Early Mortgage Payoff…a Good Idea?
By Neal Frankle
There are real pros and cons to an early mortgage payoff. Some argue that it is not in your financial interest right now. In fact, some say it’s the last thing you should do. They argue you should keep your mortgage and make investments for your retirement. Better yet, go out and get a humongous mortgage.
This argument is based on two realities:
1. Fixed-rate mortgages are really cheap right now.
2. Inflation and interest rates could rise precipitously in the near future.
Let’s take an example to illustrate this.
Assume you have a $200,000 mortgage. You’ve got a 30-year loan with a fixed rate of 4.5%. Say your monthly payments are fixed at $1,013.
Your payments are never going to go up…and that’s the key. Assume inflation heats up. 15 years from now, your payment of $1,013 doesn’t buy what it could today. In fact, that $1,013 will only buy $627 worth of goods and services if inflation rises to 3.2% – the historic norm. So, this argument stresses that your fixed payments cost you less in terms of buying power.
The assumption is that your income will rise with inflation but your payments won’t. (That’s not the case if you rent, by the way, or have an adjustable loan.)
And with that inflation, the outstanding balance on your loan is worth a lot less. While nominally, it will be$132,500, the real value of that money is much less. In fact, the value of that in current dollars at the time will be $82,041.
So why would anyone pay off their mortgage?
There are other considerations — like your emotional DNA. I personally can’t stand to owe any money to anybody — especially on my house. So I don’t really care about the economics of it. I know this is not the best financial decision, but my wife and I decided to do everything we can to get rid of all our debts ASAP. And if you have a concern that you won’t be able to make your payments because you may lose your job or retire soon, you’d want to pay off your mortgage as soon as possible. A mortgage is one of many retirement problems people like to get rid of.
Don’t underestimate the value of this huge emotional payoff. It’s huge. So the bottom line is, from a financial standpoint, it makes sense to have a large mortgage when rates are very low. But from an emotional standpoint, it’s just really nice to be debt-free.
Where do you stand on the issue? Do you want a huge mortgage? Do you plan on taking advantage of possible future inflation? Are you more like me and just want to be out of debt?
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Agree. Interest rates will rise massively to control infation, and a fear of debt now leading to paying off laons will leave you missing out in the future. Fix your debt on a 5 year term now, whilst you can.
I can’t disagree with your assessment, but I am one of those who have low debt tolerance. My house is paid for, so following the tactic of this post, should I mortgage it in order to leverage that fixed payment debt against future inflation? Hmmm.
One thing I know: the chances of foreclosure on a paid for house are zero.
Great post! I’m with you though I don’t really mind about losing out on future purchasing power I get more utility in knowing that something like that is not over my head longer than it has to be. Nice work referencing hyper-inflation too-people forget that stuff like that really does exist.
While I’m still in the “early mortgage payoff’ camp, this is the best argument I’ve seen against doing so. Definitely food for thought.
Thanks Climbing, Nunzio and Penny.
Interesting in that the “answer” to this question changes as the economics change. To be expected of course but something we just don’t revisit.
I like it from the following standpoint: basically you are saying that this is the best deal we are going to get on this area of our finances. Now it can be put on the back burner while you work on other goals such as building savings, or paying off other debt. I would suggest that when these goals are reached go back and hit the mortgage again or consider the two week accelerated payments which pay a 30 year off 7 years early. Why? My own experience. I was so close ($15,000) to having my entire mortgage paid off on my home at age 39 and planned to live debt free for ever. Live changes happened and the tab ran up again. To be that close and get knocked back still bugs me. And, I have to admit that I was so close I got complacent. Like in football, being 1st and goal is not a touchdown.
Here’s how I look at it. The 4.5% mortgage costs me 3.24% after taxes. The DVY (an ETF of the higher Dow dividend stocks) yields 3.67%, or 3.12% after the 15% tax on dividends.
So (I know the dividend 15% rate may go away) I am paying .12% or $120 per year for the potential gain on $100K of these stocks over the long term along with the increased dividends overtime. The chances of the next ten years being flat is minimal, we are now overdue for reversion to the mean, an abnormally high next decade.
You have to also add in the fact that interest payments are front loaded in a mortgage. This makes the math very complex. Large lump sum payments earlier in a mortgage are much more beneficial than monthly additional contributions. One may also consider the fact that savings from payments to a mortgage are guaranteed much like an annuity. I personally do not believe that hyperinflation is a real possibility for us here in the U.S. it would have to be done intentionally by the fed in order to pay off our debts at a cheaper rate, but it would be so politically unpopular I don;t believe it could ever happen. We would basically be holding a gun to seniors heads if we were to follow a monetary policy which allowed that to occur.
I do like your argument but what if you already have your mortgage paid off? I just can’t see myself going back to a bank and adding that payment back into my life + the few thousand in closing costs.
If I cashed out the $200K in equity, where the heck would I put it to earn more at a guaranteed rate of return?
I definitely like the emotional security of living in a home that’s paid for. Large fixed expenses make me nervous. Reducing that expense is part of my “emergency fund.”
I have almost all my savings outside of the house in stocks, so it is my way to diversify.
If you own your house of course don’t take more debt! This suggestion is more related to budgeting than an investment suggestion in my humble opinion. for those that have a mortgage, keeping the loan open can be beneficial in a high inflation environment is his only point.
If I was you, i would suggest keeping less of an emergency fund. Having all that home equity, means your need for liquidity is greatly reduced. Whereas most people want 6 months to a year of living expenses, having the ability to take a loan against your home, means you can invest and get a return on more of your money.Don’t open the line until you need it though
And Hopefully you never will.
The future is always so uncertain, I’m personally very happy to see my mortgage gone in 12 months time. After that I am more interested in using savings to invest.
Right….while the logic would argue for refinancing and taking out a huge loan to invest, I’d NEVER advise anyone to do that.
I do like your argument but what if you already have your mortgage paid off? I just can’t see myself going back to a bank
I’m not going there with you, Neal. This argument is what got a lot of people in trouble (and loose lending of course).
I think home ownership is great for the reasons you mention. However, don’t get the biggest mortgage possible. Get the lowest one that meets your needs. If something unexpected happens, the person can hopefully keep their home while dealing with a lost job or other crisis.
It is a good idea to pay off your mortgage just so that you don’t have to worry about another monthly payment that is being deducted from your paycheck. But it is also not a good idea, because you cannot enjoy the benefit of a tax write-off when you have a mortgage. Mortgage interest is tax deductible against your income for the year. So in reality, the government is actually subsidizing you to keep your home. So what the issue really is is that you should not have a mortgage that is way too much that you cannot pay for it. Buy a house you can afford and stick to a reasonably low payment mortgage.
It is not a bad idea to pay off your mortgage, then you will never have to worry about a set payment that is over head every single month. But the “negative” thing about paying off your mortgage is that you will not enjoy any tax benefit once your mortgage is paid off. Since you are already paying taxes to the government, why not get some of it back when you are filing for you taxes every single year. You also do not want to have a big mortgage that you cannot pay for.
This is a really interesting analysis Neal and I think it makes a fair amount of sense. I guess the only point to keep in mind is to not take out a big mortgage solely due to expectations of inflation. What if inflation doesn’t play out like you expect (or worst case, there is deflation). In some ways, it’s kind of like a risky investment as though you invested in gold (banking on inflation). I think one needs to be happy with the investment first and foremost, and can see the potential inflation as potential upside. Overall though, this makes me look at mortgages differently as I used to always previously think it made the most sense to pay it off ASAP.
While such concept is true, I look at mortgages, at least on primary home, as not good cause your primary home is a safe haven and as such, shouldn’t have negative things attached to it. I know almost all of us start out that way, which that’s okay, but we should work towards a manner to become debt free. However, that has to be balanced with retirement funding (keeping in mind of the IRS limitations per year for such contributions) and emergency funding (so as you don’t end up in a place between a rock and a hard place when you really do need the cash).
For me, I will first work on getting the mortgage down low enough to get rid of the MIP/PMI, which this year, I accomplished a huge amount of this goal. I am now about 70% of the way there. I hope to finish this goal next year, but given I had to shift gears and start replenishing my emergency fund, it will detract from that goal next year.
After that, I will invest until I get to a point where I can sell the investments with still a healthy backup fund but yet, also able to get rid of the mortgage, so as I can also get rid of the escrow account as the money in the escrow account earns nothing in it.
All the author is really saying is that if you have to have debt, make sure it’s the cheapest debt you can wrangle.
What he’s NOT addressing is the the best debt you can have is zero debt: no interest, no payments … nothing. Since when is it preferable to go into debt in order to “save” money.
If you can pay off your house, do so and invest that monthly sum(minus some for taxes and insurance) and let it grow for you. True, that may be a bit more difficult in today’s economy but it can be done.
Think about it, had you rather your money be making you 2% free and clear or costing you 2.89%. One puts money in YOUR pocket; the other puts money into the bank’s pockets.
Just saying…
I love the idea of being debt free. There is the financial consideration and the emotional issue. From an emotional standpoint, most people I know would prefer to be out of debt — even if it isn’t always the most efficient financial move.
From a financial standpoint, it comes down to alternatives and risks. If your after-tax mortgage expense is 3% and you can earn more than that (risk free) after-tax, you should not pay it off but rather you should invest the money. This is just simple math.
But few important decisions come down to simple math. There are always other considerations. And as I said, from an emotional standpoint, it can really be worth a lot to be debt free. Thanks for your insightful points Doug.
As for you claiming on an after tax basis with regards to the Effective Annual Percentage Rate (what I termed as ATBEAPR), you assuming the total Itemized Deduction on the Schedule A exceeds Standard Deduction, which for some peoples cases like myself who do have a mortgage on a home, that is NOT the case. As such, the ATBEAPR on my mortgage is no lower than the BTBEAPR. On the other hand, my student loans as a lower BTBEAPR than what my mortgage does, and they are also lowered by tax effect, which means the ATBEAPR on the student loans are lower than the BTBEAPR on the student loans. Even the student loan of 3 with the highest stated APR (3.75%) has a BTBEAPR of 3.82% and an ATBEAPR of 3.51%. The only reason for that, I am allowed to deduct the interest before AGI. Therefore, in this case with the mortgage having a BTBEAPR and ATBEAPR of 5.63% (after adding to this the effect of the MIP/PMI on the mortgage), it makes more sense for me to pay the mortgage down, then maybe do other investing. But then I currently need to pay down the mortgage about another $6,600 to save myself on the MIP of $45.00 or so a month. After the MIP is gotten rid of, it will then drop down to a BTBEAPR/ATBEAPR of 5.11%. I been in the home for 6 years now.
I’m 23 years old I bought my first house when I was 18 I’ve been making extra payments to my mortgage since my first payment I just made my last payment this month and going to save all the money I was putting on my house. My mortgage was 5.63% 99000 dollar loan 10% down extra 1800 a month I was paying. I’m lucky I have no other debt. I plan on saving up for a huge home I’m going to pay cash for or at least 50% down. It feels great not to be over my head living paycheck to paycheck. Now what I make is mine not the banks. Good luck to you all I would work towards being debt free its nice. Thanks for reading, Matt
Matt, that is fantastic! What a great inspiration to everyone! How did you pay off your mortgage so quickly? What other tips would you share?
Matt, that is so cool and I think quite possible for others to accomplish if they recognized the potential.
At the age of 18, I was still in high school. I wasn’t able to get a house until about 6.5 years ago. All I could do then was the 3% down.
I ended up getting the 119k mortgage with 4.99% APR, though had to have the MIP on it. As of last month, I got rid of the MIP on the mortgage. Considering I been unemployed since mid May of this year, that was an accomplishment itself.