Whenever the discussion of prepaying your mortgage comes up, someone always suggests that it's better to invest the money instead. That may be true -- or not -- depending upon several factors. There certainly have been periods in the past when investing would have been the best allocation of your extra dollars. At other times, you simply would have thrown your money into a big hole.
Investing in your mortgage differs from investing in the stock market in that it provides a known, guaranteed return over time. You never have to worry about the market hitting top or bottom, buying or selling opportunities, or what the Federal Reserve might do. What kind of guaranteed return are we discussing?
Mortgage prepayments prior to 2018
Before recent changes in the mortgage interest deduction (MID), the math to determine your return was a little complicated. First, the deduction was only available to those who itemized their deductions on their tax returns; in general, this meant you needed a combination of interest, property taxes and other deductions to be greater than the standard deduction available to you.
For most homeowners, the standard deduction for single taxpayers and married couples filing separately was $6,350 in 2017; for married couples filing jointly, the standard deduction was $12,700. As such, you needed a combination of deductions including mortgage interest to be more than these dollar amounts to make it worthwhile to itemize and capture some tax savings. Homeowners with big mortgages or those in high property tax states commonly rose above this threshold.
However, borrowers with small mortgages and especially those in low-tax states were often better served with the standard deduction and so they didn't much benefit from the MID.
Up until 2017, it used to be that the 'return' from prepaying your mortgage was the equivalent of the after-tax interest rate being charged on your mortgage. This might sound a little complicated, but if you had a 6% first mortgage and were in the 28% tax bracket and it was worth itemizing, your after tax "return" when prepaying your mortgage is about 4.32%, guaranteed. While well below the average return of the stock market over time, this is a better return than many "cash" investments.
If you want to calculate the after-tax return on your prepayment 'investment,' the math is fairly simple. Take the interest rate on your mortgage loan, multiply it by the inverse (from 100) of the tax bracket you fall into. In the example above, the 28% bracket gives you an inverse factor of 72% (100% minus 28% = 72%). Now, multiply your interest rate - 5% - times .72 (72%) and you'll come up with an after-tax return to beat of 3.60%.
Prepaying a mortgage after 2018
Starting with the 2018 tax year, more generous standard deductions for the above taxpayers of $12,000 (single) and $24,000 (married) kicked in, making it a fair bet that many folks will no longer itemize their returns. The standard deduction escalates each year; the 2024 tax year will see it be $14,600 for single filers and $29,200 for those filing jointly, and since the amount of mortgage interest paid declines over time as the loan is paid down there may be fewer folks looking to itemize their returns. As such, for many folks, there is no longer an "after-tax" component to the savings of prepayment. It will simply be a one-for-one comparison, and a 4% interest rate being charged on your mortgage means prepaying it will return a full 4% on your money.
Of course, if your total deductions will be above the new thresholds and you will be itemizing, the math above for after-tax return still applies.
Of course, this doesn't settle the argument as to whether it’s better to prepay your mortgage or invest, given today’s mortgage rates. Why not simply leave yourself flexible, and consider prepaying your mortgage as part of an investment plan, like investing in a bond fund? If stocks look like a better opportunity to you, with greater potential, send your money there, and use dividends or stock sales to fund your prepayments. Buy low, sell high... and prepay your mortgage.
Given the interest rate and investment climate over the last few years, you may be wondering: "Should I prepay a low-rate mortgage?" There's no one-size-fits-all answer to this question, but there are some things to consider as you look to manage your finances both now and for the future.
For specific "investment" alternatives to prepaying your mortgage, review our next article on choices other than prepaying your mortgage.
If you have an adjustable rate mortgage or interest-only home loan, read our previous article on prepaying ARMs and interest-only mortgages.