Warning! Your Intuition and Financial Truth May Disagree
- Discover 5 ways to accelerate your mortgage payments.
- Reveals the surprising dangers to paying off your mortgage early.
- Explains step-by-step how to find the correct answer for your situation.
Should I pay off my mortgage early or invest?
You will inevitably confront this question in your pursuit of financial security.
The problem is the answer is far more complex and confusing than generally understood.
The intuitive response is to get out of debt. We all want the security of owning our castle free and clear with one less expense to deal with. The prospect of making monthly payments for the next 30 years is antithetical to freedom.
However, there are times when intuition and finance disagree.
The decision to pay off your mortgage early isn’t just about getting out of debt because complicated equations involving return on investment, time-value of money, and inflation are involved.
Remember, this is finance. You can end up with “Alice in Wonderland” scenarios where debt is the cheapest solution, and a dollar paid tomorrow might actually be preferable to debt freedom today.
Curiouser and curiouser…
In this article, I pull back the curtain exposing the many dimensions to paying off your mortgage early. The objective is to balance your intuition with financial savvy so you can make a smart decision.
The correct answer is not cookie-cutter, but must be custom-fitted to your personal financial situation.
Let’s explore how this complicated process works…
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How to Pay Off Your Mortgage Faster
If you decide to pay off your mortgage early, there is no shortage of advice on how to get the job done.
Unfortunately, it all boils down to the same three little words – “pay more principal”. There is no magic secret. The only real difference is form, not substance.
Paying mortgage principal early is a powerful money saver because small debt reductions compound dramatically over the life of the loan, thus eliminating many times the payment in interest.
For example, this mortgage payment calculator shows you that a 30 year, $100,000, 6% mortgage has a monthly payment of $599.55, with only $99.55 going to principal in the first month.
If you add just $100 to that monthly payment, you literally double the principal paid in the beginning, eliminate 108 payments over the life of the loan, save $39,900 in interest costs, and shorten the payoff time from 30 years to 21 years.
Not bad for an extra $100 per month…
If that sounds appealing, then here are the various strategies for early mortgage payoff starting with the simplest and moving toward the most complex…
- Add Principal to Your Current Monthly Payment: Assuming your mortgage doesn’t have a prepayment penalty (check first), the simplest early payoff strategy is to just add principal to your monthly payment. You could try a one-time lump sum where you put the proceeds from selling a boat, motorhome, or unused jewelry to good use. Alternatively, you can add a little extra every month by sending your raise or bonus directly to the mortgage company. The concept behind this strategy is you got by just fine without the money before, so you'll never miss it if you never see it.
- Biweekly Payment Schedule: Rather than make one mortgage payment per month, try making half the payment every two weeks. Since there are 52 weeks in 12 months, that causes 26 half-payments or 13 full payments instead of the usual 12 – one extra payment per year. Depending on your situation, this can cut up to 6 years off the life of your 30 year loan. Check out the details first because some mortgage holders offer this payment schedule without charge, and others will hit you with a fee. I suggest you try using this bi-weekly mortgage calculator with extra payment capability to test both this early payoff strategy, and the previous one, to see how fast you can be free and clear!
- Refinance to a Lower Interest Rate: Another strategy is to refinance to a lower interest rate mortgage while keeping the term (pay off date) the same. The key is to not take any money out or extend the term when you refinance. Your new loan should offer a lower payment due to the reduced interest cost. When you continue making the same payment as before, all the extra will go to principal payoff. The nice thing about this strategy is it doesn’t require any additional money out of your pocket to achieve the desired result (unlike the two previous alternatives). All the savings comes from reduced interest costs.
- Refinance to a Shorter Term: Rather than pay over a 30 year amortization, try reducing the term to 15 years. The monthly payments will be higher, but the interest rate is usually lower, thus offsetting some of the monthly outflow. Another variation on this theme is to keep your 30 year mortgage, but make your payments as if it were a 15 year amortization. You won’t get the reduced interest rate of a 15 year term, but you also won’t pay refinancing costs either. Some people prefer this variation for its increased flexibility and reduced cost, while others prefer the enforced discipline of the required monthly payment. Either way, you can use this mortgage payoff calculator to estimate the monthly payment required to be free and clear for any date you choose.
- Downsize to a Lower-Cost Home: Changing homes isn’t for everyone, but I would be remiss as your financial coach to exclude this strategy. You could move to a lower cost area or buy a smaller house in the same area. The smaller mortgage principal means you can be debt free faster using the same monthly payment.
The key point to notice about all these early payoff strategies is how they aren't mutually exclusive. You can combine them in various ways to turbo charge results.
For example, you could downsize your home while financing that less expensive home at a lower interest rate on a biweekly mortgage. Then you could sell that boat and jewelry you never use, putting those lump sums toward the mortgage, while also dedicating this year’s raise to additional monthly principal payments.
You'll be amazed how fast you can get out of debt following this prescription.
The only limit to how fast you escape the bondage of mortgage debt is your creativity and dedication to this noble cause.
Pay Off Mortgage Early – The Pros…
Now that we know how to pay off your mortgage early, let’s look at the benefits to following this strategy.
- Save Money: The first and most obvious reason to pay off your mortgage early is it can save you tens of thousands of dollars in interest costs.
- Peace of Mind: The second reason is peace of mind from owning your own home. It gives you a warm-fuzzy feeling to know you have a secure place to live, and you won’t be put out on the street at the first temporary setback in employment.
- Reduced Cost of Living: For most people, mortgage payments are your biggest monthly expense after taxes. Without a mortgage payment, you can save more, work less, or take that dream job you always wanted but couldn’t afford because of the lower salary.
- Get Rid of PMI: When you accelerate paying down principal, your home equity will reach a threshold where PMI should no longer be required. This saves you money long before the mortgage is paid off, and allows you to accelerate the principal pay-down while still making the same monthly payment.
- Asset Protection: Many states have laws that protect home equity in the event of lawsuit or other legal proceeding. Homestead rules can provide substantial home equity protection. Also, retirees sometimes use home equity as an estate planning strategy to protect assets for the surviving spouse should one partner consume all available resources in a prolonged illness or nursing care facility. In short, there are many situations where home equity can represent a more secure asset with special legal privileges when compared to other investments.
- Retirement Planning: A free and clear home takes on additional significance for near retirees. If you are entering retirement with a fixed income (Social Security, pension, fixed annuity), then it can be a real benefit to pay off all debt rather than put money in fluctuating investments. This allows you to reduce financial variables and more reliably match forecasted income to expenses. Additionally, after retiring, that mortgage payment can require pulling money from tax deferred accounts when that money would be better off left to grow. Finally, if your taxable income is reduced in retirement, it can reduce the benefit of the mortgage interest tax deduction, tilting the equation in favor of payoff.
- Guaranteed Return on Investment: With the stock market and real estate going up and down like a roller coaster, it's comforting to put your money toward your home and know with certainty what the ROI will be. You get the imputed rental value of a place to live and the immediate return of eliminated interest expense. The certainty of this return stream is a huge benefit for investors who feel beat-up by unreliable financial markets that supposedly will pay more… but may not.
- Achievable: Paying off your mortgage feels more motivating than most financial goals because it's concrete. It's big enough to get excited about, yet tangible enough that you can wrap your head around it. It's achievable and will make a significant difference in your life. Contrast this with retirement planning, which feels more ethereal and hard to grasp for most homeowners.
In short, there are many benefits to paying off your mortgage early – and some are very compelling!
Payoff Mortgage Early – The Cons…
Before you break out the champagne and burn your payment book, it's important to consider the downside to paying off your mortgage early. This isn’t the slam-dunk decision it appears at first glance because of some complicated financial issues. Let's review them.
- Lose the Tax Break: I start with the tax break issue not because it's the most important, but because it's the most commonly cited and misunderstood. Yes, mortgage interest paid is generally deductible on your tax return if you itemize, but there are some important “caveats” to this deduction worth considering: (1) The rules are complicated and may cause you to lose some of the deduction you thought you were getting. (2) In certain circumstances, you may get as much value by taking the standard deduction as by itemizing deductions, meaning your mortgage interest payments merely replace the standard deduction and provided no real savings. (3) Even if you get the deduction, you're still paying $1 to get a 35 cents (or comparable) tax break – not a very good deal. (4) And the effective value of the deduction diminishes over time as the loan matures and you pay less and less interest with each payment. In short, there are many tax rules and situations where you won’t be able to fully utilize the mortgage interest deduction. The rules are complicated, so talk to your tax professional if this issue is important to your decision.
- Low Return on Investment: A home mortgage is likely the cheapest money you will ever borrow – and the interest is usually deductible, further decreasing the effective cost. For example, if you're in a combined state and federal tax bracket of 35%, then a 6% mortgage could have an effective cost under 4%. This means two things: (1) Higher cost, non-deductible debt should be paid off first, and (2) long-term investment returns will likely provide a higher return on your capital as evidenced by Ibbotson and Associates research showing a diversified portfolio returning in the 8% range.
- Savings Are in Cheap Dollars: A key point to consider is how all the savings you are expecting only come after the mortgage is paid off, meaning those savings must be discounted for inflation. For example, let’s assume you pay off your mortgage in 25 years instead of 30. Using this present value calculator, you’ll see that $1,000 saved 25 years into the future is only worth $375.12 in today’s terms at a 4% inflation rate. In other words, you have to discount all savings by inflation because the payments you avoid will be in depreciated dollars. This is quite important.
- False Sense of Security: You're not going to like this idea, but you never really own your property – even if it's mortgage free. This is a throwback to feudal times where the king (“royal = real” relating to the latin for “king” connecting real estate to royal estate) was the owner of all land and received “tax” for the right of possession. Today, our local governments are the modern equivalent to feudal lords who collect property tax annually. In other words, you always pay rent to someone whether the bank is out of the picture or not. If you're not completely clear about this truth, just stop paying property tax for a few years and see what happens. The truth is your monthly payment is merely a question of degree and to whom – not whether it exists or not. This ugly truth makes the idea of true mortgage freedom an illusion.
- Lost Diversification: This one is “the biggie” so pay close attention… Most investor portfolios are denominated in their domestic currency and thus carry the risk that inflationary government policies will depreciate their investment purchasing power over time. A residential real estate mortgage is the only practical way for most people to short their domestic currency and hedge against inflationary economic policy.
- Interest Rate Below Expected Inflation: Given record low mortgage interest rates as of this writing, it's entirely possible that the interest rate on a fixed rate mortgage (forgetting the fact that it might also be deductible) could turn out to be lower than the inflation rate. If that ended up being true (nobody has a crystal ball), then a bizarre financial situation is created where you are literally paid to borrow money in real terms (after inflation), even though you're paying interest every month. In other words, you make more by owing than by owning. Strange, but true. When you prepay your mortgage, you give away that financial advantage.
In other words, the way mortgage financing works is you borrow (short) your currency and use the proceeds to buy an inflation adjusting asset (real estate).
Few people understand how conventionally financed real estate is little more than a leveraged play on inflation. That's why it's such a powerful wealth building tool more than 90% of the time, and it blows up horribly when the rare deflationary event strikes (i.e. 2008).
When you pay off your mortgage, you are unwinding your short currency hedge. This means you lose the ability to be short today’s more valuable dollars and repay them with depreciated dollars in the future.
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The importance of this financial fact cannot be overstated given today’s record government indebtedness and overt government policy directed toward creating inflation.
I repeat… this is a HUGELY IMPORTANT factor in deciding to pay off a mortgage early or not! It is critical.
But don’t trust me on this issue. Consider these two facts…
- This inflation calculator (which likely understates inflation’s true impact) shows you how the Federal Reserve has destroyed more than 95% of the U.S. currency’s purchasing power since they began monetary policy. If that time period is too long, then look at various 30 year time periods (the life of a mortgage) for similarly dismal stats.
- In a February interview with CNBC, Warren Buffett called mortgaged real estate “as attractive an investment as you can make”. He further stated…
“If I knew where I was going to live for the next 5 years or 10 years, I’d buy a home and I’d finance it with a 30 year mortgage. It’s a terrific deal… If I had a way of buying a couple hundred thousand single-family homes… I would load up on them. And I would take mortgages out on them at very low rates…”– Warren Buffett
Did you get that? Read it twice! Warren is a pretty successful investor who has some clue on these matters, so strong statements like this are worth listening to.
He's telling you about the value he sees in locking long-term, low cost interest financing on an inflation adjusting asset. The last time this strategy paid off was in the inflationary 1970’s when the Savings and Loan industry went bankrupt for being on the wrong side of the transaction. Homeowners literally laughed all the way to the bank with ridiculously cheap mortgage payments on appreciating real estate.
Are you going to be able to do the same on this next time around?
When you prepay your mortgage, you give away that advantage, so tread carefully on that decision.
What’s important to note about this entire list of negatives is how they aren’t intuitively obvious.
The list of positives to paying off your mortgage discussed earlier are easy for anyone to see, but the negatives require a fair degree of financial sophistication – from esoteric tax strategy to long term inflation effects, short hedges on currency, and discounted present value equations.
It's heady stuff – financial geekism – yet it's every bit as valid to your bottom line as the more intuitively obvious reasons for paying off your mortgage early.
That's why there's so much misinformation on this subject. The concepts are complex and sophisticated once you get past the obvious reasons for wanting to get out of debt.
In short, the decision to pay off your mortgage is an intellectual battle where the emotional-intuitive desire to be debt free is matched against the intellectual realities of modern finance.
Unfortunately, this makes the decision process complex…
How Do I Make the Right Decision for My Situation?
If you're somewhat confused right now, then you're in the perfect spot. You get it, and that's a good thing. The confusion results from the tug-of-war between emotion and intellect trying to sort through the complex factors explained.
The next step is to give you a structured way to sort these issues so you can make order out of chaos and formulate a well-reasoned decision as to whether paying off a mortgage early is the best decision for your situation – or not.
The key is to realize there are two steps to this decision process:
- Personal Finance Considerations: This is a decision between paying off your mortgage early or taking care of other personal finance issues first that better reflect your personal values. This decision is prioritized ahead of any investment considerations.
- Investment Return Objectives: This is a decision between paying off your mortgage early or investing the difference. This decision only comes into play after the personal finance issues in the previous step are satisfied first.
Let’s take each of these steps one-by-one…
The First Step Is to Figure Out What's More Important Than Paying Off Your Mortgage
I’m a firm advocate of getting your financial foundation in place before pursuing more advanced financial strategies. Your wealth can only grow as high as your financial foundation can support (similar to how a skyscraper’s height is limited by the depth and strength of its foundation).
Below is an order of priorities for building your financial foundation that may take precedence over paying off your mortgage…
- Guaranteed 50% Return: Many employers still offer 401(k) retirement plans that include employer matches – typically 50% of every dollar you put in up to 6% of annual pay. This guaranteed 50% return on investment is pretty hard to beat, so it usually makes sense to make sure you are maximizing this benefit before prepaying your mortgage.
- Maximize Tax Deferral: Even if your company doesn’t offer a 401(k) plan, it may make sense to maximize tax deferred and tax free retirement savings before paying off your mortgage. Granted, tax issues are complex and vary based on individual circumstances, so it’s impossible to make a blanket statement, but every tax deferred savings opportunity you don’t use is lost forever and can't be recovered because annual limitations apply. In other words, use it now or lose it forever. The investment math often tilts in favor of maximizing every tax deferred investing opportunity available… before paying off the mortgage.
- Pay High-Interest Debt First: Even after maxing out all your retirement savings options, it still may not make sense to pay down your mortgage early when you have other debt. The reason is most other debt will be at a higher interest rate – particularly credit card debt where the interest is much higher and not deductible. Use this debt snowball calculator to figure out the fastest way to get out of debt. The order of precedence is to pay off the highest interest/non-deductible debt first, followed by low interest/deductible debt (i.e. mortgage debt) last.
- Financial Stability: Once you’ve maxed out your retirement plans and paid down your high-interest, non-deductible debt, you may want to consider building a 3-6 month cushion should unemployment strike. Some naysayers claim a home equity line of credit serves the same function, making this step unnecessary. The thinking is that mortgage prepayments increase equity, thus providing a positive return while you don’t need the funds, but can still be withdrawn through a line of credit should you fall on tough times. Either way, developing a safety cushion for difficult times is a prudent step in building your financial foundation.
- Insurance and Financial Security: One of the main goals for paying off your mortgage early is financial security, but there are many dimensions to financial security beyond just being out of debt. For example, medical bills are a primary cause of bankruptcy, so does it make more sense to increase your medical insurance coverage before paying off your mortgage? That’s a tough question because each choice manages risk – but in a different way. Similarly, the Council for Disability Awareness claims you have roughly even odds of being disabled for 3 months or more at some point during your career, with 1 out of 7 workers being disabled for 5 years or more. Would disability insurance give you more financial security than prepaying your mortgage? Again, an interesting question to consider…
- Kids College Funds: Do you have kids? Then funding a 529 college account, prepaid college tuition, and/or Coverdell IRA are additional ways to maximize tax deferred savings that should probably take precedence over paying off your mortgage.
- Underwater Mortgage: If you are upside-down on your house (owe more than it's worth), then really think twice about throwing good money after bad. I’m not going to get into a big discussion about strategic defaults here, but suffice to say there may be more secure assets for you to invest in than a house that is underwater.
Should I Pay Off My Mortgage or Invest?
Once you’ve built your personal financial foundation (maximized tax deferred savings both for college and retirement, paid off high interest debt, and properly insured) then the question becomes, “should I pay off my mortgage or invest?”
Notice how this question only becomes relevant after the prior issues are handled.
The answer to the “pay off mortgage or invest” question is actually quite simple – whatever gives you the highest after tax return on your money is the right decision.
Financial advisers will quickly point to research showing long-term historical returns for a low cost index portfolio around 8% (+ or – depending on assumptions), match that against much lower mortgage rates (as of this writing), and proclaim immediate victory… but it’s not that simple.
Investment returns are highly variable with periodic “lost decades” where even pathetic mortgage interest rates represent a superior return over a traditional investment portfolio.
The problem is the future is not the past and returns vary, but mortgage interest saved is a bird in the hand. With that said, you would be hard pressed to find 20-30 year periods (the life of a typical mortgage) where an investment portfolio would not provide a higher return than recent mortgage interest rates.
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The problem with any investment return comparison is nobody has a crystal ball. Unless you have a direct connection to the Higher Power, then you're stuck right back where you started with a decision between a guaranteed (but low) return for prepaying your mortgage, versus an unknowable but potentially higher return for investing.
In other words, you're left deciding between the certainty of mortgage payoff versus the uncertainty of investing. While financial science provides a relatively clear answer (investing should provide the higher return over the long term), this is really an emotional decision about your risk tolerance, confidence in the future, and belief in the science of investing.
It's why so many prefer to get out of debt despite the relatively compelling math.
Final Thoughts – The Human Variable…
With all that said, there is still one very important element missing from this conversation…
Life doesn’t usually go as planned. We humans aren't computers who implement our brilliant plans with mathematical precision.
Life throws obstacles our way, plans change, stuff happens, and that's just the way life works.
It's foolish to make long-term plans in an intellectual vacuum that fails to account for the random nature of life.
With that in mind, below are some fun ideas worth adding to this discussion…
- Flip the Logic: If you choose to invest instead of paying off your mortgage then consider this question – would you be willing to refinance the equity out of your mortgage (thus increasing your debt) to add to your investment accounts? If not, then you are logically inconsistent. (By the way, I write this with a wry smile because it describes me perfectly – see below…)
- No Discipline: For every 10 people who claim to be making the minimum mortgage payment and investing the difference, I would hazard a conservative guess that more than half fail to follow through on the investment part of the equation. The road to financial mediocrity is paved with the best intentions. In other words, an optional savings program that requires self-discipline is frequently no savings program at all. Contrast this with someone who places a 15 year, biweekly mortgage on their home, thus creating enforced discipline. One happens with certainty regardless of life’s wrinkles… the other is optional.
- Expect the Unexpected: Nobody expects to lose their job, have a major medical problem, become disabled, or invest in a fraud; yet, over the course of a 30 year mortgage, the odds that you'll experience one or more of these admittedly rare and unfortunate events are far greater than you would like to believe. When your home is paid off, it's easier to weather these storms with a minimum of personal adversity. Plan for the unexpected because eventually it will happen.
I suppose the best way to conclude this lengthy analysis is by sharing what I’ve chosen to do with my own mortgage(s).
The truth is, I used to be in the pay-off mortgage early camp. I hate debt and have a high value on freedom. In the late 1990s, I paid off my mortgage only to watch my investment portfolio double the next year while all that capital was tied up in my house.
Ouch! That was expensive…
Admittedly, things could have worked out very differently. I could have paid off the mortgage in 2007 instead and seen a decline in investment values the following year.
However, in general, my investments outperform mortgage interest, so it makes sense for me to prioritize investment capital.
With that said, I also find that I’m not fully rational on this issue.
I would never refinance my home and invest the equity to pursue those higher returns. From a pure logic standpoint, that makes no sense: I’m not willing to liquidate investments to pay off the mortgage, and I’m not willing to increase the mortgage to fund investments.
Hmmm… I guess I’m not as rational as I would like to believe.
The truth is the decision to pay off your mortgage is quite complex.
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Fast forward to current times, and I’m several years into a 30 year mortgage on my current home that, prior to writing this article, I would have refused to pay off.
The interest rate is pathetically low, tax deductible, will likely end up below the inflation rate over the life of the loan, and it gives me some measure of inflation protection with a small short position against the dollar.
So I’ve been at both extremes – pay it off fast, and never pay it off – only to now end up somewhere in the middle of the road going forward.
I now firmly sit on both sides of the fence as follows…
- Because my retirement and kid’s college are fully funded, I don’t need to prioritize those accounts.
- I have no debt besides the mortgage, so no issue about paying more expensive debt first.
- I have all the insurance I need.
- The discussion literally comes down to paying off the mortgage or investing.
- The math is clear that my highest return is with investing, but I’m also emotionally connected to having no debt and love the freedom of minimizing my cash flow needs. For that reason, my decision is to funnel a portion of increased revenues from this business toward prepaying the mortgage, even though it's technically irrational from a return on investment perspective.
- In summary, I’m not willing to dedicate any of my investment capital to paying off my mortgage, but I’m also not willing to leverage my house to increase investment capital. This is irrational, but it's the honest truth on where I stand on mortgage vs. investing. Regarding new income production, I’m fine with dedicating a portion of the revenues from this business toward paying off the mortgage rather than perpetually building investment capital while retaining debt. I guess the logic is that I’m getting a diminishing emotional return on more investment capital when compared with less debt. For economics geeks, it means I have a higher marginal utility on debt reduction than capital increases.
I would like to declare this a balanced perspective in that I’m comfortable with my portfolio “as is”, so I’m willing to “diversify” and lower risk by paying off mortgage debt with extra income, but in the end, I know the truth… it's my emotional desire to be debt free and reduce risk that's driving the decision. I know the math and I should be investing – exclusively.
So there you have it – I’ve personally lived at both extremes of the decision and now stand firmly in the middle.
The decision doesn’t have to be either/or: you can pay a little to debt reduction and save for investing at the same time.
Like everything in life, happiness is often found in the balance. I guess paying off your mortgage early is no exception.
So now that you know my situation, where do you stand?
How has this analysis helped you sort through the decision and what conclusion did you reach? Which issues hold the greatest sway in your decision? Please share in the comments below…
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