To prepay, or not to prepay? Should you be mailing in some extra savings to prepay the mortgage principal, or is it better to put these savings into an investment? It seems like the oldest question concerning home owners. We all intuitively know, that first we need to pay off any high interest credit cards, before investing any extra savings. But what about prepaying the mortgage? Is the mortgage, as many experts believe, a good debt? After all, a mortgage interest is deductible and interest rates are historically low. Let's examine in detail.
MORTGAGE AS TAX DEDUCTION
As we know, the mortgage interest we pay is deductible from our income for taxation purposes. The value of the deduction is determined based on which type we're using. It's worth noting, that the so called standard deduction for single filers in 2004 was $4,850 and $9,700 for joint filers. What happens when you have a relatively small mortgage and not much of any other deductions?
Example: you file jointly, mortgage interest is $6,000 per year, you are not self-employed and your deductions are limited – most likely you'll use your standard deduction, since it will probably be higher than an itemized deduction. In this case the mortgage interest will not contribute any more to your tax savings. Would it be worth to keep this mortgage any longer? Most likely not – you would want to prepay it if you can. It is still clearer for couples, where one, or both spouses are over 65 years old. They could deduct an additional $1,200, due to age. Their standard deduction will therefore be even higher and at the same time would minimize any tax advantage of holding on to a mortgage.
Let's say your broker suggests that it is better to invest in some financial instruments. After all, long-term annual returns of stock market have historically reached over 10% and you're only paying 5.5% mortgage interest, deducting it on your tax return. Should we, however, apply these figures into the future? Of course not. Dow Jones, a widely used market index, got stuck at around 10,000 and is roughly in the same place it was four years ago. Some experts expect 2005 returns to be in low- to mid- one digits. 10 year government notes yield little over 4%, and therefore may not be a good alternative as well.
Note that past performance is not indicative of future results.
In deciding to prepay your home's mortgage you should consider not only the conditions the markets are in, but what's more important, your own situation. The length of time before you retire may be the biggest factor. It will dictate the asset allocation in your portfolio, and in turn affect your decision to prepay.
Let's look at a hypothetical illustration:
Example: If you're young and are not planning to retire for another 20 years or more, majority of funds in your retirement account are probably in stocks. Your dollar invested today, considering compounding, may be worth much more in 20 years. Your chances to earn more this way may be better, than prepaying your mortgage. If, in addition, you earn good money and are therefore in a higher income tax bracket, the write-off of the mortgage interest is good for you. For that reason you should most likely keep the mortgage as is.
If, on the other hand, you plan on retiring in 10 or 15 years, your situation is different. Your retirement investment account is possibly allocated mainly in fixed income instruments, such as bonds, notes and such. Interest from these devices will not be higher, than the interest you're paying on your mortgage.
Since you won't want to pay your mortgage in retirement, it will be better to start prepaying it.
TO PREPAY, OR TO SAVE IN 401K?
Of course all the cases are not that obvious. The decision to prepay is in a sense more complicated if you consider tax advantaged savings such as 401K, IRA or others.
Remember that such accounts may give you the opportunity of investing your money and deducting the amount invested from your income.
The long-term growth of such accounts may be higher if you consider this benefit. In many cases then, it may be better to increase your rate of savings into retirement accounts, as opposed to prepaying the mortgage.
Probably the most important factor weighing on our decision to prepay mortgage is the rate at which we're paying it off. We live is an environment of historically low interest rates, yet I still meet people paying very high rates. In these situations you may want to consider refinancing the mortgage as opposed to prepaying the existing one.
Every circumstance is different, however indecisiveness may be costly. In this case I suggest the following: let's pay the mortgage more often. If, for example your monthly payment is $1,000, let's pay $500 biweekly. On the surface, it doesn't make much sense, but this method may help you to significantly cut the payoff period. With new, 30 year loans, this technique may leave you mortgage free in 23 years. The information contained in this newsletter is for educational and informational purposes only. It does not consider your particular investment objectives or financial situation and does not make personalized recommendations.
It is not intended to provide specific legal, investment, accounting, tax, or other professional advice. Individuals should consult with the appropriate professionals to help answer questions about their specific situations or needs
prior to taking any action based on this information.
Securities offered through NEXT Financial Group, Inc. Member
NASD/SIPC. Vision Financial Services is not an affiliate of NEXT Financial Group, Inc.
6348 Alderton Street
Rego Park, NY 11374 • 718 205-2880
Arthur Dolega is a Certified Financial Planner® practitioner. He lives in Middle Village with his wife and two daughters. He practices out of his Rego Park office on Alderton Street and 63rd Drive. Arthur develops and monitors investment strategies for individuals and small business owners for over six years now. His company, VISION Financial Services, assists in retirement, estate and business planning. He also sponsors workshops on education funding for children.