There's one nearly existential question that every homeowner faces at some point: Should I prepay my mortgage? In a word – no!
On paper, prepaying the principal on your home loan looks like a huge win. By just adding some extra money to your monthly mortgage payment, you'll speed up paying off your house and cut tens of thousands of dollars in interest off your home loan. How can you lose?
It sounds great, especially when the stock market is spinning its wheels, because you can lock in a return equal to your mortgage interest rate. If your home loan is at four percent, any principal you knock off early gives you a four percent return – guaranteed. But for most of us, it's a bad, bad idea.
Why You Shouldn't Prepay Your Mortgage
First off, mortgage debt is usually your lowest-rate borrowing, so if you have any other kind of debt, you're better off paying down those loans first. Even the best low-rate credit cards are charging interest rates that are much higher, and student loans can charge more than ten percent. With rates on a fixed-rate mortgages between three and four percent, you're much better off directing any extra cash you have at other debt first. The only exception might be an auto loan, if you managed to score a low-rate car loan, which can go for as little as 1.99 percent. If you want to reduce your interest payments and lower your debt, try the free Debt Optimizer by MoneyTips.
If you're paying more than the current three to four percent rate for fixed mortgages, you could be better off refinancing your loan instead of prepaying it. Check the rates and your total outlay of cash over time to see whether you can save.
The second reason you don't want to prepay your mortgage is that your home is an extremely illiquid investment, meaning it's incredibly hard to get cash out of it in an emergency. Consider all those people who saw the value of their homes crash during the recession, to the point where their mortgage balances were more than the appraised value of their properties. Not only were they unable to qualify for new home equity loans or to refinance and take cash out, but also any already opened lines of home equity credit they had were frozen or closed.
The only other option to free up money in a home is to sell it. Again, you don't want to be forced to do that in an emergency, especially if it's caused by an economic downturn that's eroded the value of your house. You'll also have to pay the costs of a commission to a real estate agent, advertising, closing costs, and the expenses of finding somewhere else to live and moving there, which will reduce or wipe out most of your profit.
Other risks to your home value that can send your investment suddenly plummeting are local housing conditions, such as a wave of layoffs at a big local employer, as well as environmental concerns or even weather issues, such as mudslides, wildfires or flooding. Any of those disasters can slash your home value and make tapping the equity that you've built up by prepaying your loan balance impossible.
When does it make sense to prepay your mortgage? If you've got a good cash cushion in your emergency fund – think at least eight-months-worth of living expenses – plus no other debt at a higher rate and you're fully contributing to your retirement, then prepaying your mortgage can be a smart move. It's also sensible to prepay your mortgage to keep your pay-off schedule on track when you refinance – such as someone who's 24 years into a thirty-year mortgage and wants to refinance to a lower interest rate into a new thirty-year loan.
For most of us, however, home is where you hang your hat, but not where you invest your extra cash. Focus on savings, retirement investing and other debt first.
MoneyTips is happy to help you get free refinance quotes from top lenders.