13

Should one prepay principal if the interest rate is higher than that offered in a savings account? For example, in the US savings rates have gone to 3% but what if one's mortgage is higher than that, say 4.5%?

  • I understand that there is a loss of liquidity and it is worse in times of impending recession so is there a premium to be added to the savings account to make it comparable to prepaying principal and knowing that there you won't be touching that money again?

  • How could one account for the mortgage going underwater if there's a recession?

  • If the mortgage goes underwater, would it be more helpful to then not pay more interest on the loan by prepaying?

NOTE: no appraisals have shown the property to be underwater but I would like to know how to deal with things if something like this were to happen.

16
  • 2
    Are you considering to declare bankruptcy? That would be one of the few times being underwater would impact the calculation of benefits for paying down the principal. Either way, you will save on interest cost [in the long term - in the short term, you will realistically just reduce the net term of the mortgage and your current payments will remain the same unless you refinance]. Commented Jan 12, 2023 at 15:24
  • 1
    The return on paying the mortgage is fixed -- 4.5% for the term of the mortgage. The return on the savings account is 3% now but will vary in the future. It could be 0.1% next month. Or it could be 7% next year.
    – Ben Voigt
    Commented Jan 12, 2023 at 22:23
  • 1
    Instead of using a savings account you could buy US treasury bonds, which currently pay out 4.6%. This changes the calculus, though of course your mortgage might be even higher than that. Commented Jan 12, 2023 at 23:24
  • 1
    Even at 4.5%, the difference of 0.1% doesn't seem like a lot. Commented Jan 12, 2023 at 23:27
  • 3
    An underwater mortgage is only a problem if you're trying to get a HELOC or sell; it does absolutely nothing to your existing finances. There's nothing to "deal with" because you responsibly took out a loan which you can afford, right?
    – MonkeyZeus
    Commented Jan 13, 2023 at 13:24

4 Answers 4

21

I think you've found the biggest drawback to prepaying the mortgage, which is that you lose the liquidity of having the cash. So it depends on how much liquid cash you have (i.e. do you have enough to cover short-term emergencies). If you have a large enough emergency fund that you feel comfortable paying down the mortgage, then mathematically that's the smarter move.

Another option would be to bump up your retirement savings, especially if you get a match from your employer. On average you'll earn more over the long term since investments have a higher return than loans over a long period. But it matters more when you plan to retire vs when you plan to refinance or sell.

I don't think the house being underwater has any bearing - that only matters when you try to sell or refinance the house. Even then, you'd still have to have the cash (or borrow it) to cover the loan, so whether you do that now or when you sell doesn't really matter.

3
  • 4
    Remember that one can take out a line of credit against the portion of the house's value not currently mortgaged, so the prepay funds aren't completely tied up, with a bit of advance notice. But the homeowner LOC is likely to be at a higher interest rate than the mortgage.... It's all tradeoffs. Try running the numbers for a few scenarios, think about how likely each scenario is, decide from that. All we can give you here is rules of the and examples.
    – keshlam
    Commented Jan 13, 2023 at 1:02
  • Isn't not paying debt and instead investing basically the same as taking out a loan to invest?
    – Jimmy T.
    Commented Jan 14, 2023 at 16:47
  • Mathematically, yes, but since the house isn't going to be paid off for many years (presumably) the long term benefits of saving for retirement (especially if there's a company match) outweigh the benefit of maying down the mortgage. IF it were a car loan or credit card balance my answer would be different.
    – D Stanley
    Commented Jan 14, 2023 at 22:21
12

You don't state the jurisdiction, but in most places, you pay income tax on a savings account, but don't pay any tax on the interest you save by prepaying the mortgage. If your marginal tax rate is 50% then a 4.5% savings account is only 2.25% after tax, which is not as good as prepaying the mortgage.

This won't be true anywhere where interest on a mortgage on a primary residence is tax deductible.

2
  • 4
    With the current high standard deduction in the US, mortgage interest is often effectively not tax deductible for many taxpayers simply because the standard deduction is higher than what one could itemize (in places where homes are not absurdly expensive.) Commented Jan 13, 2023 at 5:42
  • @BrianBorchers, the answer's first point remains valid though - I need to take the savings rate after tax, which would be lower than 3% thus making the mortgage's 4.5% more enticing. Commented Jan 14, 2023 at 16:23
0

I can tell you the cardinal rule of building wealth: get out of debt.

There are two kinds of people in the world: the 1% who are truly wealthy and owe nobody nothing, and the other 99% who are debtors. Just because a guy has a mansion and a garage full of Maserati's doesn't make him wealthy--it is only the appearance of wealth. When a man has no debt it frees his mind and provides a kind of liberty that is unknown to the debtor. When you eliminate all your debts it makes you free in a way that is priceless and more valuable than any other financial status you can have.

It is better to be a poor campesino with no debt, than to be a big shot New York developer who owes money to a lot of banks. Never forget that.

2
  • 1
    The richest people on earth have a lot of debt though and it makes more financial sense for them to not just pay it off.
    – Jimmy T.
    Commented Jan 14, 2023 at 16:49
  • That can sometimes be true, but shouldn't be stated as an absolute. For one, it depends on your definition of wealth - for some people, wealth means luxuries (the mansion+Maserati). For others, it means independence. Secondly, there is "good debt". It often makes more sense to buy a profitable business than to pay off a mortgage and have no source of income. So the answer really is "it depends". Commented Jan 15, 2023 at 6:18
-1

This really is a very personal decision; there is no globally true answer.

Among the factors that play into this are:

  • Your life priorities. Do you value your independence, or do you value material luxuries?
  • The difference in interest rates (after taking taxes into account).
  • Your expectation about future interest rates.
  • When you plan to retire.
  • What your expected income is, both now and in the future.
  • Your personality; in particular, your risk tolerance.
  • Whether you have a family
  • Whether you want to build generational wealth, leave something to your children, or whether you prefer to have your retirement nest egg last until you die, and not beyond.
  • Whether you have life insurance.
  • How certain you are about future job prospects, natural disasters and other factors that could cause you to lose your home.
  • Your insurance rates. Although this may not be a good idea, theoretically paying off your mortgage early could allow you to cancel your homeowner's insurance. Another place where your risk tolerance figures in the picture.
  • And a lot more.

One approach I use is to think of paying down the loan as a form of savings account, where you pay yourself the interest (by saving on mortgage interest).

For instance, if your mortgage interest is 5%, and you just closed on a 30-year mortgage, then paying off $1000 of that mortgage is the same as putting it in a savings account at a guaranteed rate of 5% for the next 30 years.

That's a great deal if interest rates stay low, but a terrible deal if in five years, interests on savings account go back to 1970s levels.

If you lose a tax deduction, then treat this 5% interest "to yourself" as taxable.

In addition, paying off the mortgage also is, effectively, a retirement contribution (so is saving the money, of course, if it's long term savings). Once the mortgage is paid off, your disposable income goes up during retirement. As a result, it can sometimes even make sense to use funds from an IRA/401(k)/Roth etc. to pay off a mortgage (but be careful, and look at both tax consequences, and the risk of losing your home to foreclosure or a disaster). Another thing that can sometimes make sense (and often does not): borrow against your 401(k) to pay off your mortgage. When you do that, it is financially the same as investing the 401(k) into a fixed-interest security at a fairly decent interest rate (often 4%, with a five-year maturity). At the same time, on the other end of the transaction, you replace your mortgage with a loan for a fairly low interest rate (also 4%, obviously).

There are risks to this strategy, primarily if you get sick, lose your job, or need money for some emergency.

Again, a lot depends on your personal situation, so don't take this as a recipe but as food for thought.

2
  • Some of these bullet points are snobby, and irrelevant. Asking a guy who’s asking where he should save money whether he prefers “Independence or material wealth” is particularly atrocious.
    – RonJohn
    Commented Jan 15, 2023 at 7:05
  • @RonJohn That specific item actually was particularly important, because Five Bagger's answer implied that independence is always preferable to material wealth. I share that view for myself, but not everybody will. And people who think differently aren't wrong, they just have different priorities in life (and probably different risk tolerance, too). For an example, whether you like him or not, and regardless of how high or low his net worth may be, Donald Trump scores higher than me (and presumably most Americans) on material wealth. I wouldn't want to trade places with him, though. Commented Jan 16, 2023 at 9:15

You must log in to answer this question.

Not the answer you're looking for? Browse other questions tagged .