Opportunity Cost: Payoff Mortgage Or Invest
A key piece of this puzzle is what you do with the money you would have spent paying down the mortgage. If you keep it in cash just sitting around, then that clearly doesnt help you out that much .
It also doesnt help you if you just end up levering up on depreciating toys and junk.
But the assumption is that you will invest the money you were going to pay your mortgage down with in an asset that returns a higher rate than the effective rate you are paying on the loan. This could be stocks or real estate, or another asset class.
This is one of the key reasons why real estate investors do so well over long periods of time. They lever up and capture property value increases while the level of their debt is decreasing in value. Then after a number of years of asset appreciation, they do a cash out refinance, and buy more property, resetting the clock and doing it again.
Again you need to compare the rates of return in after-tax terms.
If you are in the 25% tax bracket and have a 3% mortgage and invest in an S& P 500 index fund earning 8% , the appropriate rates to compare are 2.25% to 6% if you itemize or 3% to 6% if you dont. Therefore, by not paying off your mortgage, and investing into the stock market instead, you are earning an extra 3-3.75% per year.
Of course past results are no guarantee of future results, but that is strong evidence that a 30 year holding period of stocks is going to outperform the investment of paying down ones 3% rate mortgage.
Experts Weigh In On The Pros And Cons
Its been drilled into Americans that a mortgage is good debt, a liability that shouldnt give you pause, even after you retire.
But the pandemic has been shaking up a lot of old financial rules. The Great Resignation, as its being called for those quitting their jobs, is making a lot of homeowners wonder if they should consider paying off their mortgage early.
A record 4.3 million U.S. workers quit their jobs in August, according to data from the Bureau of Labor Statistics. With covid still surging in areas, working comes with health risks for many people. The pay isnt enough to offset the possibility of getting covid, so they quit. For others, the pandemic death toll has made them wonder if their work took too much precedence over living their best life.
While not everyone who quits can afford to get rid of their mortgage early, for those who have the option, the question is: Why not?
I spoke with two experts to get their take on the pros and cons of paying off a mortgage early. Lets start with some of the cons.
Being house poor I owe just under $80,000 on my home mortgage, one reader wrote. I am retired, and I have the cash to pay the loan, but it will wipe out over half of my savings. I am on track to pay the mortgage in less than three years.
A Focus On Mortgage Payments May Mean Missing Out On Other Investments
A con of paying off your mortgage early is that the payments are higher and may crowd out other investments for instance, contributing to a retirement plan or funding a childs college fund, said Robert R. Johnson, Ph.D., CFA, professor of finance at Heider College of Business, Creighton University. Some borrowers mistakenly view the purchase of a home as their chief investment. If mortgage payments are so large as a percentage of monthly income that people cant adequately fund their retirement account or a childs college education account, then it may be wise to simply pay your mortgage over the normal term of the loan.
Investing in the stock market may also be a better use of your funds than paying your mortgage off early.
Noble laureate economist and Yale professor Robert Shiller makes a compelling case that real estate, particularly residential homes, is a much inferior investment when compared to stocks, Johnson said. Shiller finds that on an inflation-adjusted basis, the average home price has increased only 0.6% annually over the past 100 years. Contrast that with the stock market. According to data compiled by Ibbotson Associates, the average return on the S& P 500 has been approximately 10% while inflation has averaged around 3%. The inflation-adjusted return of the stock market over the past 90 years has been approximately 7%.
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Pitfalls Of Paying Off Your Mortgage Early
Many homeowners think that they should pay off their mortgage early to get out of debt, but does it always make sense?
You do not want to pay off your mortgage and end up low on cash. It’s much easier to take cash out of a checking account when needed than it is to refinance by pulling it out of your home loan.
Ask yourself if you’ll need liquid cash in the near future. If the answer is yes, you’re better off putting your extra money in savings â not toward your mortgage.
Always have a small savings buffer to help you pay for immediate expenses.
Should I Pay Off My Mortgage
One thing Covid-19 highlighted is the importance of cash reserves. But when you pay off a mortgage early you give tens of thousands of dollars to your lender and you lose access to that cash. The only way to get it back is to sell the house or get another loan .
When you get a big mortgage, you minimize the amount of cash needed to buy a house. That lets you keep more of your cash which is thus available to buy food and medicine in a crisis.
Here are 11 reasons you should not pay off your mortgage early:
#1: It doesnt affect your homes value. Your homes value will rise or fall whether or not you pay off a mortgage.
#2: A mortgage wont stop you from building equity in the house. The value of your house is likely to grow over the next 20 years. Youll build equity over time even if your principal balance never declines.
#3: A mortgage is cheap money. Mortgages are one of the cheapest ways you can borrow money.
#4 and #5: A question people often have is Should I pay off my mortgage or invest? But those two choices arent mutually exclusive.
Your mortgage interest is tax-deductible. And mortgage interest is tax-favorable. The interest you pay on loans to buy, build or substantially improve a qualified residence is tax-deductible if you itemize your deductions.
So dont bother trying to make your mortgage go away. Instead, your focus should be to create wealth so that you can comfortably afford the cost of living in and owning your home.
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Should I Leave 1 On My Mortgage
Historically, leaving a small amount of money outstanding on a mortgage meant that the lender kept the deeds for the property in safe keeping but nowadays, deeds for the majority of properties are no longer required in paper format – records are now held electronically by the Land Registry.
On top of this, leaving a nominal amount on a mortgage in the past made it easier to borrow from an existing lender. However the impact of the recession and the tightening of affordability criteria means that any new line of credit will require a separate application with new credit checks, regardless of the lender.
Drawbacks Of Paying Off Your Mortgage Early
- Opportunity cost: Any extra money you spend on paying down your mortgage faster is money you arent able to use for other financial goals. You may be paying off your mortgage early at the expense of your retirement savings, emergency fund or other higher return opportunities.
- Wealth is tied up: Property is an illiquid asset, meaning you cant convert it to cash quickly or easily. If you faced a financial emergency or had an investment opportunity you wanted to jump on, youd not only have to sell your house, but also wait until a buyer was available and the sale closed.
- Loss of some tax breaks: If you choose to pay down your mortgage instead of maxing out your tax-advantaged retirement accounts, you will give up those tax savings. Plus, you may lose out on tax deductions for mortgage interest if you normally itemize.
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Mistake #: Not Putting Extra Payments Towards The Loan Principal
Throwing in an extra $500 or $1,000 every month wont necessarily help you pay off your mortgage more quickly. Unless you specify that the additional money youre paying is meant to be applied to your principal balance, the lender may use it to pay down interest for the next scheduled payment.
If youre writing separate checks for extra principal payments, you can make a note of that on the memo line. If you pay your mortgage bill online, you might want to find out whether the lender will let you include a note specifying how additional payments should be used.
Can You Pay Off Your Mortgage Early
If youre considering paying off your mortgage early, first contact your mortgage lender or servicer. Based on the terms of your loan, you might find out youre subject to a prepayment penalty if you pay off your mortgage sooner than your payment schedule spells out, or that you can only make payments within certain parameters.
The prepayment penalty on a mortgage can be 2 percent of the loan balance within the first two years of your mortgage, and 1 percent thereafter. Knowing this information upfront can help you map out a payoff plan that works for you and your lender or servicer.
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When Paying Off Your Mortgage May Not Make Sense
- You have to withdraw money from tax-advantaged retirement plans such as your 403, 401 or IRA. This withdrawal would be considered a distribution by the IRS and could push you into a higher tax bracket.
- Withdrawing the funds puts your retirement savings at risk or forces you to make drastic changes in your lifestyle.
How To Pay Off Your Mortgage Early
If paying off your mortgage early is right for you, here are some strategies to do it:
- Make biweekly payments. One way to get started with making extra mortgage payments is to set up a biweekly schedule. This amounts to making a full extra monthly payment each year and can reduce the time spent with a mortgage. Starting with biweekly payments can help you get ahead on your mortgage while allowing you to keep working toward other financial goals.
- Make extra mortgage payments each year. Similar to making biweekly payments, you can simply make an extra mortgage payment once a year, or pay an additional amount each month on top of what you already pay. Be sure to coordinate with your lender so that these extra funds are allocated to the principal.
- Refinance to a mortgage with a shorter term. If you stand to get a lower interest rate, refinancing to a 15-year mortgage means youll pay off the loan sooner. Keep in mind that even with a lower rate, you could be paying more each month, since your payments are now spread out over a shorter period of time.
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Other Ways To Pay Off A Mortgage Early
Paying off a mortgage early requires you to make extra payments. But there’s more than one way to pay off the mortgage early:
Add extra to the monthly payments, as discussed in this article.
A structured way to add extra: Divide your monthly principal payment by 12, then add that amount to each monthly payment. You end up making 13 payments, instead of the required 12 payments, every year.
A variation of the above tip: Deposit one-twelfth of the monthly principal payment into a savings account each month, then use that money to make a 13th payment.
Pay half a mortgage payment every two weeks. You make 26 half-payments, equivalent to 13 full payments a year. If you want to try this, first make sure your mortgage servicer is set up to receive biweekly payments.
Make a lump-sum payment toward the principal. You might do this after receiving a bonus, inheriting money or winning a lottery prize any time a large sum lands in your checking account. Coordinate with your servicer to ensure that the money goes toward reducing principal.
Refinance to a shorter term. If you can refinance with a lower interest rate, for a shorter term, it’s a win-win. For example, you could refinance a 30-year mortgage into a 15-year loan. The monthly payments will almost certainly be higher, and you’ll pay closing costs, but your overall interest expense will be dramatically lower.
My Best Advice: Plan For The Future
If you’re focused on paying off your mortgage, good for you. It’s generally always good to get rid of debt. Plus, with no mortgage, you get a guaranteed, risk-free return.
Just make sure you consider the downsides.
Aside from losing motivation, you also tie up capital in an illiquid asset when you pay your mortgage off early. Unless you have a very diversified net worth, having a lot of capital in the form of home equity can be a bad thing. Your home could collapse in the next storm or burn down in a fire.
And with interest rates at all-time lows, it might make more sense to refinance your mortgage into a low fixed-rate term for as long as you plan to own the property and then invest the rest.
The right answer depends on your current situation, tolerance for risk and long-term goals.
My best advice is to pay off your mortgage by the time you no longer want to work. Figure out when you plan to retire and divide your debt amount by the number of working years you have left.
There are free retirement planning calculators to help give you a realistic picture of your financial future. After all, there’s no rewind button in life. It’s always better to over-plan than it is to under-plan.
Sam Dogen worked in investment banking for 13 years before starting Financial Samurai, a personal finance website. He has been featured in Forbes, The Wall Street Journal, The Chicago Tribune and The L.A.Times. Sign up for his free weekly newsletter here.
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If You Decide To Overpay Your Mortgage
If, after weighing up all the facts, you decide to overpay, then you need to time it right.
If your mortgage interest is charged daily, then the sooner you make the overpayment the better.
If its charged annually, then you need to time your overpayment so that it counts towards the calculation of the interest for the year.
Switch To An Offset Mortgage
An offset mortgage works by linking your savings account to your mortgage. All the money you have saved up will be taken off the mortgage balance. So your interest payments should be lower as you’ll only be charged interest on the mortgage balance minus your savings. With an offset mortgage you could also use your savings to overpay your mortgage and repay it early.
Being able to pay off your mortgage early is a great privilege, but it may not always be the right financial decision for you. Before you make that decision, be sure to shop around for remortgage deals, check if you could get a decent savings account or pension, or simply choose to pay off your other, more expensive debts.
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Choose An Accelerated Option For Your Mortgage Payments
An accelerated payment option lets you make weekly or biweekly payments. With this option, youre putting more money toward your mortgage than with a monthly payment.
Accelerated payments can save you money on interest charges. By accelerating your payments, you make the equivalent of one extra monthly payment per year.
Should I Pay Off My Mortgage Or Invest
Weighing whether to pay off your mortgage or invest comes down to achieving balance. Just like a gymnast must maintain superb balance to avoid mistakes and injuries, somebody who’s torn between paying their mortgage and saving for their retirement must perform a delicate balancing act.
If possible, you can and should work toward paying off your mortgage while also investing for your retirement doing both can help you better prepare for the future. Here, we’ll unlock the pros and cons of focusing on your mortgage or your investment portfolioor embracing a combination of the two.
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Pay Mortgage Early Or Invest: What Does The Math Say
You probably dream of the day when you no longer have a mortgage payment hanging over your head. Being debt free is an admirable goal, but it might not make the most sense financially. Especially now, with mortgage rates so low, its cheap to hold debt. That leaves the opportunity to grow your wealth more through other investments.
Lets take a look at an example. Say you have a 30-year mortgage of $200,000 with a fixed rate of 4.5%. Your monthly payments would be $1,013 , according to our mortgage calculator, and youd spend a total of $164,813 in interest over the life of the loan.
Now lets say that youre able to come up with an extra $300 per month to put toward your mortgage. Youd shave off 11 years and one month from your repayment period, plus save $67,816 in interest.
On the other hand, you could take that $300 per month and invest it in an index fund that tracks the S& P 500 Index instead. Historically, the S& P 500 has returned an average of 10% to 11% annually since its inception in 1926 through 2018. If you want to be extra conservative, however, we can assume an average annual return of 8% on your investment.
At the end of 19 years , you would have $160,780. Thats more than double your potential interest savings. In fact, after that length of time, youd have about $105,487 left on your mortgage. If you decided to pay your mortgage early after all, you could use your investment funds and still have $55,293 left over.