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?
1. Inflation.
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?
Related Posts:
1) Which Is Better – Rental Income or a Stock Market Index Fund?
2) Adventures in Refinancing, Chapter 5
3) Which Is Better – Paying Down Your Auto Loan or Mortgage?
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I think it all depends on your interest rate and the duration of your deal. We have a fixed rate for 3 years at around the 4% mark; in the UK it is hard to find a decent fixed rate for anything more than 3 years. If you can get a fixed rate for the entire term that is attractive, I would definitely NOT pay off my mortgage early!!! I am just scared right now that interest rates will balloon in the coming decade.
Savvy Scot recently posted..Change Your Life – Step 8 Become Better with Money
No attractive fixed rates over 3 years?! That’s no good. Conventional advice in the US is to lock in for a 15 or 30 year if possible. I do agree with you that rates will probably go much higher over the years!
I’m trying to do both pay off the mortgage as my “safe play” and invest the other 30% of my money in “riskier” assets like shares and commodities.
I’m not sure what is right or wrong, but so far things are going fairly well.
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If you’ve got the money to do both, then why not?!
I think it comes down to a personal choice. I know a better return is possible, but if we were in the position to then I would pay it off early. You could throw most of that extra money at investing, plus you can be entirely debt free. Also, with the supposed Cliff, you never know if they might be taking the deduction off the table or not.
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I know a lot of people would rather bet on the sure thing, which is why paying the mortgage off early may work in their favor. Plus being debt free has a lot of perks. Sometimes the decision is based on more than just the numbers.
This is something that we are thinking about right now. We are wanting to sell our current house and move into a new one in around 1.5 years, so we don’t plan on paying our current one off. However, with the next house we do want to put a substantial own payment towards it.
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I’m kind of wishing we had more money for our first down payment. If we had more equity, it would have made the first part of my story with the refinance a lot shorter (because it would have been easier and a sure thing)!
An important reason why not is diversification. http://nicoleandmaggie.wordpress.com/2010/07/31/the-pre-paying-the-mortgage-question/
If your house is a relatively small part of your overall portfolio, then go ahead and pay it off. If it isn’t, it is risky to have all your money tied up in one piece of real estate in one market. Even if you would never ever default on that loan, it’s still important to diversify where your money goes– we could sell stocks and pay off our mortgage tomorrow, but we choose not to because of that diversification. We do some prepayment each month but aren’t focusing on killing the loan at the expense of retirement savings.
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Nicole and Maggie, you always bring a different perspective to the table! Great logic. In my case, I have lots of other investments, so I would be okay. But anyone who doesn’t have that would face significant risk by tying all their money up in one asset.
I feel that the pf community pushes hard for early mortgage payoff but between inflation, investment returns, and locking money into your house I don’t think it is the right move if you locked in a rate less than 5%. That is my personal opinion and only works if you don’t feel like a hostage to mortgage debt.
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I’m not sure why the PF community always pushes early mortgage payoff. It makes sense sometimes, but not always. In my situation, I don’t think it is worth it at the interest rate I’m locked into.
You make some great points, i just recently had a friend who’s adviser told her she had saved enough and to start putting more payments into her student and mortgage loans.
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There’s never anything wrong with using the money to pay down your debt. I just wonder if there is an even better use for that money? Depending on the interest rate, I think there might be.
I wrote about this from a slightly different angle a few weeks ago (in my link) and if I had a mortgage at today’s low rates I would probably extend it as long as possible and invest elsewhere. If I didn’t have room in tax-advantaged retirement/educational/health accounts, though, I might start paying more on the mortgage depending on the rates of return possible elsewhere. Unfortunately, I do not have a mortgage!
Emily @ evolvingPF recently posted..Ways to Monetarily Invest in Your Marriage
Interesting theory! I’ve heard other financial gurus go against the grain and recommend that you should take out a mortgage for as long as possible providing you can get one for an incredibly low rate, and invest the difference in payment. On paper, it actually does work out so long as you can get a higher rate of return from your investments.
Really, if you’re in the position where your only debt is the mortgage and you’re deciding whether to pay that off or invest, there’s no right or wrong. You’re in great financial shape, and you’ll be fine with either decision.
If you’re really stuck between the two choices, then do a little of both. Take the extra money each month and apply half to the mortage and invest the other half.
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Thanks Justin. I’d love to say I am, but in reality I’ve got some 0% interest debt and a 2.25% car loan also. But because those are practically nothing, I don’t really sweat those ones!
I would pay off the house. The reality is that you’re not factoring inflation into the fixed interest rate on the mortgage. So, if you’re paying 4% on your loan and you factor in 3% of inflation, that means you need to be earning 7% on your returns. On top of that the S&P COULD average (hence average…not actual) 8%, but why take the risk when you can have the guaranteed thing?
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Sorry Jason – I messed up and forgot to post the table of inflation values. I was surprised at how small your payment would “feel” after just a few years.
Because a fixed rate mortgage is not calculated with inflation, you’d really only net a 4% – 3% = 1% return by paying off your mortgage early.
In mid 2013 it will be the 4th year we’ve owned our home but we’ve had the money to pay it off in full for 2 months now. We’ve been asking ourselves the same question, should we? In the end there was a lot of “what if’s”. The conclusion we came up with is what if we could make more money investing, but what if we didn’t. What we do know is paying off the mortgage is clear cut.. when it’s gone it’s gone. I’d rather feel good knowing that the roof over my head is safe rather than hope the money we do have if invested works in our favour. I’ll take the sure thing then look into investing my mortgage money that I’m saving for investments.
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Regardless of what you decide, that is extremely impressive that you have the money to pay it all off if you really wanted to!
We are paying off our mortgage as quickly as possible but only after saving for retirement and some college saving for our kids. Even then we are still doing some investing in taxable accounts to stay well diversified.
There are so many arguments for not paying of your mortgage early. But at the end of the day it is a guaranteed return that significantly lowers monthly expenses once it is paid off.
I was on the fence until my mortgage guy talked to me about recasting. Essentially, at any time (sometimes for a small fee) you can recast your mortgage to take into account your prepayments. It does not lower your rate but, if you’ve made significant prepayments, it will lower your monthly payment. Before I heard about this I was worried about getting a lot, but not all, paid off and then having some sort of life change where we couldn’t get it all paid off.
Thanks and welcome to the site. I agree that retirement and college savings come first. Those are my priorities as well. During my last refinance, our agent talked to use about recasting (although I don’t think he called it that). Even if I won’t exercise it, it is an interesting option to know you have available.
I am at 2.29% and it is a rental so I am not repaying. It allowed me to put the money down for the new house in cash. I could sell a few investments, maybe at a loss but I am ready to take the risk, if I needed cash. Usually the bank of mom provides the cash flow
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That would be nice to have a bank of Mom to help out!
For me a house is shelter. Sure I want it to be nice, but I don’t view it as an investment. Instead, I’d rather have the security of ridding myself of it and not worrying about payments. If another great recession hits and I lose my job I won’t have to pull mortgage payments from my E-fund.
Justin@TheFrugalPath recently posted..Finding Your Path To Financial Independence
I’m always concerned that another Recession could be around the corner. Having no more mortgage would certainly cut down on how much income you actually need. Perhaps a good compromise would be to have at least a few month’s worth of payments ready to go!
We refinanced our house at 3.25% and I was so excited!!! I have seen now that it is more like 2.75% for a 15 year. I guess I didn’t wait long enough =) I’m still happy with 3.25%, though.
We are in the mortgage payoff camp. Our house will be paid off in 34 months. I hate debt and that doesn’t exclude my mortgage. But, we are also saving aggressively for retirement so I don’t have to choose one or the other.
Holly@ClubThrifty recently posted..Club Thrifty: Turning Our Dreams into Reality
Well, I think congratulations are in order for both the 34 month countdown and extreme retirement savings! Way to go!
I totally understand the psychological argument, but inflation trumps it for me. The government is doing everything to drive up inflation long term. At 2.75% I am paying the minimum for sure.
DC @ Young Adult Money recently posted..How Networking Can Benefit Your Career
Agreed! 20 years from now when my $1000 payment feels like $544, I’m pretty sure I’ll be fine with my decision.
We just closed last week on yet another mortgage refi – my 4th since I’ve owned the home! I’ve saved thousands upon thousands of dollars every single time. Got a 15 year at 3% this time, down from 3.75% only two years ago. And yes, we absolutely intend to pay it off early. Partly because we just added 2 years with this refi.
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I wish I could say we did the same. If only we had just a little more equity, then we could refinance again with no issue. Stinks being under-water!
I think the key factor that governs your decision is the interest rate. For instance, if I had to make that decision in 70′s when interest rates were in double digit, I’d have paid my mortgage off; it’s better to invest your money into a safe instrument like Vanguard total market index fund instead of paying off your mortgage since you can borrow money for your house at a rate far below the return you would receive from your investment.
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I agree Shilpan. It’s all about arbitrage – the difference in rates between what you owe and what you’re earning.
And thinking back on the days of those high interest rates, I wish I had taken out more long term CD’s and bonds! I remember having a CD at 8%!
I prefer the Dave Ramsey method of getting rid of debt to limit your risk in the long run. And getting a better interest rate in a safe investment isn’t exactly easy today.
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As always, you have done an excellent analysis. For me #1 is the biggest motivator and we are going for the early payoff.
Kim@Eyesonthedollar recently posted..Is There Ever a Reason to Blow Your Christmas Budget?
For someone who plans to own several houses, I can see why! Thanks for the compliment!
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It may make sense to payoff your motgage early when you consider that you could lose your stock investment over night.
You’re absolutely right that you could lose your investment overnight when it comes to stocks. But at the same time, those same stocks could also go up.
In all choices, its important to consider your comfort and aversion to risk. All options with higher rates of return usually involve some higher risk taking. In my case, I’m pretty comfortable with risk since my investment time horizon is pretty long. But at the same time, I plan to invest in the most sensible companies I can find so that my choice isn’t doomed from the start.
My wife and I paid off our home this last year. Our 401k allows for taking up to half out for a home loan.. and then, I have to pay myself back (with interest).
I went from paying almost $5,000 a year in interest on a 30 year note (that I still owed 23 years on) to repaying a 401k loan that will cost me less than $5,000 interest over the next 5 years (less than 4 now).
There’s something to be said about opportunity costs too. Having a home paid off for 20 years of your young life is a lot of opportunity to do things that one could never do otherwise. Getting the home paid off at 80 does me little good in regards to enjoying life.
What an interesting strategy: I wouldn’t think that the interest payback from borrowing on a 401k is less than the interest you pay on your mortgage. What was the spread of interest rates?
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[...] MyMoneyDesign also had some interesting points to consider. [...]
[...] MyMoneyDesign also had some interesting points to consider. [...]
To me the answer is pretty simple. A home always has value, no other investment always does. Blue Chips like GM can go bankrupt, eliminating the value of both stocks and bonds. Cities can go bankrupt, making their bonds worthless. Banks go under.
Paying off your home before retirement is a clear necessity if you want an affordable, stress-free retirement. And the extra money you have available every month after paying it off can be funneled completely into other investments if desired — secure in the knowledge that your most important necessity has been taken care of.
You can also borrow on your home after retirement if you face an emergency. And if you do a reverse mortgage then, you’ll never have to worry about repayment during your lifetime.
Unless you plan on defaulting on your mortage, it won’t matter if you have to move & sell at a loss — you’ll take the hit regardless of whether you’ve paid it off beforehand.
Only reason not to prepay is if the neighborhood could become inhabitable during your lifetime, and you plan on defaulting and turning the house over in that event.
Note: Yes, it’s theoretically possible that the money could potentially earn more in other investments. It’s also possible you could lose it all in other investments. You have a lot more control over your own home value than any other investment. And it will always have the inherent value of keeping a roof over your head, which is generally worth $1K-$3K monthly. I can’t see the risk often being worth it, especially if you can pay cash up front, as that can also secure you a better sale price.
Bottom line, look at the fact that you’ll pay twice as much if you buy a house on time vs. paying cash for it up front, or as soon as possible. I don’t care about inflation, etc. — once you realize you’re gambling that much money hoping the other investments will make up the difference, the choice becomes clear to me. You can gamble with other invesetments, but pay off the house as quickly as possible. And don’t borrow for ANYTHING unless absolutely necessary. Just makes everything cost more.
This all gets back to your comfort level on investments. Some people feel uncomfortable taking a risk on getting a better return rate. With a 30 year time horizon, the fact that stocks have returned 8 to 10% on average since 1926, and never lost money over a 20 year time period, I’m good with taking the risk.
Despite how you feel about inflation, it doesn’t change the fact that it is a reality. Using the rule of 72 and 3% inflation, the price of everything will double in approximately 24 years. Basically in the future your mortgage payment will feel like half of what it is relative to everything else we spend money on. This can be a useful trick when you consider all the other opportunities you have to use that money and grow it in other places.