Pay off home mortgage early

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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.