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Prepaying Your Mortgage When You Expect to Sell

Prepaying Your Mortgage When You Expect to Sell

If you are wondering about paying down your mortgage, consider the numbers.

By Gary Foreman

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If you plan on selling your home fairly soon, prepaying your mortgage could be an excellent choice. There's a good possibility that you'll need some extra cash when you buy a new home. When you sell your old one the "savings account" represented by the prepayments will automatically be available to you.

One cautionary note. When you prepay your mortgage be sure that you clearly note that the money is meant to prepay principal. If it's not noted, your mortgage company could just apply it to your next monthly payment, which will have almost no positive effect.

Basic Assumptions
For the sake of illustration, let's begin with some assumptions. We will make our calculations based on a new, 30-year, 8% fixed mortgage of $100,000.

Using a mortgage calculator (the one we chose was on, this means monthly payments are $733.76. We will consider adding another $75 per month to the payments, for a total of $808.76.

In one year, one prepayment of $75 will reduce the principal amount due on the mortgage by $81. That's because you are borrowing less money next month and every month thereafter. So less of your next payment goes to covering interest and more goes to reducing principal.

The $81 represents an 8% return on the $75. Not surprising since that's the rate of the mortgage. So lesson #1 is that when you prepay your mortgage you will always earn the interest rate on your mortgage.

Suppose you sell your house in five years. What will a one-time $75 prepayment be worth then? After five years, the principal would be reduced by $111. So if you sold the house at that time, you would walk away $111 richer.

If you put away $75 every month for five years, you will end up with a loan that's $5,511 less than it would be without the monthly prepayments.

Investing Versus Prepaying
What happens if you invest the money instead? In part, it will depend on what you invest the money in and how much that investment earns.

Remembering that you get a guaranteed 8% return on the prepayment, pick something safe, like a certificate of deposit. If you could buy a $75 CD with a five-year maturity, it would earn about 6.5%. That would mean you would get back $103 when you redeemed it. You would actually be $8 ahead ($111 minus $103) by prepaying the mortgage.

Realistically, you won't be able to buy a $75 CD each month. You will either need to settle for money market rates or put it into a mutual fund that's not guaranteed.

We won't get into predicting how mutual funds will do. But just for a moment let's assume that you chose one that earn 10%. That's about the long-term return on the stock market. Your nest egg would be $5,807 after five years. If you invest at 10%, taxes will lower the return to about $5,550

Your Choice
So what's the bottom line? It really depends on your personality. If you're a cautious person who likes getting a guaranteed return, then prepay your mortgage. You won't find a safe, guaranteed rate that's as high as your mortgage rate. You'll also be happier knowing that your mortgage is facing early retirement.

On the other hand, if you don't mind a little risk in your life you might want to put the money into a mutual fund that invests in stocks. Over the long haul you could get a higher return.

Gary Foreman is a former Certified Financial Planner who currently edits The Dollar Stretcher Web site .


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