Whether or not to accelerate mortgage payoff is a question that crosses most homeowner’s minds at some point. It’s especially top of mind this time of year as you gather the documents to file your taxes and realize how much you paid in interest last year on your mortgage. As I discussed this with a client recently, I thought it might be interesting to share my thoughts with you as well.
On a high level, it typically makes sense to invest rather than pay off debt when you believe you will earn a higher rate of return than you are paying in interest on a loan. With a mortgage (in most cases), you get a tax deduction for interest paid on the loan. This essentially lowers the effective interest rate that you are paying on your mortgage. Despite this, many still see the interest they pay over a life of the mortgage and get motivated to pay it off ASAP. If you look at the numbers, however, it’s likely you should pay the minimum and invest extra cash given today’s low rate environment.
Consider the Numbers
I certainly understand the sentiment that it would be awesome to be completely debt free, but let’s consider the numbers for a moment.
Here’s a common scenario for someone who has purchased or refinanced in the last 5 years:
- Mortgage Start Date: 2012
- Beginning Balance: $250,000
- Current Balance: ~$225,000
- Principal & Interest Payment:$1,157.79
- Term: 30 Years
- Rate: 3.75%
- Scheduled Payoff: 2042
Now let’s say you’ve gotten a raise and have $500/month extra cashflow to work with. You are considering 2 choices:
- Option 1: Put $500 extra toward your mortgage each month ($1,657.79/month to mortgage)
Option 2: Invest $500/month and continue paying the same mortgage payment ($1,157.79 to mortgage, $500 to investments)
Option 1: If you choose option 1, your mortgage is paid off over 10 years early! You will be mortgage free in January 2032. At that point, you have your entire principal and interest payment as free cash flow to put toward an investment account.
Option 2: If you chose this option, your mortgage isn’t paid off until 2042, but you begin building an investment account that is growing and compounding immediately. You also have the benefit of flexibility here; while we’re looking at what happens if you keep that money invested, in reality, it is money that is readily accessible to use at some point (given you don’t do something silly like put it in a whole life insurance policy).
The big variable here is the return you get on that investment account. If you were to earn 4% on your investment account, you’d be a little better off investing than paying off your mortgage balance. In 2042, you’d have an investment balance of $257,065 vs. $251,345 in 2042 if you had waited to invest until the mortgage is paid off.
If you were to earn 6% on your investment account, you’d be even better off investing than paying off your mortgage balance. In 2042, you’d have an investment balance of $346,497 vs. $280,523 if you had waited to invest until the mortgage is paid off.
If you were to earn 8% on your investment account, you’d be MUCH better off investing than paying off your mortgage balance. In 2042, you’d have an investment balance of $475,513 vs. $314,095 if you had waited to invest until the mortgage is paid off.
For purpose of illustration, we’ve made this relatively simple. We didn’t consider the lost mortgage interest deduction you face by paying off your mortgage earlier. Including this would simply skew the results further toward the ‘Invest now’ decision as you would essentially have tax savings that could theoretically add to your investment total in the ‘Invest now’ scenario. We also assume a straight line return, but we’re assuming that same straight line return in both scenarios. It’s also worth noting that in each scenario, the exact same amount of money is being put toward mortgage and/or investments every month through 2042 so that we’re comparing apples to apples.
The big question you might be asking is, ‘What if I don’t get that rate of return on my investments?’ This is certainly an important consideration. If you are investing the savings in a low interest CD or savings account, of course, an 8% rate of return is not realistic. If, however, you are investing in a low cost, diversified portfolio that includes a healthy allocation to stocks, history says 8% per year is well within reach over a period of almost 30 years.
Sometimes we have a tendency to let emotions guide our decisions around money. I agree that the feeling of having zero debt is worth something, but before you decide to pay down your mortgage early, consider what you are giving up for that sense of freedom.
Note: This content is property of Modern Dollar Planning, LLC. If you are a financial advisor reading and would like to use this content, you must receive our express written consent.