When Does It Make Sense to Prepay a Mortgage?

A reader writes in (in reply to last week’s article about calculating the after-tax interest rate on a mortgage), asking:

“I get that the point of calculating an after-tax interest rate is to determine whether it’s better to prepay your mortgage instead of investing. But where do you draw the cut-off? How high does the interest rate have to be in order for it to be better to pay it down rather than invest? Would looking at historical returns for the funds I own would be useful here?”

Prepaying a mortgage provides a safe rate of return. That is, you know that the return you’ll get from paying down the mortgage is equal to the after-tax interest rate on the mortgage.

As such, generally speaking, what you want to do is compare the after-tax interest rate on your mortgage to the after-tax expected return on the safe investments (e.g., bonds or CDs) that you hold or that you are considering buying.

For example, if your mortgage has an after-tax interest rate of 3%, and you are holding fixed-income investments that have an after-tax expected return of 2%, you’re essentially borrowing money at 3% in order to lend it back out at 2%. In most cases, that doesn’t make sense.

Conveniently, it’s fairly easy to get a decent estimate of the expected return for a fixed-income investment. In most cases, just look at the yield.*

Look at After-Tax Expected Returns

A key point here is that, just like we looked at the after-tax interest rate on the mortgage, we have to look at the after-tax expected return for the investments in question.

In the case of tax-sheltered retirement accounts, the calculation is easy. Specifically, if you would be liquidating assets from retirement accounts (or choosing not to contribute to retirement accounts) in order to prepay the mortgage, the return on the investments in question wouldn’t be taxed, so the after-tax rate of return is the same as the before-tax rate of return.

In a taxable brokerage account, however, determining the after-tax return can be somewhat trickier. It’s simply calculated as the before-tax expected return multiplied by (1 – your marginal tax rate). But your marginal tax rate will depend on your tax bracket, what type of investment we’re talking about (taxable bond? muni bond?), and on other factors such as whether or not you’re subject to the 3.8% tax on net investment income.

A Reason Not to Prepay

Regardless of the above comparison of rates of return, it definitely does not make sense to prepay your mortgage if doing so will cause you significant liquidity problems.

For instance, if you have an “emergency fund” sitting in a savings account earning little to no interest (and you truly would need that money in the event of a large unexpected expense), it’s not a good idea to use that money to pay down your mortgage, despite the fact that doing so would earn you a higher rate of return than the savings account is earning.

*Specifically, you’ll want to look at the yield to maturity for most bonds, the yield-to-worst for callable bonds, and the SEC yield for bond funds.