Owning a home outright is a dream that many Americans share. Having a mortgage can be a huge burden, and paying it off may be the first item on your financial to-do list. Competing with this desire to own your home free and clear is your need to invest for retirement, your child’s college education, or some other goal. Putting extra cash toward one of these goals may mean sacrificing another. So how do you choose?
Deciding between prepaying your mortgage and investing your extra cash isn’t easy, because each option has advantages and disadvantages, but you can start by weighing what you’ll gain financially by choosing one option against what you’ll give up. In economic terms, this is known as evaluating the opportunity cost.
Neil says: Here’s an example. Assume you have a $200,000 balance on a new 4.75 percent, 30-year mortgage. If you were to put an extra $250 toward your mortgage each month, you would save approximately $65,000 in interest, and pay off your loan almost 10 years early. By making extra payments and saving all of that interest, you’ll clearly be gaining a lot of financial ground. However, before you opt to prepay your mortgage, you still have to consider what you might be giving up by doing so, such as the opportunity to potentially profit even more from investing.
Ashleigh says: To determine which option is more advantageous, start by calculating the after-tax rate of return expected from prepaying your mortgage. This is generally less than the interest rate you’re paying on your mortgage, once you take into account any tax deduction you receive for mortgage interest. Once you’ve calculated that figure, compare it to the after-tax return you could receive by investing your extra cash.
For example, the after-tax cost of a 4.75 percent mortgage would be approximately 3.25 percent if you were in a combined federal/South Carolina tax bracket of 32 percent and qualified to deduct mortgage interest on your return. Could you receive a higher after-tax rate of return if you invested your money instead of prepaying your mortgage?
Keep in mind that the rate of return you’ll receive is directly related to the investments you choose. Investments with the potential for higher returns may expose you to more risk, so take this into account when making your decision.
Neil and Ashleigh say: While evaluating the cost is important, you’ll also need to weigh many other factors. The following list of questions may help you decide which option is best for you:
• What’s your mortgage interest rate? The lower the rate on your mortgage, the greater the potential to receive a better return through investing.
• How comfortable are you with debt? If you worry endlessly about it, give the emotional benefits of paying off your mortgage extra consideration regardless of the opportunity cost of the investments.
• Will you have the discipline to invest your extra cash rather than spend it? If not, you might be better off making extra mortgage payments.
• Do you have an emergency account or have you saved enough for retirement? If your answer is no, you may wish to focus on these goals over an early payoff.
• Are you saddled with high balances on credit cards or personal loans? If so, it’s often better to pay off those debts first.
• Are you currently paying mortgage insurance? If you are, putting extra toward your mortgage until you’ve gained at least 20 percent equity in your home may make sense. Then, once you build sufficient equity in your home, apply the monthly PMI payment toward your principal balance in order to expedite the payoff date.
• How much time do you have before you reach retirement or until your children go off to college? The longer your time frame, the more time you have to potentially grow your money by investing. Alternatively, if paying off your mortgage before reaching a financial goal will make you feel much more secure, factor that into your decision.
If you need to invest for an important goal, but you also want the satisfaction of paying down your mortgage, there’s no reason you can’t do both. It’s as simple as allocating part of your available cash toward one goal, and putting the rest toward the other. Even small adjustments can make a difference. For example, you could potentially shave years off your mortgage by consistently making biweekly, instead of monthly, mortgage payments, or by putting any year-end bonuses or tax refunds toward your mortgage principal.
Remember, no matter what you decide now, you can always reprioritize your goals later to keep up with changes to your circumstances, market conditions and interest rates.
Life is a journey; plan for it.
Neil A. Brown is a CPA and CFP with Burkett Financial Services in West Columbia. Reach him at www.uscneil.com or (803) 200-2272. Ashleigh Brooker, CFP, is the principal of A.J. Brooker Financial Associates in Columbia. Reach her at info@AJBrooker.com or (803) 724-1235.