If you own your home and/or investment property, especially if you are nearing retirement years and want to enjoy your properties with no monthly mortgage payments to make, your first thought might be prepaying the current mortgage.
For example, if you have a 7 percent home mortgage interest rate and you make an extra $100 principal payment this month, you really invested your $100 at 7 percent because you won’t have to pay any more interest on that borrowed $100. Your investment “earnings” from prepaying mortgage principal come in the form of future interest savings over the remaining life of that mortgage. In other words, you will avoid paying interest on the $100 of that mortgage principal this year, next year and every year in the future.
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In addition to the obvious interest savings, here are the important things to consider about prepaying an existing mortgage:
1. Unless you plan to keep a property at least 10 years, prepaying part of the mortgage principal periodically won’t result in much total interest savings. The reason is the extra principal payments shorten the life of the mortgage, and the interest savings come at the end or last few years of a mortgage’s term.
2. Prepaying on a mortgage balance will leave the borrower with less cash available for other purposes. For this reason, it is often not smart to make a large lump-sum mortgage prepayment because you can’t easily get that money back if you need it for an emergency or investment sometime in the future.
3. An exception to the rule that money “invested” prepaying a mortgage cannot be easily borrowed again except by refinancing with a new mortgage is a home equity line of credit (HELOC). Paying off or paying down a HELOC balance results in instant interest savings from prepayment, but the money can be quickly re-borrowed again by writing a check on the HELOC account. That’s why I recommend, after paying off your mortgage, obtaining a HELOC secured by that property for emergency use.
4. If your existing mortgage has only a few years remaining, such as a mortgage in the 25th year of a 30-year amortized term, the actual interest savings will be small. This is hard to explain, but the reason is in the last few years of an amortized long-term mortgage, most of each monthly payment goes toward paying off the principal balance and very little is tax-deductible interest.
The best way to understand this is to print out a monthly amortization schedule of your mortgage for its remaining years showing each month’s allocation to principal and interest. If your lender provides a monthly payment statement, you will see this principal-interest allocation each month.
5. If your home mortgage requires PMI (private mortgage insurance) monthly premiums, when the loan balance is paid down below 78 percent of its original balance (usually after about 11 years), be sure the lender cancels your PMI premiums. Or, if your loan-to-value ratio is 80 percent or lower, and you have an on-time payment record for the last 24 months, most mortgage lenders will cancel your PMI if you pay for a new appraisal by one of their “approved appraisers.” Check with your lender if you think you are eligible to cancel your PMI either from principal reduction and/or property-value appreciation. The PMI monthly premium savings can be huge!
6. Forget about losing the income tax interest-deduction savings on your home mortgage. The reason is it is not a dollar-for-dollar saving. To illustrate, if you pay $100 of mortgage interest and are in the 28 percent income tax bracket, you save $28 of federal income taxes for each $100 of home mortgage interest deducted. Paying $100 of mortgage interest to the lender to save $28 in income taxes is obviously NOT a “good deal.” Of course, it’s better than no tax deduction at all!
7. The “psychic value” of owning a property free and clear seems to be the major motivation why many homeowners make extra mortgage principal payments. Frankly, I own one property free and clear, but that property worries me because I think I have too much idle equity at risk in it. So I got a $100,000 HELOC on it just in case I need some “fast cash!”
(For more information on Bob Bruss publications, visit his
Real Estate Center).
