Client Question: Debt Pre-payment

May 30, 2024

While meeting with a client this week, we were discussing cash balances and potential uses. One topic that came up was the pre-payment on debt instrument (in her case, a mortgage). Let’s take a closer look at things to consider when evaluating debt prepayment

Basics of Consumer Debt

Debt serves a useful purpose for many individuals, allowing major transactions (such as a home purchase or car purchase) to take place. The difference between cash on hand and the purchase price of these assets is supplemented by debt, which is paid off over a set period of time. Banks don’t provide this benefit for free. The cost of any debt is the interest rate attached to it. As long as the debt is outstanding, you will pay interest on the balance.

What is prepayment?

When you enter into a debt agreement (like a mortgage or car loan), there will be a scheduled stream of required payments. These payments are based upon the underlying interest rate and term and are based upon an amortization schedule set at the time of the loan. Prepayment would involve paying more than the scheduled payment at any time during the life of the loan (payoff would be paying off the entire balance). Most loan agreements don’t penalize you for paying off a loan early but before doing anything on your specific loan, be sure to check your agreement!

Pros/Cons of Prepayment

If you find yourself in a position of having excess cash (ie: cash balances in excess of your near-term liquidity needs and emergency reserves), you may wish to evaluate whether prepayment of debt makes sense. As noted above, as long as you have outstanding debt, you will be paying interest. So wouldn’t it always make sense to eliminate that cost if you can? The answer is it depends. Here are a few things to consider and evaluate for your own situation

Rate Comparison

To pre-pay (or pay off) a debt instrument, you are going to be pulling cash from somewhere. You need to think thru what you can earn on that cash if saved/invested versus applied to the debt. If you keep the funds in cash, you have an ability to earn a rate of return. In today’s market environment, the return potential on cash is unusually elevated due to efforts of the Federal Reserve to slow inflation. Money market funds are paying over 5% as of today. You could also take that cash and invest it in an asset with higher-earning potential (your longer term investment portfolio) or use it to fund a retirement account that may assist with your income taxes (if you fund a pre-tax IRA or 401k) or your future retirement picture (if you fund a post-tax Roth IRA and Roth 401k).

That interest rate on cash (or potential return on funds if invested) can then be compared against the rate you are paying on your debt. If your earnings on the cash/cash if invested far exceeds the rate you are paying on your debt, you may wish to hold off on any prepayment.

Given the exponential rise in rates in the past two years (which followed a period of historically low rates in the aftermath of COVID), this comparison varies greatly by individual and by type of debt today. When it comes to mortgages, many homeowners are holding low-rate loans (2-3%). However, individuals looking to finance a new car purchase may be shocked to see a 9-10% rate attached to the loan. This is why it’s important to consider your own fact pattern and own interest rate.

Liquidity Needs

Another item to carefully consider before prepaying on a debt instrument is you cash level and likely future liquidity needs. Perhaps you have excess cash right now – but you have upcoming large expenses (maybe you are planning to do a major renovation within the next year or you are looking for pay for a child’s wedding within the next two years). If you prepay on a mortgage or a car loan, that cash is gone. The only way you will be able to get a new loan to fund these needs in the future would be to borrow anew – either refinance your mortgage or use a home equity line or credit card (gasp!)

It’s worth considering whether those future rates will be more favorable than your current rate. Given the movement in borrowing rates in recent years, it is very likely that the rates on new debt in a year may very well exceed your current rate. As a result, if you know you have upcoming cash needs, it would be advisable to retain that cash versus having to borrow again later.

Qualitative Considerations

All of the above discussion points relate to quantitative considerations. These calculations are important and should be heavily weighted in your decision. However, for many, the qualitative considerations are just as – if not more – important.

Debt can be a psychological weight for many people. The idea of making a fixed monthly payment to someone else – even if the rate is low – is burdensome. They would simply like to be done with the whole affair and aren’t concerned with the “math.”

I also hear the discussion of prepayment with increasing frequency as people approach retirement. They want to control monthly outflows moving forward, especially if they will be needing to draw on pre-tax funds in retirement.

There is nothing wrong with taking these emotions into account as well. Just be sure they are properly weighted against the points above to arrive at the decision that is best for you.

As you can tell from above, the answer to “should I prepay” is clearly “it depends.” Be sure to work thru your specific fact pattern before heading to the bank!

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