I had a lengthy and interesting discussion with my wife this morning about the interest rate on our home loan. We are locked in at 5.875%, and I told her that at that rate, we were better off not paying extra on the loan and instead putting it away in an HSBC Direct account at 5.05%. At first, she said I was batty, but after I drew it all out for her, she came around to my way of thinking. Here’s why.
Let’s say that we have a $200,000 loan that’s fixed at that 5.875% rate over thirty years. Using the calculator over at BankRate, if we make no extra payments at all, we’ll pay a total of $226,137.30 in interest over the life of the loan. However, we’re also in the 28% tax bracket, so that means we’ll have $226,137.30 in deductions, which will save us $63,318.44 over the life of the loan, meaning we will effectively pay $162,818.90 in interest and taxes over that period.
So what happens if we pay $500 extra in principal each month? For starters, we pay off the loan much, much earlier, in just under 15 years. Nice! Over the life of the loan, we only pay $100,499.55 in interest. With that as a tax deduction in the 28% bracket, we will effectively pay $72,359.68 in interest and taxes over that period. In short, investing $500 extra a month into our mortgage will net us $90,459.22. Right now, you should realize where this is going, because you’re putting in $90,000 ($500 times twelve months times fifteen years) to only get $90,459.22 – and it’s even worse if the income tax is higher than that.
On the other hand, what happens if we put $500 a month into a 5.05% APY savings account for 15 years? I used Excel to crunch the numbers here and discovered that doing this will give me $133,912 at the end of those fifteen years. By putting that $500 a month into just an ordinary savings account, you blow away the return of putting it into your home mortgage.
The more astute folks out there will look carefully at that mortgage calculator and observe that after fifteen years without paying extra principal and instead putting that $500 into a savings account, you won’t be able to take that balance and pay off your home loan, while the other way you would have your home loan paid off. The difference is the income tax savings each year.
If you put the extra $500 into a savings account instead of against your principal, your income tax bill at the end of the year will be significantly lower than prepaying your mortgage. If you take that money you saved on income tax each year by putting the $500 a month into the savings account instead of the mortgage and put it into that savings account each year, you’ll have an extra $63,139.55 in the account at the end of the mortgage. That leaves you with a final account balance in that account of $197,051.50. You’ll only owe $142,249.76 at the end of fifteen years, so you can just write a check to pay the whole thing off and still have more than $50,000 in the bank. In fact, if you so wish, you could actually pay off the home at the end of year thirteen and still have several thousand in the account.
In short, if your interest rate is below 7% – and especially if it is below 6% – and you have willpower, you’re much better off putting mortgage prepayments in a high interest savings account or other investment than putting it in the principal of the mortgage.
After figuring things this way, our current plan is to just put our planned mortgage prepayment into Vanguard index funds (instead of HSBC Direct because we’re pretty sure we can get better than 5.05% APY over twelve or so years in index funds). We’re currently planning on double payments, so we would effectively put a payment into the mutual fund each month and then just let it grow. We never intend to prepay on our home loan; instead, we’ll just let it ride until we move on to our dream home, then sell it off at our own pace.