Smart Moves by Ellen James Martin

TO PREPAY OR NOT TO PREPAY ON A MORTGAGE

Americans have built an addition onto the dream of homeownership. Due to economic uncertainties, more people now crave ownership of their property "free and clear" of mortgage debt. Few have the cash to pay off a home loan in one lump sum. But many are attempting to make extra payments to principal to shorten the term of their mortgage.

"People have a growing aversion to debt. So there's a trend toward wiping out mortgage debt as quickly as possible," says Bruce Hahn, president of the American Homeowners Foundation, a consumer education group (www.americanhomeowners.org).

There's more than one way to knock off mortgage debt before the term of a loan ends. Those who receive a windfall -- perhaps through an inheritance -- can sometimes pay off the full mortgage all at once. But most pre-payers simply make extra payments each month. That way they could cut the payoff time on their mortgage from, say 30 years to 15.

Consumer advocates say many families can't afford the extra monthly cost of pre-paying mortgage principal. But even those who could afford to cut years off their term may not choose to do so -- assuming an analysis of their financial situation convinces them they could make better use of their discretionary cash.

As Hahn says, the pros and cons of mortgage prepayment depend on the circumstances for the homeowners involved. Considerations include age, income, expenses, job stability, how long the owners plan to live in their home and their investment philosophy.

Here are a few tips for homeowners thinking about prepayment:

-- Take all the pros into account.

Besides the savings you can enjoy from reduced interest charges, one obvious benefit of paying off a mortgage early is that your living expenses will decrease once your home is paid off. That means you'll free up funds to use for other, perhaps more fun purposes.

Prepayment often makes the most sense for homeowners with a mortgage rate well above the prevailing market rate, though another option for such owners would be to refinance. But even those with a low current rate could be justified in pre-paying their home loan -- assuming they recently took out the mortgage.

"The way a mortgage works, interest charges are front-loaded. So you get a lot more savings when you start prepaying early," Hahn says.

And consumer advocates also see other advantages to prepayment.

"Full ownership of your house gives you a tangible asset with a bundle of values. You can live in the house, borrow against it, sell it or rent it out," says Barry Zigas, director of housing policy for the Consumer Federation of America, a Washington, D.C.-based advocacy group (www.consumerfed.org).

He says pre-paying a mortgage can make particular sense to people heading toward retirement who expect to stay in their home indefinitely.

"In retirement, your income declines and your tax advantages from mortgage interest start to diminish," Zigas says.

Does it make sense from an investment standpoint to prepay your home loan? Most homeowners whose properties have lost value in recent years are skeptical. But Zigas says that in the near future a modest level of appreciation is possible.

"We can't expect double-digit inflation in home prices. But there is likely to be some level of appreciation in property values over time -- especially in strong neighborhoods where the demographics are positive," he says.

-- Don't overlook the negatives.

Besides the advantages of mortgage prepayment, Hahn urges homeowners to take note of the downsides.

"A house is a less liquid asset than money in a savings account. You don't want to sink all of your funds into the house. You might need liquid savings in case of a catastrophic medical expense or some other crisis," he says.

While prepayment may make sense for older couples, Hahn says many families with young children have a greater need for cash to keep up with current expenses, such as day care and educational costs. Thus it may make sense to keep mortgage payments as low as possible in such cases.

-- Carefully calculate how much extra it would cost for pre-payment.

Some homeowners mistakenly believe they're not allowed to accelerate payments to principal on their mortgage. But as Hahn notes, a combination of state and federal regulations now prohibit lenders from imposing mortgage prepayment penalties in nearly all cases.

How much would it cost you to prepay? That depends on how quickly you wish to wipe out your mortgage debt. Obviously it would cost less per month to pay off a 30-year mortgage in 20 years than in 10 years. The other variables include the size of your outstanding debt and the interest rate on the loan.

One good way to find out how much your prepayment plans would cost on a monthly basis is to use one of the free mortgage calculators now available online. Two of the websites that offer these are: www.hsh.com and www.bankrate.com.

Any homeowner can stop voluntary prepayments to principal at any time. Even so, Hahn strongly suggests that those considering prepayment first consult a financial adviser.

"Your accountant is in a good position to evaluate whether prepayment makes sense in your case once all the factors -- including your tax situation -- are taken into account," he says.

(To contact Ellen James Martin, email her at ellenjamesmartin@gmail.com.)