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Does Early Mortgage Repayment Still Make Sense?
Early mortgage repayment looks on paper at least like a wonderful deal. If you have a typical mortgage and you are near the beginning of the mortgage term and make an extra $25 a month in principal payments, you could potentially save $25,000 in interest over the life of the loan.
Note: The exact amount of early repayment savings depends on the loan, but, in general, the apparent savings are astounding.
In spite of the superficial profit that seems to come from early mortgage repayment, it's often not a good decision. The tragedy here is if you would have used that $25 a month to boost your individual retirement account, or IRA contribution, you would end up with $50,000 in your IRA account. If you would have used the $25 a month to make extra contributions to your employer's 401(k) plan, you might have easily ended up with $75,000 in a 401(k) account.
The reason for these discrepancies is simple. In effect, when you calculate the interest you save by early mortgage repayment, or the interest you make by investing in an IRA or a 401(k), you are making a compound interest calculation. Any time you compound interest over long periods of time, the numbers eventually grow large. But the most important factor driving the interest rate compounding calculation is the interest rate. The larger the interest rate, the faster the compounding and ultimately the larger the final value.
If you can prepay a mortgage that charges 6% but invest in an individual retirement account or 401(k) account that will pay 8%, mortgage repayment is actually a terrible idea. And, unfortunately, very small differences in interest rates ultimately produce very large differences in the final compounded values.
Although early mortgage repayment is a technique that many financial writers who don't know better recommend, you are typically better off using the money you would have used for early mortgage repayment for additional individual retirement account or 401(k) contributions. The one scenario in which you could save money through early mortgage repayment is when you have already taken maximum advantage of these other investment choices and are still looking for some other place to "save" additional money.
About the author:
Redmond WA tax CPA Stephen L. Nelson is the author of both Quicken for Dummies, QuickBooks for Dummies and more than 100 other books as well. Nelson holds an MBA in Finance and an MS in taxation.
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