Prepaying mortgage versus saving

Most people believe they should rid themselves of their mortgage before they save for other accumulation goals.  However, as Todd Ballenger pointed out in his book “Borrow Smart Retire Rich” this decision comes with hidden costs.

Here is an example, let’s assume a homeowner has $1,000 each month to either save or use to pay down their mortgage.  Let’s also assume that their mortgage carries an interest rate of 7.00% and that their savings/ investments will earn an after tax return of 7.00%.  Finally, we’ll assume that this homeowner has a 32% marginal tax bracket so their net after tax of borrowing is actually 4.76%.

Here is a breakdown of these two options over 30 years.
Amount invested: $1,000      $1,000
Return:                  4.76%        7.00%
Term (years):          30              30
Growth:             $796,282    $1,219,971

As you can see the decision to pay off the mortgage would cost this homeowner over $400,000 over the course of 30 years.

Net after tax cost of borrowing

In Todd Ballenger’s book “Borrow Smart Retire Rich” he trademarks the term ‘EPR’ which stands for Effective Percentage Rate.

This concept it important in making decisions regarding how much a homeowner should borrow.  Here is a simple explanation:

1) First, it’s important to understand that most homeowner’s are able to deduct the interest that they pay on their mortgage from their taxable income to determine their tax liability.

2) Therefore, a homeowner’s interest rate does not truly represent the actual cost of borrowing.  For example, a person who has a mortgage with a 7.00% interest rate and finds themself in a 28% marginal tax bracket will have an EPR of 4.34% (7.00% * (1-.28%)=4.34%).

3) If cash-flow was not an issue this homeowner would be smart to borrow as much money as they could so long as the capital was used to earn a return in excess of 4.34%.