I shared in my weekly email update this article by Jonathan Clements: Best Investment 2018. It’s about prepaying your mortgage. I said paying off my mortgage would also be my focus this year. Besides contributing to retirement accounts, all my extra cash will go to paying down my mortgage. I’d like to pay it off as soon as I can.
This brought a comment from a reader. He said the real estate market in his local area has done very well in the last several years. Because we all hear residential real estate only tracks inflation over the long term, he expects a reversion to the mean. He doesn’t want to invest more money into real estate after the home value already appreciated a lot.
Except prepaying the mortgage doesn’t really invest more in real estate, especially after the home value already appreciated a lot.
Let’s do an example. Supposed you bought a home for $300k. You put down $60k and you borrowed $240k at 4% interest rate. You had great timing when you bought. Now the home value doubled to $600k. After making the mortgage payments for some years, your mortgage balance is now $200k. Your home equity is $600k – $200k = $400k. The question is whether the real estate market going forward should affect your decision to prepay your mortgage.
Scenario A – Don’t prepay. If you just follow the normal payment schedule you will pay $200k * 4% = $8,000 in interest in a year (actually a little less due to amortization but let’s use simple numbers for now). Suppose the real estate market crashes during this year. The home value goes from $600k back to $300k in a year. Suppose your normal payments lowered the mortgage balance to $190k now. Your home equity goes from $400k to $110k after the crash. Ouch.
Scenario B – Prepay. Suppose you come up with $200k and pay off your mortgage before the real estate market crashed. Your home is now worth $300k and you own it free and clear.
Your home equity is higher by $190k if you prepay than if you didn’t prepay but remember in Scenario A you also made regular payments of $10k in principal and $8k in interest. So even though the real estate market crashes you don’t lose your $200k. It doesn’t make your loss any worse. The only difference is in avoiding the $8k interest.
This is because your home doesn’t know you have a mortgage. Its value will go up or down regardless. You invested in real estate when you bought the home, not when you pay down a mortgage.
| Don’t Prepay | Prepay | |
|---|---|---|
| Purchase Price | $300k | $300k |
| Current Value | $600k | $600k |
| Mortgage Balance | $200k | $200k |
| Value after crash | $300k | $300k |
| Mortgage Payments | $18k | $200k |
| Mortgage Balance | $190k | $0 |
| Home Equity | $110k | $300k |
| Equity – Payments | $92k | $100k |
What would make a difference is if you don’t have much equity and the crash is severe enough to wipe out your equity entirely and you have the option to walk away.
Suppose the real estate market didn’t go anywhere after you bought your home. The value is still $300k. You now owe $200k after a few years.
Scenario C – Don’t prepay. If you just follow the normal payment schedule you will pay $200k * 4% = $8,000 in interest in a year (again, actually a little less but let’s use simple numbers for now). Suppose the real estate market crashes during this year. The home value goes from $300k down to $150k in a year. Suppose your normal payments lowered the mortgage balance to $190k now. You are upside down. In a non-recourse state you have the option to walk away and let the bank foreclose. You lost your $100k home equity plus the payments you paid during the year but thankfully you didn’t sink more into it.
Scenario D – Prepay. Suppose you come up with $200k and pay off your mortgage before the real estate market crashed. Your home is now worth $150k and you own it free and clear.
After prepaying $200k you only have a home worth $150k now. You lost your previous equity plus some of your prepayment.
| Don’t Prepay | Prepay | |
|---|---|---|
| Purchase Price | $300k | $300k |
| Current Value | $300k | $300k |
| Mortgage Balance | $200k | $200k |
| Value after crash | $150k | $150k |
| Mortgage Payments | $18k | $200k |
| Mortgage Balance | $190k | $0 |
| Home Equity | $0 | $150k |
| Equity – Payments | -$18k | -$50k |
Your equity is actually -$40k in the “don’t prepay” scenario. The negative equity can be erased if you choose to default. If you don’t default, you are still better off with prepaying (-$58k versus -$50k).
So if you have substantial home equity and you don’t expect a market crash would wipe out your equity entirely, prepaying your mortgage doesn’t really make you invest more in real estate. If you don’t have much home equity, prepaying can make you lose some of it if the crash is severe enough and you choose to default.
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FinancialDave says
Harry,
Like you say, how much equity you have in your home does not affect your real estate investment. You just own an asset that is leveraged if you have a mortgage, much like buying stocks on margin. The good news is even if your home value is “under-water” you will not lose your home if you maintain your mortgage payment. Walking away is not the answer either as you will still owe any balance due.
One reason to pay down your mortgage is if you are a conservative investor and have nothing better to do with your money than make a “guaranteed” amount of interest equal to the loan interest for the rest of the life of the loan. The bad news is once that loan is paid off that guaranteed interest goes to zero, but it does free up your mortgage payment to do something more productive with it. Maybe by then you will actually be able to invest in some “safe” investments that are guaranteed to pay you 4%.
Scott R says
If you’re already maxing out other pre-tax retirement accounts and prefer the idea of investing at the fixed rate of whatever your mortgage happens to be (vs investing in index funds, for example), then I guess it makes sense.
It still feels to me, though, like it makes more sense if you’re happy with your home and don’t expect to sell it anytime soon (or ever). In my case, I’d like to downsize and am just trying to get my wife on board with the idea (she claims she’s open to it once our daughter graduates from college in a couple of years). So, if I had $40K cash burning a hole in my pocket, I’d rather keep that money liquid, rather than convert it to extra equity locked into my house. That would give me more flexibility when it comes time to sell, as I could, for example, purchase the new house before selling the old house.
Harry Sit says
All else being equal, the sooner you plan to sell the home, the sooner you get that money back, like buying a shorter term tax-free CD at a very good rate. You are right in that your need for liquidity still has to be accommodated.
FinancialDave says
Scott,
Nothing wrong with holding the cash, but IMHO you should NEVER buy a new house before selling the old one, that is so 1980’s thinking. In the 1980s you could put a contingency on your purchase that you need to sell your house first, but nobody really wants to do that now days. Those that survived 2008 trying to sell a house would never buy a new one before getting rid of the old. You never know how long it will take to sell your house and paying two mortgages is just not the place you want to be.
Scott R says
FinancialDave,
The plan would be to downsize, and our finances are such that we could manage paying both mortgages simultaneously while trying to sell the other house. Also, I know that having a contingency that you need to sell your house could put us at a disadvantage when making an offer on a new house. I agree, though, that it wouldn’t be my preference. My wife really hates the moving process and the mad scramble to try to move stuff out of our house the same day we’re closing on a new house is especially a problem for her, but there are ways to minimize that (e.g., pay extra to get the moving truck filled a couple days before and have it sit).
Alternatively, we could rent out the old house (which obviously brings with it another set of headaches).
Jon says
I think that the only downside to paying off the mortgage is in the case where the housing market tanks, you become severely underwater and you just want to walk away from the loan (which is exactly what happened to thousands of people in the last crisis).
If you prepay and walk away then you eat the loss. If you don’t prepay then the bank eats it.
Malav says
If you invest same money somewhere else instead of prepaying – may be s &p 500 for long term, you will get much better return isn’t it?
Harry Sit says
Prepaying mortgage and investing in S&P 500 are not comparable in terms of risk. Otherwise no one would invest in bonds when S&P 500 is expected to give much better returns in the long run.
Henry Harper says
I’m not sure I understand what else someone would do with that cash if they aren’t prepaying the mortgage. Are you assuming that excess cash goes into a bank account or a CD? One important consideration is that people do weigh investing in bonds vs. the s&p500. You must be assuming that all readers have only one perspective on risk and return.
If you believe that housing is a low volatility and safe investment, then the example you give of a house loosing 50% in value is a bit extreme, even considering for the downturn in the Great Recession. Investing into the S&P500 is a valid alternative adjusting for risk, and you are compensated for that risk in the long term, so I don’t really follow how you can ignore the alternative investment.