic example. There are entire books written on this very idea.**Everything in life is 100% financed.**What that means is that you either pay an employment cost which is the cost of employing someone else’s capital (in this case the mortgage rate) or you self-finance and pay an opportunity cost. A simple way to conceptualize opportunity cost is: every time you turn left, you deny yourself the opportunity to turn right. In this context, every dollar you put into the home is a dollar that you don’t have to pay interest on but is also a dollar that you cannot earn interest on. The opportunity cost also extends to the risk of job loss or injury (as we discussed in the post Ron alluded to in his answer) so there are “layers” of risk when identifying opportunity cost.**When you deduct interest (assuming you are not subject to AMT) you do so at your earned income tax bracket (can be as much as 35% federal)**. For those who are very detail oriented, you can read all about the deductibility of mortgage interest in Publication 936 of the internal revenue code. Here is a link: www.irs.gov/pub/irs-pdf/p936.pdf When you earn interest on investments and leave the money in there for at least 1 year and a day, you will pay long term capital gains tax. The top capital gains tax rate is currently 15% (changing after 2010 to 20% top bracket unless changes are made by congress). What does this mean? Well, let’s say that you are paying a 7% interest rate and you are in the top earned income tax bracket, your effective payment rate after tax is: 4.55%. Let’s further assume that you can earn 7% in an investment which is taxed at capital gains rates. Your effective rate of return after tax is: 5.95% a positive spread of 1.4%. That may not seem like alot, but it adds up to a 30.77% Internal Rate of Return. That is pretty good in my book. Keep in mind that this is a simplistic example, it is merely intended to illustrate a complicated idea known as tax arbitrage.

**DISCLAIMER:**The actual rates may be more or less and your own personal tax situation may be different–consult your tax advisor always to make sure that my crazy rhetoric would actually apply to you in the real world.**What is the meaning of debt free?**Is it having absolutely no debt or is it having enough assets in the left pocket to pay off the liabilities in your right pocket at any time. In other words, if you have $100,000 in liquid assets and a $100,000 mortgage. You are effectively debt free or at what I like to refer to a your “Freedom Point” which is the point at which your assets are equal to your debts. Given the uncertainty of the future, I personally would like to have the cash (if I can afford the employment costs comfortably) in my pocket rather than in my house if, say, lending guidelines change and I no longer can refinance to get the cash, I lose my job, I get injured and cannot work, or home values drop. If the value of your home drops below where your mortgage balance is and you have separated the cash, you can cover the shortfall if you need to sell, and maybe have even earned a little interest along the way. If the money is in your home, you have lost that wealth it until values return to their previous level–remember, gains are not profits until they are realized.

Now, if you did pay down your HELOC, that would save you the interest payments on that $10,000. At 6.49% assuming an interest only payment, you would save $54.08/month. The question is you need to answer is “does that $54.08/month stretch my budget?” As I said before, a HELOC is not a fixed rate (although many times you can fix certain portions of your balance, but we will discuss that at another time) so if rates went to say 10%, it would cost you $83.33/month.

### Bottom line is that there is no right answer

Everyone has different financial philosophies and different risk tolerances. You need to decide what is best for you. Many people make decisions about the best thing to do simply based on “conventional wisdom” rather than the economic facts. The problem with conventional wisdom is that tax laws change, lifestyles change, and the value of a dollar changes. Hopefully through our conversations on Bigger Pockets, we can raise our financial IQ so that we can make informed rational decisions about how best to utilize our hard earned cash.

## 9 Comments

A great question to ask people is:

“What’s the difference between being debt free and financially free?”.

Most people confuse the two.

Financial Freedom means not having to worry about working for income to pay your expenses.

It can be attained in one of two ways:

1. Passive investments that generate enough consistent cashflow to cover your expenses.

2. A large “nest egg” that can be liquidated over time to cover your expenses.

Drew

A lot of folks have written on this question – whether it makes fiscal sense to pay off your mortgage – but, this is the best I’ve read on the subject. Thanks for the great post.

In the first point, you say that money sitting in home equity is actually losing value due to currency devaluation and inflation; does this statement assume 0% appreciation? The real gain would be (home appreciation percentage) minus (inflation percentage), correct?

Shawn,

Yes. That is exactly what I am saying. If there is 0% appreciation, then the property still loses value do to the forces of inflation and loses relative value due to fluctuations between the dollar and other currencies around the world. Even if appreciation were positive, there could still be a nominal loss in value if the rate of inflation is greater than the rate of appreciation. Make sense?

Steve Heideman’s last blog post: Comment on What’s Ahead For Mortgage Rates after the Stimulus Plan? by Steve HeidemanSteve,

Can you send me your calculations of 200,000K Net Interest?

I ran the same numbers you did and came out with 122,000. Trying to see where I messed up. You have a very good point though.

-Justin

Will I have to pay capitol gains if my mortgage company refinances me at fair market value ( 412K worth 227K) ?

Steve, Thanks for sharing this good info post with us.

Thanks for a great post, the information was really useful and thank you to Drew that was a great explanation of the difference between those to, and you explained them in easy terms. I think I would like to financially free, but it is going to take me awhile to get there,

If you are subject to AMT, and you have a chunk of money doing nothing but sitting in a money market account with a stated “30 day yield of 0.00%” (that’s what my monthly statement now shows), why not pay down the mortgage? The fact that I have $100k in accessible funds does not hide the fact that I still have that $100k mortgage – being “essentially” debt free is costing me – because I am paying interest on the mortgage, get no benefit in deductibility, my cash is earning diddly (and even if money market rates were higher, I would be paying taxes on that income but still not getting mortgage interest deductibility) I am essentially paying my mortgage rate for having that money. It only makes sense having that money available if I can invest it in something that is going to guarantee me a risk free after tax return greater than my mortgage rate.

Considering the way things are between the economy and the stock market, I’ll take the guaranteed return of paying off the mortgage.

As to your points, #1 is clearly wrong in this situation – home equity is a guaranteed rate of return today with absolutely no risk.

#2, money you invest is compounding only if you reinvest the interest. Secondly, the fact that it is compounding only matters if the interest rate is higher than the mortgage rate (and you’re not subject to AMT).

#3 is a nice annectdote and obviously it’s true. You either finance something with your own money and then have the opportunity cost of possibly using that money for something else (as this entire discussion is about) or you finance using someone elses money and pay for using it. As I said, it boils down to whether the opportunity cost is more or less than the mortgage rate.

#4 every year more and more people are getting pulled into the AMT. As more and more people get pulled in, the more it makes sense to pay down the mortgage specifically because the interest deductibility is lost. A decade and two ago, this was one of the big benefits of taking the most money the mortgage company would give you – because the interest paid is deductible. Couple that with a low interest rate and nobody would lend you money at such ridiculously low rates. However, if you throw away interest deductibility, further reduce the amount you can make elsewhere with no risk and if you do happen to make money elsewhere you’re fully taxed on it. Again, more reason to pay the mortgage down.

“Let’s further assume that you can earn 7% in an investment which is taxed at capital gains rates.”

When you make assumptions, you had better look at what happens if your assumptions are all wrong. Is your 7% return guaranteed with zero risk? You’re guaranteed to be making your 7% year in and year out with absolutely no risk to your principal? Your answer is definitely no and therefore you are not making a valid comparison. Paying down the mortgage is a guaranteed return with zero risk. This is exactly why so many cities and municipalities are getting killed today with all of these newfangled derivative products that Wall St. put over on them – because they never considered “what if” their assumptions were wrong. If you are investing for a 7% return, when the Fed rate is less than 1% you are taking on risk – I don’t care what you are investing in.

#5 – as I mentioned, being “essentially debt free” doesn’t do it for me in my book because if you’re paying more than you’re taking in, it makes no sense not to pay off the mortgage. If you have no other savings or assets and need the cash for your emergency fund, then again, though you may be essentially debt free, you’re not debt free and therefore are still paying for the privilege of having that money on loan.

“Bottom line is that there is no right answer”

I would be more inclined to agree with you on that. However, based on everything you had written up until that point, that conclusion appears to come from out of left field in blatant contrast to all the points you’ve previously made.

In any case, this topic has gotten more airtime in the media recently as the markets and housing tanked and interest rates are at historical lows. It can makes lots of sense to pay down the mortgage depending upon the homeowner’s financial situation.

Another factor to consider when deciding to pay it off and have no more mortgage is whether or not you are carrying any other debt and what it’s cost is.

You also need to figure out with a prefessional where you are in regards to building an adequate retirement account. Being simple interest and generally tax deductible, your mortgage is usually the cheapest debt you have, and there are good cases for most people to not lock up their money by paying down the mortgage.