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I recently refinanced my $260,000 mortgage at 4.6 percent for 15 years. I can also afford to pay an additional $900 per month on the loan, which would pay it off in just over nine years. Am I better off investing the $900, or prepaying my mortgage? I plan on working at least 17 more years.
-- Geri Woodward, Cave Creek, Arizona
There are financial considerations and non-financial considerations when it comes to deciding whether to use extra cash to prepay your mortgage.
On the non-financial side, there's the warm and fuzzy feeling that comes from knowing you own your house free and clear. You don't have to send that mortgage check off each month (although you still have to pay insurance and real estate taxes, maintenance, etc.).
On the financial side, the question largely comes down to whether the rate of return you can earn by investing your extra cash is higher than the rate on your loan. In other words, can your investment earnings exceed the interest savings you would receive by prepaying?
How much would you save, either way?
Assuming a 25 percent tax rate, your 4.6 percent mortgage has an effective after-tax rate of about 3.5 percent. So the question is, do you think you can earn more than 3.5 percent after-tax by investing your cash?
Obviously, there are no guarantees when it comes to investments. But I think the odds are pretty good that a diversified portfolio that includes mostly stocks (for long-term growth) and some bonds (for stability) can do better than 3.5 percent after tax.
Only you can decide whether to give the non-financial or the financial factor more weight in your decision. But if I were in your position, I think I'd be more likely to invest the extra $900 per month.
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Why? Well, I suspect that the biggest reason most people want to pay off their mortgage is so that they don't have it hanging over their head in retirement. When you have less income coming in, it's nice to have lower expenses as well.
You mention that you plan to work for 17 years. That means that if you continue to make scheduled payments to your loan, you will pay it off in 15 years, or two years before you retire. So it seems to me you've already put yourself on a course to have no mortgage when you retire.
Have both benefits
If you continue to pay off your mortgage and invest your $900, then not only will you have no mortgage debt when you call it a career, you'll have a tidy little pool of assets as well that you can draw on for retirement income.
It's true, of course, that if you pay your mortgage off in roughly nine years and then invest the money that would have gone toward the mortgage payment for the next six years (the remainder of your original mortgage term), you'll also have a nice little investment stash.
But, all other things being equal, I'd rather start my investing plan earlier than later because I think it gives you more flexibility, which is another reason I'd be more apt to take the investing rather than the prepayment route.
One final note: Mortgage rates began climbing after the Fed cut the fed funds rate last week. Apparently, bond investors feel the economy may be ready to start growing more strongly, which would put upward pressure on rates in the future.
But you never know. If economic data comes in that shows the economy is still struggling, it's possible we could see mortgage rates head south again. So keep your eye on the mortgage market. If rates do fall for whatever reason, you might want to consider refinancing again (assuming you can recoup the costs of refinancing within a reasonable period of time). A lower rate means interest savings for you -- and lowers the hurdle your investments have to beat if you decide to prepay.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged."
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