Are you asking yourself, “Should I pay off my mortgage?” Lots of folks are asking this question right now. Interest rates are so low that some people wonder if it doesn’t make more sense to go the other way and actually borrow more instead. In short, is paying off a mortgage early smart? Here’s an e-mail I received a few weeks ago from a reader, Mark:
I have a $300,000 30yr fixed mortgage at 5.2% and $100,000 in the bank. I plan to own (or rent) the home for a long time (15yrs or more). Should I be looking into paying off a big chunk or refinancing at a lower rate for 15 yrs?
Good question…but to answer it we have to break the facts down.
Here’s what we know:
- Mark has a $300,000 30-year fixed mortgage at 5.2%.
- He has $100,000 in the bank.
- He plans on staying in his home for at least 15 years.
- Mark has an investment time frame horizon of at least 15 to 30 years.
We don’t know how fast Mark’s house is going to appreciate, and that’s an important part of the decision too. But judging by the tone of his e-mail, Mark doesn’t seem to be looking at his home as an investment, but rather as a place to live.
Now, how can Mark use what we know to be the best investment decision?
Neal’s Notes: Just because money is cheap doesn’t mean you should do anything necessarily. I say that because at times, people refi only to find themselves with worse problems. Before you do anything, make sure why you want to refinance and determine if there are more pressing problems that require your attention.
The first issue is, at what rate could he refinance the existing loan? That’s the point of comparison. So for our example, let’s assume that Mark could obtain a new $300,000 loan at 30 years for a rate of 4.5% or a 15-year loan at 3.75%.
Assuming Mark goes for a 30-year loan, if he pays down the debt, it’s like he’s earning 4.5% on his money – guaranteed with no risk. That’s not too shabby, and it’s likely much more than he’s earning in the bank.
But wait. Is keeping the money in the bank Mark’s only alternative? No. He could invest the money in broad based mutual funds. Lately, mutual fund performance has been spotty at best. But if he can grow that $100,000 at 7% over 10 years, it would be far better than using the money to pay off the mortgage. In fact, if we assume that the house appreciates slower than the market, he should actually sell the house, go live in an apartment and invest the money in the market. Of course, this alternative has far greater short-term risk than the alternative of paying down his mortgage. It’s also an alternative I never recommend to anyone.
The bottom line is that this decision, like any financial decision, has a financial and emotional component. If Mark felt comfortable with investing in the market and felt that, over his 15 to 30 year time horizon, he could earn at least 4.5% or more, then the best financial decision would be to take the biggest, longest-term mortgage possible and invest the money or…as I said, sell the house and invest the money in the alternative that pays the best return over the time frame.
While this may make sense financially, most people I know are much happier owning their home and getting rid of their mortgage payment. It may not be the absolute smartest financial move always, but there is something very valuable and powerful about owning your home outright. I can’t advise Mark to go this route because I don’t know how he feels about risk and investment alternatives. But I can say that paying down the loan and refinancing over 15 years wouldn’t be a dumb thing to do either. Sometimes feeling secure trumps making the absolute best investment.
Where do you stand on this? What have you done with your mortgage? What would you suggest to Mark?