This Week's Q & A

Q: Is there a rule-of-thumb that will tell me whether and when it makes sense to pay off my mortgage early?

A: There is no set formula that will apply equally to all borrowers. The relative advantages of prepaying your mortgage will depend entirely on your financial circumstances, the economic outlook, and your overall financial planning strategy.

While there are many, mostly obvious, advantages to prepaying your mortgage (you’ll save thousands of dollars in interest payments and instantly improve your equity position), there also may be some advantages to keeping your mortgage in place. The interest payments you make may be painful, but they also are tax deductible, and they represent about the only interest deduction available to consumers. While that is not, in itself, an argument against prepayment, it is a factor; and, depending on your tax situation, it may be a significant factor in your decision.

To assess the pros and cons of prepayment, start by determining the value of the mortgage interest deduction compared with the improvement in your monthly cash flow situation that will result from eliminating your housing debt. You also have to consider the competing investment alternatives available to you. Would you be better served by putting your cash into stocks, or money market funds, or wheat futures, rather than into your house? That is partly a function of your guess about how the likely appreciation rate for your home will compare with the yield you could expect from other investments. You also have to consider the relative risk of those competing investments, along with your tolerance for the risks involved.

Your time frame also is important. The longer your occupancy horizon, the greater the potential interest savings and the more appealing prepayment is likely to be. On the other hand, if you’re planning to sell your home in the next two or three years, I suspect you can find a better use for your money.

In addition to timing, you have to consider your liquidity needs. Do you have other sources of cash available to cover expenses you can reasonably anticipate (college tuition bills, for example) as well as emergencies you can’t predict, such as major medical bills or home repairs. Prepaying your mortgage will give you more equity in your house, but tapping that equity may not be an option. A job loss or credit problems could prevent you from qualifying for a loan, and a sharp decline in realty values could leave you will less of an equity cushion than you need. It is probable – and more likely than not – that real estate values will increase over time. But real estate is cyclical, and this boom, like all the other booms before it, is going to end. The question isn’t whether the market will decline, but when, and how severe the downturn will be. So if prepaying your mortgage will absorb all the cash you have, or are likely to have available, you have to consider the worst case scenario for the housing market, as well as the best.

Probably the most important aspect of the prepayment decision is its position in your overall financial planning strategy. This is only one strand in a complicated patchwork, and you need to understand how pulling in one direction vs. another will affect the overall patterns in your financial quilt. A financial planner or an accountant may be able to help you see those patterns more clearly and avoid potentially costly snags.