Your Mortgage: Pay Now, Or Hold Off to Invest?

The Cullens prepay their mortgage each month because they want the debt paid before their son heads off to college. But some people argue that the money would be better off placed elsewhere. Terri looks at when it does and doesn't make sense to prepay your mortgage.
By: Terri Cullen: The Wall Street Journal Online
Early next year my husband Gerry and I will reach two milestones in our finances: Our mortgage's outstanding balance will drop below $100,000 and, more significantly, more of our monthly payment will go toward principal than interest.

With the passing of both of these milestones, Gerry and I will be that much closer to paying off our 20-year fixed-rate mortgage, a process we're hastening by making additional principal payments of $195 a month. (Why the odd figure? I'll get to that later; the short story is that it is part of $395 a month in spare cash we debated over where to invest. ) Our goal is to have the loan paid off before our seven-year-old son Gerald enters college in 2017, leaving us with income available to meet any potential shortfall in our college savings.

Some people believe paying off a mortgage is a stupid move, and would advise us to forgo the mortgage prepayments and invest that $395 a month elsewhere. This school of thought holds that the wisest financial move you can make is to get mortgages with the lowest monthly payments possible - refinancing as rates decline - and never pay off the loans, a strategy that improves your cash-flow and lets you benefit from potential home-price appreciation.

Gerry and I don't agree - we feel paying off our mortgage as soon as possible is essential to our goal of getting Gerald through college and then retiring. Let me walk you through our thought process. When we purchased Gerry's home from his dad in December 2000, we took out a 20-year mortgage for $122,000. Our timing was good: We nabbed a historically low fixed rate of 5%, with a monthly payment of $805 (not including property taxes and homeowners insurance). We'd been paying $1,200 a month for the mortgage on our first home, so we had a decision to make: What to do with the $395 a month in income the new, lower-rate mortgage freed up?

Our son Gerald was a year old at the time, so saving for college was on my mind. By investing the entire $395 sum in a tax-deferred college-savings account, such as a 529 college-savings plan, we'd be able to sock away $155,822 by the time Gerald graduates high school (assuming we invested in mutual funds with a conservative annual investment return of 6%). That's more than enough to cover the $134,916 this College Board calculator estimates a four-year public university will cost in 2017.

Gerry liked the idea of saving for college, but he was pondering another substantial expense: home remodeling. Our worn-down home was in need of some substantial renovations, starting with the kitchen and a bathroom. We'd planned on tapping a home-equity line of credit to fund these projects, and that $395 a month would help us pay off the debt more quickly. In 2004 our kitchen remodel cost $45,000, and we paid for it with our 10-year, $100,000 home-equity line of credit. At 4.5%, our monthly payments on the remodel were $466.37. As this Bankrate.com home-equity calculator shows, that additional $395 a month would have reduced our payments by five years, saving $5,786 in interest.

What about retirement? By saving that $395 a month in a tax-deferred IRA, we'd save an additional $169,542 for retirement, according to WSJ.com's 401(k) planning tool. Logic ruled that we'd get the biggest benefit from funneling the cash into a retirement-savings account, but Gerry and I decided against that because we'd done our retirement planning and felt we were on target with our savings goals. (Whether we rue that decision as we near retirement age remains to be seen.)

Finally, Gerry thought, why not just keep making our old monthly mortgage payment? By tacking an extra $395 principal payment onto our $805 monthly mortgage nut, we'd shave six years off our 20-year loan term and save $16,535 in interest. Once the mortgage is paid off, another $1,200 a month, or $14,400 a year, would be available to help pay Gerald's college costs.

The more we talked about it, the more Gerry wanted to prepay the mortgage. That six-figure mortgage payment has loomed large over my husband since the night before he closed on his first home in 1992. That night he lay awake, terrified by the $134,000 debt he was about to shoulder. A mortgage that size was mind-boggling - up until that year he'd never borrowed from a lender in his life, and he hadn't even owned a credit card until his real-estate agent suggested he get one to start building a credit history.

What made him most upset was the way mortgages are structured, with the bulk of the monthly payment going to pay interest at the beginning of the loan term. Fast-forward eight years, when we refinanced our mortgage to buy the new home. That's when Gerry realized that of the $94,391 he'd paid out on his old mortgage over those years, just $12,035 had gone to paying down principal. His reaction? It was ugly.

Neither one of us liked the idea of our refinanced loan taking us back to the starting line in terms of paying principal and interest. Prepaying the loan would help get us closer to where our total principal payments were with the old mortgage.

Still, I knew if we put off thinking about college costs, years might slip away before we got serious about saving. And getting a head start on saving would mean we'd need to save less than if we waited a few years, thanks to the power of compounding interest.

In the end, we decided to split the difference: We'd take half of that $395 a month and save for college, and use the other half to prepay our mortgage. By paying an additional $195 a month (we chose the odd number because it took our $805 monthly mortgage payment to an easy-to-remember $1,000). By doing so we'll shave 47 payments off the term of our 20-year fixed-rate mortgage, saving $11,939 in interest. And in 2014, if things go as planned, Gerald and his high-school pals can join us at our mortgage-burning party.

Prepaying our mortgage works for us, and I see paying off your mortgage while you're still in the work force as a key to having a financially secure retirement: Should you get into a financial bind, you could either sell your home and downsize to a less-expensive one, or (if you qualify) take out a reverse mortgage that lets you tap your home's equity.

That said, there are a number of situations in which making prepayments isn't a good idea. Generally speaking, if you're planning on selling your home within five years, don't bother prepaying - you won't save enough in interest costs to make it worthwhile.

If you're saddled with a lot of high-interest credit card debt and are prepaying your mortgage, you're paying off the wrong lender: Use all of your disposable cash to pay off the credit cards, then go shopping for a card with a better rate.

If you've been slacking on saving for retirement - or haven't started saving at all - forget about prepayments. Figure out how much you'll need to save for retirement here and then use your spare cash to get there by saving through a tax-advantaged retirement account, such as a 401(k) or Roth IRA. Ideally you should aim to save 10% of your gross annual income - though my print colleague Jonathan Clements would argue that daunting figure is still too low.

Finally, if you're already in retirement and still paying off your mortgage - with no end in sight - don't even think about prepaying. Instead consider this radical idea: refinance to a 30-year fixed loan. You might be able to obtain a lower mortgage rate, which would boost your cash flow. And because you pay most of your interest upfront, you may pay less in taxes thanks to the mortgage-interest tax deduction.