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November 2, 2017

The Case for Prepaying your Mortgage

Christi R. Wann has posted The Case for Prepaying your Mortgage to SSRN. The abstract reads,

Households that already contribute sufficiently to tax-deferred retirement accounts often believe that the tax break from interest expense deduction is more beneficial than prepaying a mortgage. This idea stems from a faulty assumption regarding the appropriate opportunity cost of funds. This study covers a 26-year period and shows that prepayment is optimal for this type of household when correctly comparing the after-tax cost of the mortgage and the after-tax return of the risk-appropriate competing investment. The study illustrates that interest expense savings are greater than tax deduction benefits from 1990-2016 when prepaying 15-year and 30-year mortgages.

While somewhat technical, this paper argues that mortgage prepayment makes sense for many people who reject that idea based on bad information. It recommends that people who are making all of the right financial moves, like sufficiently funding their retirement, should prepay their mortgage if they have the resources to do it. The conclusion section is worth reading in full, if you want to know more:

This study proposes a proper competing investment that better accounts for the risky aspect of home ownership which is rarely addressed in the prior literature. Relying on the precedent 16 established in the commercial mortgage industry related to mortgage prepayment through defeasance, Treasury securities are recommended as the proper competing investment. This case should be compelling given the fact that Section 2(a)(16) of the Investment Company Act of 1940 as amended (15 U.S.C. 80a-1) requires that the substitute collateral in defeasance consist only of government securities. For example, this study shows that the opportunity cost of not paying off a 30-year mortgage five years early is 1.42 percent. This represents the excess mortgage interest rate paid over the interest that could be earned by investing in a five-year Treasury security.

A key assumption in this study that makes the Treasury security a valid competing investment is that particular households have already contributed the recommended minimum of at least ten percent of their earnings to their tax-deferred retirement account. It is important to note that the study advocates contributing sufficiently to a tax-deferred retirement account before considering an early mortgage paydown. Both foreclosure risk and interest expense are reduced when mortgage prepayment occurs for households projected to have sufficient retirement income.

This study computes the required average monthly extra principal payment and average total interest expense savings net of lost tax shelters for the early retirement of 30- or 15-year mortgage debt for various scenarios from 1990 to 2016. For example, it would only take an average extra principal payment of $83 a month to prepay a 30-year mortgage five years early and save an average $33,477 based on the historical rates for the last twenty-seven years. Similarly, by making an extra principal payment of approximately $218 households can prepay a 30-year mortgage ten years early and can save an average of $65,191. The estimates reported in this study are very conservative because they target married persons filing jointly in the 25 17 percent marginal tax bracket and the study assumes a 20 percent down payment. Further, based upon the 25 percent tax bracket for 2014, the study assumes an average state tax rate based on an average tax bracket of greater than $45,504 up to a maximum tax bracket of greater than $139,400. Therefore, the savings could be much greater for those in lower tax brackets and those without state income taxes. The results of the study are of interest to homeowners who have the financial ability to make extra principal payments but fear losing the commonly cited tax benefit of interest expense deductibility.

The prior literature revealed that, in general, most households could not liquidate all of their financial assets to pay down their mortgages [citation omitted]. Further research should determine the characteristics of households that overextend themselves with respect to their mortgage debt. These results could be used for targeted education about how much house to buy. Further, the priority of investing in retirement assets and having an appropriate emergency fund should also be included in this education. Once households are equipped with and utilize this knowledge, then mortgage prepayment can become optimal for most households. This result would warrant a study of the effects of such a widespread change in the mortgage market on aggregate household saving and the consumption of non-housing goods. (15-17)

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