How Age Affects Your Prepayment Decision


NEW YORK (MainStreet) -- Making extra mortgage payments is a strategy that thrills some homeowners and leaves others cold. Unfortunately, that means most people choose a side and stick with it, while the best approach is to switch back and forth as conditions change.

Homeowners who rejected prepaying when they were young (and used extra cash for other investments) might find it more appealing as they get older. The value of pay-downs changes as the expected returns on other investments rise and fall, and since older investors are wise to be more conservative, that makes owning a home outright more appealing.

The basics are simple: Make extra principal payments on a regular, intermittent or one-time basis, and you can save a bundle on interest charges in the long run. For every $100,000 borrowed at today’s average interest rate of 4.2% on a 30-year fixed-rate loan, you would pay about $76,000 in interest for the life of the loan, according to the BankingMyWay Mortgage Loan Calculator. Paying an extra $50 a month would reduce interest costs by more than $14,000 and retire the loan in 25 years instead of 30.

But there are some downsides to the practice. For one, that $50 in extra principal payments is tied up in the home and thus not available for other purposes. To get it back in liquid form you’d have to sell, refinance or take out a home-equity loan or reverse mortgage.

Even if tying the money up is not an issue, the cash could probably be invested in more profitable ways. In effect, the extra principal payments are equivalent to an investment with an annual return equal to the interest rate on the mortgage. So, in this example, if you could earn more than 4.2% on an alternate investment, prepayments would not make sense.

Many advisers would point out that 4.2% earned on a prepayment, where the return is guaranteed, is very good compared to earnings on other rock-solid investments. The average one-year certificate of deposit, for example, yields just 0.331%.

But this is where factors like the homeowner’s age come into play: People in their 20s, 30s and 40s typically emphasize stocks in long-term investments, because there’s plenty of time to ride out market downturns and enjoy stocks’ high expected returns in the long run. U.S. stocks averaged about 10% a year in the 20th century.

For the younger homeowner, a mortgage prepayment earning 4.2% might not be very attractive compared to the returns expected in long-term stock holdings. Also, many young homeowners have more immediate needs like children’s college expenses to plan for.

But the same homeowner might see things very differently a few decades later. People approaching or entering retirement tend to look for safer investments, and 4.2% on a mortgage prepayment would look pretty attractive compared to the 0.25% you could earn on a two-year Treasury note, or the 2% yield on a 10-year Treasury.

Of course, the older homeowner still must weigh the fact that the prepayment “investment” does not produce interest earnings for living expenses. The money stays in the home.

Changing conditions in the economy and financial market are also a factor in the prepayment decision. If stocks are on a tear, they may be preferable to prepayments even for the older homeowner. And younger people might prefer the certainty of prepayments when the financial markets are in turmoil.

Clearly, the mortgage rate is also a factor. If rates rise in a few years and you’re stuck paying 7% or 8%, prepayments would be more competitive with stocks, for example. That’s why some homeowners choose to make prepayments for a time, then suspend the practice, then restore it later as conditions change.

Keep in mind, though, that once a prepayment is made, its return is fixed at the loan rate until the loan is paid off. After that, the return equals the rate of home-price appreciation. It’s difficult (and expensive) to get that money back out of the home to invest elsewhere. So make prepayments only if you will be satisfied with the return for the long run, which might still be 30 years away.

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