For years financial experts have recommended that homeowners should not prepay their mortgage and instead invest extra savings into a diversified portfolio. To this day, you can build a compelling financial case that the returns of a well-designed investment account over the long haul will earn more than the interest on most mortgages. Even when you’re no longer working, your average financial outcomes will be better when you make minimum mortgage payments.
The math is simple. If you are paying 4 percent on your mortgage with a taxable family income of $100,000, after tax savings this cost you about 2.9 percent in Colorado. If by comparison we consider an investment in the Vanguard Balanced Fund Index mutual fund, its 15 year annualized return is 7.7 percent, or about 5.9 percent after taxes. If you’re borrowing money at 2.9 percent and then earning 5.9 percent on those same funds, you’ll prosper.
Before you rush to take out a cash out refinance and invest the proceeds, there are some new factors to consider when deciding whether to prepay your mortgage.
Mortgage rates are no longer at all-time lows. The average rate for newly issued conventional 30-year mortgages now exceeds 4.7 percent according to Bankrate, up from under 3.5 percent a few years ago. When you make extra principal payments on your mortgage, in many ways it’s the same as investing in a guaranteed fund that earns the interest rate of your mortgage. The higher your mortgage interest rate, the more it makes sense to direct some of your savings toward your mortgage.
You probably can’t deduct mortgage interest. The Tax Cuts and Job Act increased the standard deduction for married couples to $24,000, while reducing many deductions including state and local taxes. Although estimates vary, we expect the number of taxpayers using itemized deductions will plummet by over 50 percent when compared to last year. If you don’t itemize, there is no tax benefit to paying mortgage interest. To use the example above, that 4.7 percent mortgage really could cost that much.
Don’t forget liquidity. Once you make a mortgage payment, it can be a challenge to get that equity out if you need it for an emergency or investing opportunity. Sure you can establish a home equity line of credit to borrow additional funds against your home, but as we saw in the Great Recession access to this resource can be cut off with little notice. Unfortunately, you’re most likely will need emergency funds at a time when your lender might drop your home equity line. Nothing beats the financial strength of having access to cash in your taxable investment account.
Interest rates may increase further. While you may think that interest rates are high now, they are forecasted to increase. Although we’re not there yet, the time may come if you have a low mortgage rate that you can find interest earning investments that will exceed it. In the 80s those with older 5 percent mortgages loved to put away savings in a money market earning 20 percent. For our economy’s sake I hope we don’t go there, but you can see that interest rates could far exceed what you’re paying on your mortgage.
So where does this leave us? First of all, you need to make sure you have an emergency fund of three to six months spending that you can access – and that’s not your home equity. Second, you should maximize Roth IRA annual contributions of $5,500 ($6,500 if you’re 50 or over) if eligible. If you’ve checked those boxes, consider an incremental approach to making principal payments on your mortgage by increasing your monthly payment, while still contributing to your portfolio. That way you can adjust to different financial conditions in the future, whether it’s higher interest rates or other pressing demands for your savings.
David Gardner is a certified financial planner with a practice in Boulder County and can be reached with questions at firstname.lastname@example.org or twitter.com/Dave_CFP.