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Note: Read our guide on what to do once you pay off your mortgage. If you are still some ways off towards this goal, we summarize below whether you should pay off your mortgage early or not.
For most of us, our monthly home mortgage payment is our single largest expense. It allows us a place to call home, to raise our kids, and to live our lives. But at the same time, it constrains us in many ways. For example, it may make it difficult for one spouse to leave a job to stay back home with kids. It creates stress whenever job security is called into question. For some, the burden of a significant debt such as this can be overpowering and they may be looking to get out of debt completely, regardless of whether it is the best course of action or not.
Unfortunately, there are probably as many good arguments against paying off a home mortgage early, as there are for it. Bible Money Matters provides an excellent summary of both sides of the arguments and makes a case for paying it off early.
If you are considering paying off your home early, think why? Is it because you want to get out of debt quickly, or is it the improved cash flow after the pay off? If you are towards the end of your loan term, than it may make sense to pay it off and be done with. However, if you are within the first 10 years of your loan you may want to crunch some numbers before you decide on a course of action.
Should you invest extra cash or pay down the mortgage
For some, seeing their loan balance dwindle at a fast rate is very powerful. The true answer lies in three very important numbers. These are, the rate of interest you are paying on your loan, the remaining term of your obligation and the expected rate of return on the investments you are considering. Now here is what happens. You know the parameters of your mortgage: months left to go and the interest rate if you are on fixed. But you can only guess on your returns on the investments in the future. This is one of the reasons why you may feel more comfortable making extra house payments compared to investing that money. It is easier to take an option where the facts are known.
However, if you choose to make history your guide, than you will find that investing in US Large Caps over a long term (defined as 20-100 years depending on the study you look at) has returned 9-10% in nominal terms or close to 6% in real terms (after adjusting for inflation). US bonds on the other hand have returned close to 5-6% over a long term. Many academics, such as Jeremy Siegel believe that you will not lose money in the stock market (assuming diversified portfolio of US stocks such as SP500 index) if you invest for 20 years or more. This is based on the US historical data and includes market turmoil due to world wars, many recessions, oil shocks and the great depression. It is however debatable if the US markets will ever perform in the future in the manner they did in the past. Good news is that as an investor, we are no longer shackled to the US markets and can take advantage of international growth.
Let’s crunch some numbers, shall we. First, let me outline my assumptions (which you may change to fit your situation).
Assumptions
- 30 year fixed rate mortgage of $350,000
- 7% annual interest, compounded monthly
- 30% tax deduction on mortgage interest
- $1000 available every month to make extra house payments OR to invest
- 20+ year expected investment returns of 10% annually, compounded monthly. The number you use here will depend on your risk profile and asset allocation.
These assumptions yield the following scenarios
| At the end of | House balance with regular payments | House alance with extra payments of $1000 per month | Value of investment of $1000 per month |
| 5 years | $329,460.56 | $257,867.66 | $78,082.38 |
| 10 years | $300,343.34 | $127,258.53 | $206,552.02 |
| 164 months | $271,517.03 | $0 | $350,912.79 |
| 15 years | $259,066.03 | $0 | $417,924.27 |
| 30 years | $0 | $0 | $2,279,325.32 |
The following conclusions can be drawn from the table above:
- Paying $1000 extra every month for the house pays it off completely in little less than 14 years. We cut down the effective term of the loan by more than 50%
- If you choose to invest, at the end of 164 months (by the time you would have paid off your home if you had made extra payments), you will have $350K in your investment account. This is enough to pay off the balance of the mortgage at that time if you choose, with almost $80K left over
- If you choose to continue to invest and pay only the regular payments on the mortgage, at the end of 30 years you will be paid off with $2.3 million in investments
On the other hand if you pay off your home in 164 months and start investing your monthly payments (including the extra $1000), at the end of 30 years you will have $1.65 million in investments at the end of 30 years, which is almost $630K less than if you had decided to just make regular monthly payments and invest the excess capital every month.
If you bought your house in early 30s, this extra $630K in 30 years could amount to as much as $5 million for your estate assuming you die in your 80s (also depends on your investment mix)
Other reasons why you should choose to invest your extra cash
Liquidity: Cash that is invested is much more liquid than tying it up in your home. Very little discussion takes place about liquidity on the blogs and in the financial press, but if you have an emergency you would much rather have investments as opposed to trying to tap your home equity
Opportunity Costs: Investments would allow you to have capital (and possibly more of it) when a good business opportunity presents itself.
Tax benefits: Yeah, I know this is a cliche but consider this: You would pay approximately $300K less in interest over the life time of the mortgage (in the example) if you pay it off in 164 months as opposed to 30 years (and still end up with less savings at the end of 30 years). If you take 30% of this number as the tax benefit you realize over the life of the loan, and invest it as you accrue this benefit (in addition to the $1000 that you invest), you will end up with greater than $2.7 million in investments after 30 years, which is more than $1million more if you compare this to paying off your mortgage early. Now of course there will be taxes on your investment returns (dividends, capital gains, etc) so the ultimate benefit may be somewhere in between $630K and $1million, but it is still a good chunk of change.
Earnings interruption: If you lose your job, or your earnings are interrupted for any reason before your home is paid off, you are still required to continue paying by your bank. This may become difficult if you are trying to pay off your mortgage early and have not saved much in the process. If on the other hand you had invested the excess capital, you would have extra savings to fall back on to continue making your payments for some time.
Create a separate investment account for extra mortgage payments
If you are still torn between paying off mortgage early versus investing, here is a quick tip. Create a separate investment account and pay this extra mortgage payment into this account instead of sending this to your mortgage company. Select well diversified stock investments like a combination of S&P index fund and few diversified international etfs. If you want to reduce volatility in this portfolio (returns will be lower as well), you can throw in some high grade bond funds in the mix, but try not to have more than 25-30% of your portfolio in bonds as this will reduce your long term returns. Once you have settled on your portfolio mix, just keep contributing to this account every month, and once a year, re-balance your portfolio to bring your asset allocation in line.
If at the end of 14-15 years, you still want to pay your mortgage off completely, just tap into this account and write the check to the mortgage company. Or if the stock market has not done too well over this period, you have the luxury of waiting for the right time to sell your investments to pay off your mortgage with this method.
More likely than not, you will find that investing the money has given you much better returns and you would rather continue to invest.
If you want some extra cash flow now, consider refinancing mortgage at the current low rates, and if you are able to do it, invest a large part of the savings in your mortgage investment account. In the unlikely event 🙂 if you are still convinced that paying off your mortgage early is a great idea, you can refer to fivecentnickle’s post for ideas on how to pay off your mortgage early.
It looks like a no brainer that people should NOT pay off their home early. I’m not sure if you mentioned this, but you also need to take into account the liquidity of each of the “assets”.
Happiness Is Better, you are absolutely right. Most people get caught up in the emotion of the decision and end up making sub-optimal choices. Some hard number crunching is called for, especially for something that can have such a large impact on one’s finances over time.
‘Liquidity’ is the most under discussed topic in personal finance and I still do not understand why.
I lean toward the idea of having a plan to eliminate the mortgage. If you can afford the payments, a 15 year fixed loan is a good way to plan for retirement, while saving thousands in mortgage interest.
I started putting money into a 401(k) about 20 years ago, maxed out my contributions each year, and I certainly don’t have $417k in it now – the amount you are estimating above for 15 years worth of $1k/month investment.
In 2001, the tech market bubble burst and the last 10 years the S&P turned out to be pretty much a wash – no gains. And it’s going to take at least another 10 years to recover from the current downturn.
Your assumption of an average 10% return over a 30 year period is just that, an assumption, and a big one at that.
Some of us don’t want to take that gamble, choose to pay off early, and then have lots of disposable income to invest…or not. Next year, at the age of 41, I’ll own my home free and clear and have another 25 years to invest my income that’s no longer going toward a mortgage, or retire early, or take a more fulfilling lower paying job. If I’d invested my cash in the market instead of paying down my mortgage, that investment would now be worth half AND I’d still owe 25 years of mortgage interest and principal.
The decision is one for each person to make depending on their finances. I have fully funded my retirement plan each year, have a well-funded emergency stash of cash and stock(liquidity!), and have extra to invest or pay down a mortgage, so it made sense to me to retire my mortgage debt. One size financial advice does not fit all, especially when it’s based on estimations and assumptions about investment returns over any given period.
@Nicole, Thanks for the comment! Believe me, I appreciate the fact that everyone will make their own decisions,I am just presenting my rationale on this topic.
Regarding your comment on average 10% return over a 30 year period being an assumption, it is not. Historical returns are readily available for almost all stock indices in US and it would not be difficult to validate the figures. Alternatively, you may wish to click the link to the returns study cited in this article to look at the historical returns data. I will provide another link for you: http://www.finfacts.com/stockperf.htm. You will see that if you take ALL 30 year periods in the stock market for Dow Jones, and average the returns, this average is 11.83% in nominal terms. You will also see another interesting factoid, the average actually drops from 11.83% to 3.28% if you missed 90 best trading days in each span of 30- years. Which means, that over 72% of the returns in each span of 30 years were generated in only 90 individual days!
So first of all, your contention that 10% average over 30 years is an assumption is wrong. It is based in historical facts and is even a little bit more conservative than the reality. Now it is indeed an assumption that future will yield similar results compared to the past. No body knows. It may do better or worse. History suggests that stocks as an asset class have almost always done better than any other publicly investable asset class in the long run, and in absence of a crystal ball I would probably take my lessons from history.
Second, a 30 year average return indicates an average. Some stretches of 30 years do worse than the average, and some stretches of 30 years do better than the average. Besides, this only applies if you invest in stock only portfolio. If you are more conservative and invest a part of your portfolio in bonds or cash, than your returns will be lower than the long term stock returns and when “Your” expected investment return is lower, paying down mortgage may indeed make more sense.
I am really glad that your mortgage is close to being paid off. There are situations where I will advise people to pay off their mortgages first, specially if they are paying a high rate of interest on the mortgage and are unable to refinance at a rate lower than, say 7% or so. At a low enough mortgage rate, it does not make sense to pay down the mortgage early at all regardless of risk-tolerance as an investor, because you may be able to get better returns on treasuries. Take for example someone who gets a fixed mortgage this year at 4.5%. Sometime in the future when the economy is doing better and the interest rates have gone up to contain inflation, Treasury bonds may be yieding 6% which is a super safe guaranteed return (unless you believe that the US government will default). Would you advise that person to invest his excess cash in treasuries or would you advise him to keep paying down mortgage?
A very interesting post thank you
i’m intrested in trying to set up my account where there able to draft my payments every two weeks.
People say “don’t get caught up in the emotions”, but that’s kinda the point. Paying your mortgage off is so motivating for some people, you happily cut costs elsewhere and reduce spending to pay it off.
Mathmatically, a credit card with points would be a better way to pay for things than cash, but the average person saves 10 – 15% when they pay with cash. It doesn’t make sense, unless you agree there are a lot of emotions involved with money.
Sure, if you saved the exact same amount of money in both scenarios, you would do better with stocks. But I would never save as much as I am right now if it weren’t for the idea of paying off my mortgage (also contributing 15% to 401k), so I don’t have to die exhausted and bored in florida.
I feel that your argument (to not pay off house early), is flawed. Tell me if this makes sense to you. (executive summary at bottom)
Let’s forget it is “interest savings” on a house for a moment and pretend that the savings are income.
So, can’t you apply your same argument to apply to telling people who are investing, that they should invest in high-risk/high reward (funds or stocks) over low risk/low reward (funds or stocks)?
That may not be good advice. But that isn’t what I see as the main cognitive flaw. I think the flaw is that you are presenting the house as a totality of the investment and comparing it to stocks as a totality of investment. When, in reality, we have a mix of low and high risk/reward investments. You are only comparing the house loan to stock investments, which should only be a PORTION of a person’s investment portfolio.
My argument is that paying off the house can be considered to be a PORTION of the pie chart, filling in the percentage a person wants as a low risk/low reward *certainty* in place of say a money market, CD’s, T-Bills, and so on.
What’s smart for one may not be smart for another, but…
Executive summary:
…what’s smart depends on an individual’s strategic risk categories and percentages, and NOT your argument’s forced BLACK/WHITE (stocks vrs. house) example. Unless of course someone wants 100% of their investments in growth stocks.
But, if your pie chart is one solid color labeled “growth stocks,” then, heck, by all means…. 😉
However, you *can* think of the early pay-off as a category of investment that you label “low risk” income.
To me your argument works only if two things are true. 1) Your house payment is not your *only* available investment money. 2) Your investment strategy is 100% stocks.
Yes? Or, am I full of it? 😉
Should read:
1) Your house payment IS your *only* available investment money.
Sorry… dyslexic. 😉
Sorry to go on.
For example: If you are buying $1,000 in money market/t-bills/cd’s per month. Stop, and start paying an extra grand on the homestead, instead.
That’s the comparison that should be made, not house vrs stocks.
Allen,
You are right in suggesting that the choice is not between stocks vs mortgage. It is between extra mortgage payments versus whatever asset allocation is appropriate for you. The potential returns that you will plug into your model for analysis would correspond to your chosen asset allocation and not pure stocks (unless pure stocks is your allocation which it very well might be if you are young). I picked one example in the article, but of course every one will need to do the analysis based on their own situation.
I will leave you with this thought. Suppose you bought a house last year and were able to get a 4.5% fixed mortgage. Now suppose that 5 years later, US Treasury bonds are yielding 6% and the US is still considered an excellent credit risk. Would you not invest your extra savings in treasuries over paying the mortgage down since you are getting a iron clad guarantee of 1.5% better return in treasuries.
The reason I wrote this article is to hopefully encourage others to rationally look at the data before making this decision.
“1.5% better return in treasuries”
Yes, switch. Of course. If I were paying say $1,000 per mo extra on a mortgage, I would buy the T-Bills (same safe asset category) for as many months as the better safe category return existed, then go back to the extra house payments. Or, if I had an ALL-stock/higher-risk investment strategy, I’d always pay the minimum house payment.
Thanks for reading that and replying.
Cheers!
Nicole hit the nail on the head… and so did a few other responses. The situation depends on your current financial standing and investment direction. The only arguments that I hear after Nicole’s and others great points, is that “what if in the future the bonds yield more?” Well, yes…. but aren’t we talking about now?
Unfortunately after reading numerous articles on this topic, I have come away with 2 conclusions.
1) People who write black and white articles like this are pushing people towards more risky investments, and away from paying interest to banks. Most likely these people are financial advisers who want your money to invest, or they benefit from people paying the full interest $$$$$ for the life of their mortgage. This is sad, and when you see the black and white tones in an article, TAKE IT WITH A GRAIN OF SALT, they are probably just trying to keep you as an interest paying sheep.
2) You need to do your own research and crunch your own numbers. Many situations can be twisted and contorted with details left out so as to make their point valid. ALWAYS ALWAYS ALWAYS break down each point of each argument, especially in an article like this.
Great discussion going on here. We infact were able to pay off our mortgage early, just by applying extra payments. At that time interest rates were so low on anything else that it just made sense to get rid of our biggest debt. I agree that everyone’s situation is different and they each need to do what benefits them the most.
what’s smart depends on an individual’s strategic risk categories and percentages, and NOT your argument’s forced BLACK/WHITE (stocks vrs. house) example. Unless of course someone wants 100% of their investments in growth stocks.
@Doug,
Fortunately I can report that I have no vested interest in making my recommendation. I do not work for a bank/mortgage company, nor do I get paid based on how people invest.
I wrote this article as I struggled with this question myself and while the emotional appeal of different choices were tempting, I wanted to formulate a structural approach to decision making in this regard to make sure I make a rational decision.
And you are absolutely right, everyone needs to do their own analysis AS EVERY SITUATION IS DIFFERENT.
@Doug/@biblemovies – With respect to your contention that the article is too black and white and the comparison is forced, I would just like to say that I am not comfortable managing my finances based on my feelings. My financial life is not touchy feely. I want real hard numbers and that means forcing a degree of black-and-white-ness on the whole thing.
And yes, I could have picked many comparisons other than house v stocks, but it does not change anything really. The comparison is between two asset classes with different returns and the asset class with better long term return wins. I am sorry, but that is the way it is and I am not going to change my advice to match whatever passes for political correctness in the personal finance industry.
How people take my advice depends on their risk tolerance and I have no problem with that.
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I would just like to say that I am not comfortable managing my finances based on my feelings. My financial life is not touchy feely. I want real hard numbers and that means forcing a degree of black-and-white-ness on the whole thing.
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I too, thought this when I was younger. I ran all the numbers with the best of them 20 years ago, and would constantly explain to my wife why we shouldn’t pay off the house early. However, as time has progressed, I contemplated the fact my wife and four children rely on my ability to put a roof over our heads every day. Personally, I will pay the mortgage off early *every single time*.
We (in the US) live in an *extremely* uncertain economy. “Feelings” do indeed enter the conversation, for me at least.
These are good notes for us all and it is a personal preference based on individual circumstances. It is always better to have liquid monies in the bank or whatever, and it a home it is not liquid. A good portfolio needs to be diversified. There is no right answer or no perfect formula that would be a perfect fit for everyone.
We all have to review our own goals and make a decision based on our own situations. I personally feel to pay off a mortgage sooner is better. To me, it gives one more flexibility to do other things. It is a wonderful stress reliever. That is why in the next couple of months I WILL pay off my 67,000 mortgage. I do not want to be paying on that when I am 80. Peace of mind is priceless.
One thing that I almost never see written in these debates is regarding a situation in which both spouses work, but one would like to stay home with the children. If the two decide to hammer away at the mortgage until it is paid off and then one spouse can stay home and raise the kids, how could that be considered a poor investment option? The truth is that if both stay working, the two would not likely invest the difference, but it would invariably get spent on cars, vacations, wardrobe, daycare, commuting, eating out, etc. We can almost maintain our current lifestyle on one income, including maxing out our Roths, his 401K, and investing what I was contributing to my 401K if we do not have a mortgage payment. We can only do this if we are mortgage free. This sounds like a wonderful gift for our family and children.
Liz, if the discipline to invest the difference is not there and if paying the mortgage off is a greater motivator, than you should choose what works for you. If you do want to give the investment idea a go, than one way to do this is by setting up automatic transfers to your investment account (or automatic deductions from your paycheck if your payroll provider allows it). And to make it even harder to spend that invested money, you may want to buy mutual funds directly from the mutual fund company instead of a broker. This way withdrawals will require paperwork and mailings and it will force you to stop and think if the expense is necessary before you access your investments.
That being said, most of us tend to think in terms of “if situation x was like this, I could do y …”. It is the wrong way to think about. You are mentally creating a link between x and y when there does not have to be. In this case you are thinking, if only mortgage were paid off, one of us can stay home and raise the kids.
Flip the question around. Ask “we want one of us to stay home and raise the kids. How can we do this?” instead. This will than help you explore a whole bunch of new ideas about generating more income with part time, 2nd job or side business, or save on expenses, move to a cheaper neighborhood, etc. This works better because you are giving priority to staying home to raise the kids aspect instead of paying off the mortgage aspect and so it will generate different solutions.