Should I Pay Off My Mortgage Early or Look for a Better Return?



should I pay off my mortgage early I think at some point everyone has thought to themselves should I pay off my mortgage early or do something else with my money?

We’re told all the time by the media that sending in a few extra bucks every month with our mortgage payment will help erase thousands of dollars in interest payments – and that’s a good thing!

But at what cost? What if you could be doing something else with those “few extra bucks”? Perhaps that something else you could be doing may even lead to a better rate of return …

 

Asking the Question of Should I Pay Off My Mortgage Early:

Where this is all coming from is when my wife and I recently got the itch to check into the possibility of moving into a new house. Moving can be exciting! Basically our decision came down to this:

  • A) Move and take on a higher mortgage payment than we have now? or
  • B) Stay in our current house, keep paying our current mortgage, and possibly accelerate the payment schedule by sending in the extra cash we would have used for the new house?

Because the two of us are committed to our plan to reach financial freedom early, we ultimately decided to stay in our current house (for now). But then that begs the question:

Should we then stick to our plan to pay off the mortgage early?

Crunching the numbers, I calculate we’d have to send in an extra $500 per month to have our house completely paid off by the time we plan to retire (11 years from now).

I don’t know about you, but $6,000 per year ($500 per month) is a lot of money! While paying off that debt would be a great accomplishment, it sure seems like there are a ton of different things I could be doing with that money. Could any of them potentially be better?

With that said, here are my thoughts to both sides of the argument for why we should or should not pay our mortgage off early.

 

Why You Should Pay Your Mortgage Off Early:

You don’t need me to tell you that there are plenty of good reasons for paying off your mortgage early and why people rave about why you should.

1. Finally being debt free!

Doesn’t it just feel good to get rid of that mortgage payment? The simple fact of knowing that you’re finally done and don’t have to send in any more money to the bank is one of the most powerful psychological reasons why people do it.

2. Saving yourself thousands of dollars in interest.

A mortgage is a loan. And loans have interest. Therefore the longer you have your mortgage, the more interest you’ll end up paying to the bank over time.

Who wants to do that? Why not keep more of your money instead of giving it away every month.

I highly encourage you to go to a calculator and see just how much interest you end up paying on your house over the life of your mortgage. It is extremely eye opening!

3. Locking into a fixed return rate.

Consider this: When you pay down your mortgage early, it’s the equivalent of investing that money and getting the same rate of return.  What does that mean for you? Say your mortgage interest rate is 5%. Then for every dollar you use to pay your mortgage off early, it’s like getting a 5% return.

For an in-depth explanation of how that works, read my post Which is Better – Paying Off Your Mortgage or Investing the Money?
All in all, that’s necessarily not a bad way to get a guaranteed rate of return for your money. Think of the last time a CD at the bank offered you 5%? Depending on how you like to invest your money, you might have to take on substantial risk to get that same return.

4. Reducing the amount of money you’ll need later or during retirement.

A big part of retirement is minimizing how much you need as far as cash flow. So if there was no more mortgage payment, then you’d need a whole lot less during 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 target nest egg of $1,200,000 instead.

5. Lower taxable retirement income.

Along the same lines as No. 4, if you’re smart about how much taxes you’d like to pay when you’re retired, then you’ll want to make sure you pay off your mortgage before you enter into retirement.

The reason is this: When you retire, you’ll want to withdraw as little money as possible from your nest egg and Social Security so that you pay little to no taxes.

Suppose for retirement you decide you’ll need $30,000 per year pre-tax. Now let’s say that $10,000 of that $30K are your mortgage payments. If your mortgage was paid off, wouldn’t it be better to only need $20K instead of $30K. At $20,000, you’d actually owe no Federal taxes whereas at $30,000 you’d owe something.

Of course there are many ways to dance around paying taxes altogether during retirement, and this could be a complete non-issue. If you’re interested in knowing more about this, check out my how to have a tax free retirement. We actually worked out a scenario where you could withdraw $132,500 from your nest egg without paying any taxes at all!

6. Lowering your risk and protecting your best asset.

If you did pay off your house in full, then you’d never really have to risk losing it! Usually when someone faces a job loss or something like that, it causes them a great deal of stress because they worry about falling behind on their mortgage. But if you own your house outright, then you’d be worry-free.

 

Why You Should Not Pay Off Your Mortgage Early:

While each of the above reasons above were pretty good, the reasons NOT to pay down your mortgage ahead of schedule can also be just as equally enticing.

1. Heging inflation.

If you have a fixed rate mortgage, then your principal and interest payments will be the same for the next 15 or 30 years (depending on whatever kind of mortgage you took out).

While that may not sound very special, it actually has a very unique benefit to you in terms of inflation protection.
Consider this: As time goes on, all your other monthly payments will go up like your food, gas, utilities, car payments, insurance costs, etc, will go up.

But not your mortgage. Your mortgage is frozen in time. And relative to everything else you’re buying, that payment will actually “feel” like less the longer time carries on.

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:

paying your mortgage off early

Your future self might appreciate this!

2. Find a Better Rate of Return

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 stock market (such as the S&P 500 index) is 8.0%, then that’s a difference of 8.0% – 4.0% = 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. Inability to tap into the funds due to loss of 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. According to this story from ABC News, this is unfortunately exactly the kind of thing that happened to one couple when they decided to use their 401k retirement funds to pay off their mortgage rather than waiting.

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. Low interest rates.

When I refinanced my house two years ago, I thought I’d never see interest rates that low ever again. Imagine my surprise when rates continued to fluctuate and banks were offering 15 year loans 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.

If you were lucky enough to lock into one of these ultra low rates, then you’re basically paying a historical low of almost next to nothing for your mortgage.

5. Fewer income tax return 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.

Unfortunately this point can be somewhat weak in the pay off your mortgage early debate. Suppose you own a median priced house with around 20% equity in the house. In that instance the IRS Standard Deduction would automatically exceed whatever tax benefit you’d receive from itemizing.

6.Taking Care of Other financial goals.

Foregoing putting money into your 401k?

Not stuffing your emergency fund with the cash it needs?

Do you have high interest debt you should be paying off instead?

Maybe relative to these things paying off your house early just isn’t a huge priority.

Perhaps you’d rather dream big by starting a business, buying real estate, or fund other investment goals (like buying more dividend stocks) instead.

 

What is the Right Answer?

So after all of that, you’re probably wondering to yourself which of these directions is the right one to go in.

The short answer – it depends entirely on you.

Only you know your own financial well being. Perhaps some of the points we made here carry more weight to you than others.  Regardless, there is never really a good one-size-fits-all answer to these kinds of situations. All you can do is look at the possibilities and decide for yourself which ones fit your position the best.

Readers – What do you think? Have you ever given much thought to the question of should I pay off my mortgage early? Did you end up doing it? Or did you find other reasons why you should do something else with the money?

 

Related Posts:

1) Which Is Better – Rental Income or a Stock Market Index Fund?

2) How Much Money Would I Make If I Rented Out A House?

3) Which Is Better – Paying Down Your Auto Loan or Mortgage?

Image Credit: freedigitalphotos.net

Comments

  1. says

    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 MoneyMy Profile

    • MMD says

      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!

    • MMD says

      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.

    • MMD says

      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)!

  2. says

    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.
    Nicoleandmaggie recently posted..Mr. Money Moustache vs. Laura VanderkamMy Profile

    • MMD says

      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.

    • MMD says

      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.

    • MMD says

      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.

  3. says

    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 MarriageMy Profile

    • MMD says

      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.

  4. Justin @ The Family Finances says

    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.
    Justin @ The Family Finances recently posted..Friends of the Family: Setting Goals EditionMy Profile

    • MMD says

      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!

  5. says

    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?
    Jason @ WSL recently posted..Want to Win an iPad 3? Luckily for You, We’re Giving One Away…My Profile

    • MMD says

      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.

  6. says

    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.
    Canadian Budget Binder recently posted..How to Earn Optimum Points Fast at Shoppers Drug MartMy Profile

    • MMD says

      Regardless of what you decide, that is extremely impressive that you have the money to pay it all off if you really wanted to!

  7. says

    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.

    • MMD says

      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.

  8. says

    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 :)
    Pauline recently posted..Little house in Guatemala, week 6My Profile

    • MMD says

      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!

  9. says

    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 RealityMy Profile

    • MMD says

      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!

  10. says

    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.
    Shilpan recently posted..Effect of Taxes on the EconomyMy Profile

    • MMD says

      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%!

  11. joe schmoe says

    It may make sense to payoff your motgage early when you consider that you could lose your stock investment over night.

    • MMD says

      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.

  12. says

    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. :)

    • MMD says

      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?

  13. says

    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.

    • MMD says

      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.

  14. RobM1981 says

    Here’s a twist:

    If you are sitting on old stock options, or stocks, consider what has happened over the past year.

    The stock market has inflated tremendously. Nobody – and I mean nobody – can point to fundamentals that explain why many stocks have doubled in value. Most people view this as a bubble – the economy is so poor that investors are pouring money into the stock market, and driving up prices, “just because… what else can they do?”

    Thus the “inflation” argument might be turned upside down here.

    If you suddenly have enough stock-value to pay off your mortgage, even after capital gains takes its bite, then consider doing so.

    It all depends: do you think the market is still going to climb, or is this a peak?

    If you think the bubble is going to burst, you’ll be paying for a hard asset (your house) with inflated dollars. Depending upon your tax situation, your stomach for risk, etc., that might be a wise thing for you to do.

  15. Suzie says

    Interesting post. Just one thing. Our mortgage payment has never stayed the same. We’ve been in our home over 12 years. Well ok the actual payment to towards the loan is the same, but because the bank pays our property taxes our escrow account changes every year. Our property taxes keep going up because of school levies. So technically our mortgage payment keeps going up.

    • says

      I completely understand. My P&I has always been the same as well. But the taxes, insurance, PMI (escrow) can fluctuate. I suppose on that point if you really think about it, paying off your house completely won’t be that grand because you’ll still have to deal with taxes and insurance – those won’t go away!

  16. says

    For me I would pay it off because I want to avoid all risk. I would feel more at ease with a paid for house, than trying to hedge the market with the interest rate game. Once its paid off then you can plunge the entire mortgage payment for a year, and start investing some big dollars.
    EL @ Moneywatch101 recently posted..How Greed can take over?My Profile

    • says

      There’s a lot to be said about risk adversity. Certainly it would be great to have your biggest asset paid off and the deed in your hands. When people site that as their most compelling reason to pay their mortgage all off early, I can really sympathize with that notion.

  17. says

    Someone mentioned this option to me the other day and I think it is perfect. Invest the money. Then, when you have however much you owe on your loan in your investment account (after taking into account taxes on gains) decide whether or not you’d rather have the investments or no mortgage. You’ll be better off all around :D If, and only if, you can invest the money you’d throw into the mortgage without fail.
    Lance Cothern recently posted..The Two Main Paths To Retirement Couldn’t Be More DifferentMy Profile

    • says

      I think the whole investment vs mortgage payment return is well worth considering. If all goes as the market has done on average for years when you invest, you’ll end up with all the mortgage payoff money you’ll ever need (and then some) to settle the debt.

    • says

      That’s how I feel about it Jon. If mortgage interest rates were higher (and thankfully they’re not), I’d be happy to effectively “lock” into a decent figure. But my mortgage rate is so low that I feel like I’m practically getting the loan for next to cash.

    • says

      Regardless of which side of the debate you’re on – I say good for you! Paying off a large debt of any kind is a huge accomplishment and display of responsibility in my book. I can’t imagine how great that feels not to have to worry about those payments anymore, right? I’m sure it could almost be intoxicating.

  18. says

    This is a question I have been writing about lately. I think it mostly depend on whether you are concerned with being debt-free or with getting the greatest return.

    But why not do both?

    It’s not a bad idea to invest the extra money into some good index funds and let it grow instead of putting it toward your mortgage each month. Once you have created some wealth with that money, you can always pull it out and it towards your mortgage.

    My wife and I are doing exactly that. When we have accumulated the amount that we have left on our mortgage, we will simply pay it off.

    Just a thought. Great post!
    Kalen @ MoneyMiniBlog recently posted..3 Powerful Strategies to Pay Off Your Mortgage EarlyMy Profile

    • says

      I think that’s a perfectly fine approach as well. Essentially you’re locking into the return you’ve made from the index funds and then re-locking into the rate of your mortgage interest (but more importantly paying down your debt). More than once I’ve questioned taking money from taxable investment account after one or two wild rides and using the proceeds to wipe out our own mortgage. Good suggestion!

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