With the current low interest rates for mortgages and the present status of the stock market, should you be putting extra payments onto your mortgage and pay it off faster, or should you rather invest that money? Thanks to a suggestion from a client, we will try to give you some solutions in this article.
First, let’s first start with this case study. Teddy and Donald Smith recently re-financed their house for $200,000 for a 30 year mortgage at 3.75%. Their monthly payment for principal and interest and is $926, which does not include taxes or homeowners insurance. Let’s assume that they make 1 extra payment per year. By making that one extra payment, they chop 4 years off their mortgage, finishing in roughly 26 years. Meanwhile, Hillary and Bernie Jones took out the same mortgage, but rather then make an extra payment on the mortgage; they invested that annually for the same 30 years at a 6% rate of return. For this same example, let’s assume that after the mortgage is paid off, Teddy and Donald save their $926/monthly for 4 year years at 6%, which the results are shown below:
As you can see, after 30 years (and both mortgages are equally paid at this point) the couple that invested that extra annual payment had an extra $18,943 than the couple that did not, even though the couple that invested the money paid an extra $19,135 in mortgage interest!
These numbers work because of the current low interest rate environment for mortgages and may not always be the case. This was a very basic example that does not take into account tax deductions for mortgage interest. Please know that the mortgage decision is rarely ever this simple. It depends on your specific situation – your tax rate, mortgage interest rate, investment return, portfolio allocation, credit history, ability to save and risk tolerance.
I have to admit that I am a fan of having the mortgage paid off by retirement time. The reason behind that is that if you have a mortgage payment of $1,000/monthly (not including property taxes or homeowners insurance), then you would need to have approximately $300,000 in investments to cover that monthly cost (utilizing a 4% distribution rate). Once your mortgage is paid off, you would not need that $300,000 or at least be able to use that money for other fun discretionary things – like travel!
The example above shows what you could have, depending on what you do with the money for the extra payment. Some Pros to paying off your mortgage early include:
Peace of mind. If paying off your mortgage means you are less likely to panic when your portfolio value is down, it may be a good idea. Investing in a portfolio of stocks and bonds is more risky than using the same funds to reduce a mortgage, and therefore, should have a higher expected return.
Good savings vehicle. If you are not a good saver, by paying off the mortgage, it creates a form of forced savings.
Tax Deduction versus interest paid - Why pay $20,000 in interest to get $6,600 back from the IRS? It does not make sense just to have a mortgage for the tax benefits alone. Generally, the tax benefit of the mortgage interest deduction is most meaningful for families with high income and significant other itemized deductions. As you continue to pay for your mortgage over the years, the tax benefit becomes less and less and you pay more interest in the early years.
On the flip side, some Cons to paying off your mortgage early:
Leverage. By borrowing for long periods of time at low rates and investing the difference, you may likely end up with more wealth versus paying off the mortgage.
Inflation Hedge. Over a 30-year history, assuming the borrower makes all the monthly payments, the bank can never call the loan. This provides for a fixed payment for 30 years that will never change. Taking inflation into account, it's possible that 20 years into the mortgage, the payment will be equivalent to an electric or similar bill.
Don't pay off the mortgage early if you're not staying put. You may be planning to sell your house within 5 years and it may not make sense to stick that extra cash into the mortgage payment. You may be better off keeping it liquid, rather than tying it up in the house. If you plan on living in the house for at least 10 years after the mortgage is paid off, it may make sense to pay it off.
If you have not built up a safe cushion in the bank (3-6 months living expenses), then it is not a good idea to put that money back into paying down the mortgage. For example, what happens if you need to replace the roof, windows, or furnace; the money will not be available unless you charge it or take out another loan.
Paying off debt, on the other hand, is risk-free, which provides a substantial emotional benefit that is not measurable in dollars and cents. Some people prefer the peace of mind than a few hundred thousand dollars of potential economic gain.
If you are interested in coming up with a personalized strategy for you and paying down your mortgage versus investing, please call our office to set up a meeting and we can come up with a plan specifically for you! Many times we have developed a hybrid strategy of investing an extra payment, which may give you the flexibility down to the road to pay off your mortgage earlier if you wish. In the meantime, get that fire pit ready - as some day – with some careful planning, you too can have a Mortgage Burning Party!
