Does it make sense to prepay your mortgage, or buy real estate with a big downpayment?

These are the core questions raised by Antonio Gidi, an assistant professor at the University of Detroit Mercy Law School, questions which everyone should consider.

"Some people," explains Gidi, "say 'put no money down', 'do not prepay your mortgage', 'do not give money to the bank', 'refinance and reinvest your equity outside the house'. Other people say 'put money down', 'pay more and apply towards the principal', 'have your house debt free'. Who is correct?"

"Does it or doesn't it make sense financially, to put money down and/or prepay your mortgage?"

Gidi points out that you can buy today with no money down and use your cash elsewhere. Also, the money used to prepay a loan can just as easily be devoted to other investments, including some with higher effective yields.

We certainly see that many people are buying with no money down. Figures from the National Association of Realtors show that 42 percent of all first-time buyers and 13 percent of repeat purchasers buy with no-money-down, 100-percent financing. (See: The 2004 National Association Of Realtors Profile Of Home Buyers And Sellers, page 47)

Buying with no money down in a rising market can be -- with caveats -- attractive. The caveats? First, while home values nationwide have been soaring during the past few years, there are no guarantees that either prices or rental rates will eternally rise. Second, less down means more debt, and more debt means higher monthly mortgage payments. That's not a problem -- unless income declines, or total debt increases and can no longer be carried.

The leverage gained when real estate prices are rising, works in the opposite direction when prices and rentals stagnate or actually decline. And despite recent value increases, declines are possible: Japan, as one example, had what appeared to be a booming economy when the Nikkei reached 38,915 on December 29, 1989. As this is written the same measure stands at 11,873 according to NikkeiNet . The balance between risk and reward has largely favored those who have maximized risk in the past few years. But the same was once true for those who invested in "sure things" with great track records such as Enron and Worldcom -- at least until the crash of 2000.

Prepayments

There are surely circumstances where it makes sense to prepay a mortgage -- but not always. For instance, before prepaying a mortgage it's better to first pay off high-interest debt such as credit cards.

Prepaying a mortgage often works because most people in this country are not rich. For most, mortgage amortization -- paying down principal over time -- and simple real estate ownership are some of the surest ways to increase net worth over time, lower monthly living costs, and increase inter-generational wealth. Today, an adjusted gross income of $100,000 puts you in the top 6.8 percent of all tax returns according to the IRS. However, returns with such income often include two salaries and not just one, and for many, $100,000 is hardly the definition of "rich."

"In many affluent cities and top professions," says The New York Times, "a salary of $200,000 has become the new $100,000." (See: "Six Figures? Not Enough." Feb. 27, 2005)

For most people, putting an extra $50 a month into a mortgage means collecting change at the end of the day, or not dining out once a month. In effect, prepayments are simply a better way to use money that might otherwise disappear.

No less important, for most people the choice is not an absolute, either/or decision to either place more money in a mortgage or to invest in stocks, bonds, or whatever. Instead, the practical choice is to use some money for mortgage prepayments and other money for other purposes.

At six percent, a $100,000 mortgage costs $599.55 a month for principal and interest over 30 years. Add $50 a month, and the loan will be repaid in 24.54 years. The potential interest bill will go from $115,838 to $91,292 -- a savings of $24,546.

Is this a huge savings? Perhaps not in the context of indicted corporate executives, but $24,546 is a big number in a country where the annual household income is $43,318 . Truth is, not having mortgage payments for five years is a benefit few people can ignore.

Imagine that federal, state, and social security taxes equal 25 percent of gross income. In such circumstances, an individual would have to earn $32,728 to net $24,546 in cash. Suddenly the persistent saving of $50 a month seems very attractive.

Taxes

Mortgage interest deductions make home financing more affordable because many owners have a greater ability to direct the use of their funds. However, tax deductions -- by themselves -- cannot justify real estate purchases. No one suggests paying 12 percent interest in a six percent market even though the tax write-offs would be greater.

Given a choice of paying mortgage interest with a tax write-off or paying less interest, it's better to pay less interest. The usual example works like this: If you're in the 25 percent bracket and pay $100 in interest, you can reduce your taxes by $25. That's good. However, if you can avoid paying $100 in interest by getting a lower rate or having less debt, your taxes increase by $25 because you have less to write-off -- but you have $75 extra in your wallet. That's better.

Of course, the value of a mortgage deduction is not the same for everyone. If you're poor you may not pay much, if any, income tax so the value of the mortgage write-off is minimal if nonexistent. If you're in the middle class, then mortgage interest deductions make ownership debt more affordable. If you're doing well, current tax rules reduce your ability to write-off personal deductions once adjusted gross income tops $142,700 (if married and filing jointly) or $71,350 (if single). If there's no state income tax where you live, there's nothing to deduct at the state level no matter what your federal tax bracket and mortgage interest in most cases cannot be written off from federal returns for residential financing above $1.1 million. (See a tax pro for details.)

So to answer the good professor's question, there are situations where making a downpayment and prepaying a mortgage make real-world sense -- and other situations where leverage is best. You have to look at such factors as personal economics, tax obligations, rates of return for alternative investments, risk, local real estate trends, mortgages rates, and individual preferences -- and then decide what's right for you.

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