Early Mortgage Repayment: Pros and Cons

When you work through the numbers, the savings that stem from early repayment of a loan can seem almost too good to be true. Can a few dollars a month really add up to, for example, $25,000 of savings?

Well, sort of.

When you save money over long periods of time and let the interest compound, the amount of interest you ultimately earn becomes very large. In effect, when you pay an extra $20 a month on a 9% mortgage, you’re saving $20 each month in a savings account that pays 9%. By “saving” this $20 over more than 25 years, you earn a lot of interest.

In the earlier example, this monthly $20 really would add up to roughly $23,000.

But you can’t look just at the interest savings. If you placed the same $20 a month into a money market fund, purchased savings bonds, or invested in a stock market mutual fund, you would also accumulate interest or investment income.

How can you know whether early repayment of a loan makes sense? Simply compare the interest rate on the loan with the interest rate (or investment rate of return) you would earn on alternative investments.

If you can place money in a money market fund that earns 6% or repay a mortgage charging you 9%, you’ll do better by repaying the mortgage. Its interest rate exceeds the interest rate of the money market account.

But if you can stick money in a small company stock fund and earn 12% or repay a mortgage charging you 9%, you’ll do better by putting your money in the stock fund.

One complicating factor, however, relates to income taxes. Some interest expense, such as mortgage interest, is tax-deductible. What’s more, some interest income is tax-exempt, and some interest income isn’t tax-deferred. Income taxes make early repayment decisions a little bit complicated, but here are three rules of thumb:

• Usually, if you have extra money that you can tie up for a long time, you’ll make the most money by saving your money in a way that provides you with an initial tax deduction and where the interest compounds tax free, such as a 401(k) plan or an individual retirement account (IRA). (Opportunities in which an employer kicks in an extra amount by matching a portion of your contribution are usually too good to pass up—if you can afford them.)
• If you’ve taken advantage of investment options that give you tax breaks and you want to save additional money, your next best bet is usually to pay off any loans or credit cards that charge interest you can’t deduct, such as credit card debt. Start with the loan or credit card charging the highest interest rate and then work your way down to the loan or credit card charging the lowest interest rate. For this to really work, of course, you can’t go out and charge a credit card back up to its limit after you repay it.
• If you repay loans with nondeductible interest and you still have additional money you want to save, you can begin repaying loans that charge tax-deductible interest. Again, you should start with the loan charging the highest interest rate first.

If you are considering early mortgage repayment, consider discussing this idea with us next time we work together on your tax return. We may together be able to identify a better way to build your wealth. For more information about how to reach us, visit our contact page.