When I refinanced my house last winter, I thought I’d never see interest rates that low ever again. So imagine my surprise when almost a year later I’m noticing rates for a 15 year loan as low as 2.75%. Could you imagine a mortgage with a rate as low as 2.75%? That’s less than the average 3% inflation rate.
While all this sounds enticing, this has me wondering about my overall mortgage situation altogether. In previous posts, I’ve talked about how paying off your mortgage early could actually help your money design. But when it comes to investing, it’s always important to look at things from both sides of the fence. So in this post, we’re going to ask: Should I pay off my mortgage early or look for other opportunities with a better rate of return?
Should I Pay Off My Mortgage Early – The Reasons Why:
First of all, let’s highlight the typically good reasons for paying off your mortgage early and why people place so much emphasis on this act:
1. Being debt free. Doesn’t it just feel good to get rid of a payment?
The psychological effect of not owing anyone anything and claiming their home as 100% theirs is one of the major reasons why many so many financial gurus often preach to do this.
2. Reducing the amount of money you’ll need during retirement.
As I’ve written about before, early retirement is all about cash flow. So if you’ve been paying your mortgage off early and don’t have a payment anymore by the time you reach retirement, then you’ll technically need less money throughout retirement.
For example, let’s say you have a $1,000 mortgage payment and $4,000 in expenses. In the classic calculation, you’d need $5,000 x 12 months = $60,000 per year which equates to a retirement savings target of $1,500,000. But if your mortgage was paid and all you had was the $4,000 in expenses, then you’d only need $48,000 per year which equates to a savings target of $1,200,000 instead.
3. Locking into a fixed return rate.
When you make a fixed interest payment on your debt, it is the equivalent of investing that money and getting the same rate of return. For an in-depth explanation, read my post Which is Better – Paying Off Your Mortgage or Investing the Money?
Or if you prefer the short answer, it goes like this: If your mortgage was at a 5% fixed interest rate, then making an early payment would be the same thing as if you had invested the money and achieved a guaranteed 5% return rate. Compare that to the current payout of a CD at the bank!
The Reasons Why I Should Not Pay Off My Mortgage Early:
While each of the above reasons were pretty good, what’s on the other side of the argument?
If you have a fixed rate mortgage, think about the fact that your principal and interest payments will be the same for the next 15 to 30 years (depending on whatever kind of mortgage you took out). So while all of your other payments will go up like your food, gas, utilities, car payments, insurance costs, etc, you will have some comfort in having a mortgage payment that is frozen in time.
For example, let’s say you’re paying $800 today for principal and interest. For as long as you have the loan and do not refinance, you’ll always pay $800 every month. So if inflation increases by an average of 3% every year, that $800 will “feel” like the following over time:
2. Better return rate.
Above we said that making a mortgage payment is basically the same thing as getting an investment with the same return rate. So let’s suppose that you refinanced your mortgage within the last year and got a fixed rate at 4.0%. If the average annualized return of the S&P 500 stock market index fund is 8.0%, then that’s a difference of 4.0%. If you’re investing for the long haul, then rather than paying off your mortgage early, why not go for the market average and shoot for an 8% return instead of a 4% one?
3. Evaporating equity.
What if we have another Great Recession like we had in 2008 and house values don’t go back to where they once were? What if they drop even further?
While debt is debt and you’ll have to pay off your mortgage no matter what your house value is, it may not strategically make sense to “park” your money in your house by paying your mortgage off early.
Consider if you made extra payments towards your house and you suddenly had to move for some reason. What if your house unfortunately sold for less than what you still owe on it? You’d never recover all that money you paid into your mortgage, and so you’d be out.
A better place may be to temporarily park your extra cash in an emergency fund or someplace where you can have access to it in case something came up.
4. Tax breaks.
You may not realize it, but your mortgage interest is deductible against your U.S. income taxes. Most other forms of debt (like a credit card or car payment) are not. While there is always a Standard Deduction, in some situations it may work out better for your tax situation to have more interest to declare.
5. Other goals.
Maybe paying off your house just isn’t a huge priority. Perhaps you’d rather start a business, buy real estate, fund other investment goals (like buying more dividend stocks), or payoff other high interest debt instead. Since you are ultimately responsible for your own financial well being, your preference on these goals is all that matters when you’re considering paying off your mortgage early.
Readers – How many of you are planning on paying off your mortgage early? Why or why not? What is driving your decision?
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