Should You Prepay Your Mortgage?

A mortgage prepayment is usually a good idea which I often recommend. My forecast is for the stock and bond markets to produce a low rate of return for the next several years so one may be able to get a better return by paying down their mortgage. If the S&P returned about 2 or 3% annually in the past decade and bonds are now paying about 3 to 4% then a mortgage pay down is attractive.

The recommendation needs to be tailored to each client’s needs. So if a client is self-employed or financially shaky they may need to have a lot of liquid assets and thus it would be wrong to use up liquidity to pay down a mortgage. It is hard to get a cash-out refinance so if you pay down your mortgage and then later need cash you may not be able to get hold of funds that were used to prepay the mortgage principal.

Another caution is that if a mortgage becomes small by the standards of lenders then it may be harder to get good economies of scale when later shopping for a refinance. For example a lender may be unwilling to work for a 1% fee on a $50,000 mortgage but would be willing to do so at $300,000. So if the decision is made to prepay a huge amount of principal it may be better to pay off the whole thing rather than have a small mortgage.

The most important criterion is to be sure the client will have plenty of liquidity after paying down the mortgage. The current era is a “credit crunch” era where people could find that they can’t get loans at precisely the time they needed funds the most. This includes the risk that lines of credit and credit cards could be cut off by a bank even if the client was in good shape financially and not in violation of any loan covenants.

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Don Martin, CFP®

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