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?
Joanne says
Much of the info I read bases the arguement for NOT paying off or paying down a mortgage based on the long view and subsequent value of accounts. What about cash flow? 1. If a person pays down the mortgage to get rid of PMI, then less will be owed each month, the house is paid off sooner because of the accelerated payment, and less will have been paid for the house in the long run. 2. If a mortgage is paid off in less than 30 years, then the payoff occurs when a person is able-bodied and in good health…..and then we are more able to pay rising energy and food costs in the future without having to afford a mortgage. (Our ability to work: physical or mental labor is, in reality, what we use to pay for the stuff we need. Money as we know it is not real).
Beatrix says
While it makes sense to use his 100 K to invest, he is living in that home as his primary home. The problem with refinance is that people might get “comfortable” and don’t think of risks and what if issues. When five years ago I had the chance to pay off my house, that’s what I did. Without thinking I paid off the 270,000 I owned to the bank and it was done. I felt safe and free. For me this was the best thing to do, but we are different. Others might have different preferences. After I had zero mortgage I felt happier and healthier than ever. Nothing can beat health and calmness. I still had about 60,000 to work with, but after paying off that big chunk now I could sit down and think and make the best decision about the remaining part. My advice: pay off your house loan if you can. It makes you free.
Neal Frankle says
I would have to agree. It is wonderful feeling to be debt free.
Ronald Dodge says
Be careful about refinancing. That’s cause again, we don’t have all of the information. Two things Neal didn’t factor in are:
1) Closing costs. How much more will this be?
2) MIP/PMI, what is this cost if any? Does the bank require you to pay for this?
How much time will you be in the home?
How much time at the minimal will it be before you can get rid of the MIP/PMI, should you be forced to take it out on the new loan? 2 years (what seems to be the general rummer)? 5 years?
How far down do you have to pay on the MIP/PMI before you can get rid of this expense? 20%? Greater than 22%?
In my example, I have a US Bank mortgage, which I was required to pay down greater than 22% as compared to the home value and I can not get rid of the MIP/PMI until a minimal of 5 years has elapsed. Now that I been in the home for 6 years and I am very near to meeting that >22% paid down, the bank sent an offer to me about refinancing the mortgage taking the rate from 4.99% to 4.125%.
Now in my case, there is no tax benefit for me as for my wife and myself, our total itemized deductions isn’t even remotely close to the standard deduction, so there’s no sense of taking taxation into account in this case. On the other hand, if I was to go with this deal, I would have to forgo the following:
Pay the MIP/PMI for a minimal of 5 years.
Pay the MIP/PMI until it’s below 78% of current market value (which is now at only about $99k as opposed to $121k 6 years ago for the market value of the property).
PMI jumps from the $45.44 cost to about $80.00 per month expense.
Pay a closing cost close to $4,000 based on the numbers in the documents (didn’t say the closing costs, but using mathematics, I was able to come to that closing cost amount based on the other numbers in the document)
I called up the number it said for me to call and when I questioned the other person about the closing cost, he said those numbers in the letter was only hypothetical numbers, and the closing cost would only be $1,700. I did not one bit believe the guy cause the numbers they used in the letter basically matched what it was for the mortgage at the time the letter was typed/printed out.
But even aside from that, I put it quite blank, why would I want to increase my actual expense of the mortgage by $10.00 per month not counting the closing costs to the refinance? Yeah, sure, the interest would drop by $70.00 per month, but I would have to pay $80.00 per month for a minimal of 5 years, when I’m about to get rid of the MIP/PMI on my current mortgage. When I said about, I meant by the end of the current calendar year, which that is holding true. He was attempting to get me to take the deal by saying it wouldn’t last for the life of the loan. I’m like, “No, I will not do it cause I can refinance it when I do get the mortgage down below 80% of the current market value, whenever that may happen (either by paying down more or by the market value going up on it, or some combo of both). I only have about $1,000 left to pay down on that MIP/PMI.
Currently, I am attempting to avoid using my emergency fund for anything cause I am currently unemployed (as of May 13th of this year). So far, I been fortunate as I have yet to dip into it. Unemployment doesn’t pay much at all, and starting as of 9/21, I am starting up full time college with 18 credit hours working towards my CPA, so I’m not going to have a lot of money to work with for the next 1 year or so. The unemployment income will only cover my mortgage, utility bills and student loan payments. Nothing else will be covered with my unemployment income. I been relying on other sources of income to pay for the remaining expenses and paying down the mortgage. Once that mortgage is paid down enough to get rid of the MIP/PMI, I will then be shifting gears again and going to my next long-term financial goal. Getting rid of the MIP/PMI will be a good thing in 3 ways:
First, it will reduce cash flow demand, which is very much so needed in the current household economic situation.
Second, it will greatly reduce the daily residual expenses, which currently between dropping daily residual financial expenses and increasing daily residual financial income, I have improved that amount by $2.64, which by getting rid of the MIP, that will add to the improvement by $1.49 per day ($45.44 per month * 12 / 365.25) for a total of $4.13, which exceeds the goal of $3.65 per day improvement. Of course, by dropping the mortgage, I will further drop the daily interest charge from the balance it was at the start of the year to the balance it will be once the MIP/PMI is gotten rid of will be an improvement by $0.75, which isn’t very much, but it’s an additional amount to the $1.49, which comes to a total of $2.24. In the end, to shell out about $5,500 (some of that already built into the monthly mortgage payments) to get rid of the MIP/PMI and improve the daily rate by $2.24, that’s like an interest rate for this one year of 14.875%. You bet, I will pay down the mortgage at least to this point to get this sort of improvement to our finances in the long term. Don’t get me wrong, this is only a one time deal as far as improving the daily amounts by getting rid of the MIP/PMI is concerned, but it’s the daily residual amount I look at very heavily as it impacts how one will do in retirement years living strictly off of residual income.
Anyhow, just be careful with what you are getting into and take into account of the various costs you may have to pay for (many of which are junk costs that only line the pockets of the banker).
Katherine says
Paying off primary mortgage for sure as I don’t even get the deduction (loan balance and/or interest is too low to itemize advantageously) and I want to get rid of the monthly obligation. Debating on whether it makes sense to pay off mortgage on investment property because I actually do get to deduct that … plus the loan balance is much larger so it seems more daunting.
krantcents says
I always believed that since the IRS subsidized my mortgage by letting me itemize, I would invest the extra money instead of paying down the mortgage. I change that thinking as I get close to retirement.