When It Makes Sense to Prepay Your Mortgage
By Jim Krapfel, CFA, CFP
May 2, 2022
Mortgage rates had been so low in recent years, with numerous households securing rates below 3%, that it made little financial sense for most to prepay a mortgage, which is to make more than the standard payment each month. However, mortgage rates have exploded higher this year with the average conventional 30-year fixed rate shooting up to 5.1%, up from 3.1% in December. Similarly, the 30-year mortgage on jumbo loans, which are for loans more than $647,200 in most geographies, just reached 4.9%, versus 3.2% in December.
Rates this high for new mortgage owners begs the question if accelerating principal payments begins to make sense. In this financial planning article, we discuss the necessary conditions that make prepaying a mortgage a prudent financial move, strategies for executing it, and how prepayments affect future mortgages payments.
When It Makes Sense to Prepay a Mortgage
Making the regular mortgage payment is already a major financial commitment for most people. Before we dive into whether to commit even more cash to a mortgage, we want to be sure we’re accomplishing the following, in rank order:
1) Pay off very high interest rate debt such as credit cards. We consider very high interest debt to be anything that has at least a 10% interest rate.
2) Establish an emergency fund of 3-6 months’ worth of expenses. Those who have highly secure jobs, come from dual income households, possess large liquid invested assets (such as brokerage accounts), and/or exhibit greater risk tolerance can target the low end of the range.
3) Contribute an amount to a 401(k) that generates the maximum employer matching. That is free money after all!
4) Pay off other high interest rate debt. We consider high interest debt to be anything that has at least a 6% interest rate.
5) Contribute the annual maximum to a Health Savings Account if enrolled in a high deductible healthcare plan. Contribution limits in 2022 are $3,650 for self-only coverage and $7,300 for family plans. See our article on why HSAs are an underappreciated retirement vehicle.
6) Contribute to a 529 college savings plan if you have children and wish to help fund their education. See our article on why 529 plans are best in class.
7) Contribute an amount to a 401(k) that represents the portion not matched by the employer. Total employee contributions are limited to $20,500 (or $27,000 if 50 or older) in 2022.
8) Contribute to an IRA if you do not earn too much to receive a tax deduction in the case of a regular IRA or earn too much to contribute at all in the case of a Roth IRA. Maximum contribution is $6,000 (or $7,000 if 50 or older) in 2022. If you earn too much to contribute to a Roth IRA, a Backdoor Roth IRA could be executed if you do not have assets in a taxable IRA. See our article on how a Backdoor Roth IRA could pad your retirement.
If there are available funds after all these items are funded, then we can look to whether it makes sense to prepay a mortgage versus investing the funds in a taxable brokerage account. There are clear tradeoffs to each.
The benefit to prepaying a mortgage is that you’re guaranteed to “earn” a return in the form of saved interest payments. If you take the standard deduction on your tax return (versus itemizing), as over 90% of American households do, then your mortgage interest payments are non-tax-deductible. This means that prepaying your 5% mortgage results in a 5% tax-adjusted return too.
The major downside of prepaying your mortgage is primarily the opportunity cost of investing those assets. Indeed, investing in the S&P 500 has compounded at a 9.4% annual rate over the last 50 years. Even if you tax effect the stock market return to 8%, the cumulative return over a hypothetical 30-year period would have been 906% when investing versus 332% for prepaying a 5% mortgage. Prepaying your mortgage also makes your money less accessible should a major expense or financial emergency arise.
Figure 1: Pros and Cons of Prepaying a Mortgage
Source: Glass Lake Wealth Management
The breakeven mortgage interest rate unto which one is indifferent on the two depends on one’s risk tolerance level. For a person with average risk tolerance, 4.5% sounds reasonable. For a high risk tolerance individual, such as someone in their 30s with no other major financial obligations, then as high as 6% could be the breakeven point. Conversely, one with low risk tolerance, such as a 60-year-old woman who would like to retire in five years and does not have much cushion in her retirement plan, then 3% could be it.
Strategies for Executing a Mortgage Prepayment
This is not an all-or-nothing proposition, of course. An average risk tolerance person with a 4.5% mortgage rate could devote 50% of excess savings to each of mortgage prepayment and investing. Conversely, a high risk tolerance person with the same mortgage might devote just 20% to prepayment, while a low risk tolerance person might allocate 80%. It all depends on the individual’s preferences and particular financial situation.
As far as actually making the contribution, there are several options that could suite you well. Many people opt to pay half the mortgage amount every two weeks if they’re paid bi-weekly, which results in making an extra mortgage payment each year. Others choose to schedule monthly payments that exceed the required mortgage payment if the extra payments are not expected to crimp their monthly budget. A third option is a once- or twice-a-year extra payment that corresponds to anticipated financial windfalls such as an annual bonus or tax refund.
What If I’m Paying Mortgage Insurance?
Private Mortgage Insurance, better known as PMI, is typically required by lenders if less than 20% down payment is made on a home purchase. PMI protects the lender if the borrower defaults on the loan. The cost for PMI is typically tacked on to the mortgage payment as a percentage of the mortgage. The percentage can vary widely depending on your credit score and down payment, but 0.5% to 1.0% is typical.
If you have PMI then you have extra reason to pay down your mortgage early because once you have established 20% equity in your home, or as the mortgage industry refers to it – 80% loan-to-value (LTV) -- you can request to stop paying PMI. In such case, PMI removal ought to be granted if mortgage payments are consistently made on time. PMI automatically ends once LTV reaches 78%.
If your home has significantly appreciated since taking out your loan, you could instead ask your lender to reappraise your home to see if you can reach an 80% loan-to-value. You would have to shell out several hundred dollars for an appraisal, but you could lower your mortgage payment significantly without having to prepay your mortgage or waiting years until enough principal was paid to reach 80% LTV.
What Happens After Prepayment Is Made?
You may understand how mortgage amortization tables generally work, but let us review. A key feature is that the monthly mortgage payment is fixed through the duration of the loan. As Figure 2 illustrates, the composition of payment in the early years is largely devoted to interest, with a greater share of the payment going towards principal as time goes on.
Figure 2: Abbreviated Amortization Table on a $500,000 30-Year Fixed Mortgage at 5%
Source: Glass Lake Wealth Management
Prepaying a fixed-rate mortgage does not change the monthly payment amount (though an ARM does). Rather, it shortens the duration of payments. It also shifts a greater portion of future mortgage payments to principal reduction and away from interest.
Let us work through an example in which the same borrower pre-pays $100,000 with the third mortgage payment. As expected, future mortgage payments stay the same, a greater share of future payments apply towards principal reduction, and in this case, mortgage payments cease 10 years, 5 months early. Interest saved over the life of the loan by prepaying the $100,000 is $236,793.
Figure 3: Revised Amortization Table With $100,000 Prepayment in Month 3
Source: Glass Lake Wealth Management
Bottom Line
New mortgage owners faced with higher mortgage rates, especially those with PMI, could benefit from making more than the required mortgage payment to secure a decent return and manage risk. When a fixed-rate mortgage is prepaid, future mortgage payments do not change but one benefits from having a greater share of payments being applied to principal paydown and becoming mortgage-free sooner. Before considering prepaying your mortgage, be sure that prioritized contribution buckets are filled up first.
Disclaimer
Advisory services are offered by Glass Lake Wealth Management LLC, a Registered Investment Advisor in the State of Illinois. Glass Lake is an investments-oriented boutique that offers a full spectrum of wealth management advice. Visit glasslakewealth.com for more information.
This article is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory, legal, insurance or accounting services or an offer to sell or solicitation to buy insurance, securities, or related financial instruments in any jurisdiction. Certain information contained herein is based on or derived from information provided by independent third-party sources. Glass Lake Wealth Management believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions in which such information is based.