“We’re thinking about paying off the mortgage on our house,” said my client in a recent meeting. This family also wants to pay for both their children to attend college, so their desire to use surplus funds to pay off their mortgage was surprising. “We’ve got extra cash and it would be awesome to not have to pay that monthly bill.”
It’s a question I’ve heard a lot in the past year: Should I try to pay off my mortgage early? What are the benefits of paying off my mortgage early? Should I refinance? The challenge is that there is no simple answer because it varies depending on the terms of your current mortgage, your personal financial situation, philosophy, and prevailing alternate investment opportunities.
Benefits Of Prepayment
Prepaying a mortgage refers to making extra payments towards the principal balance of the loan, effectively reducing the overall term of the mortgage. There are a lot of reasons people want to pay off their mortgage early, some of which are logical and some that are emotional:
- Interest Savings: Paying off the mortgage early may save the borrower on interest payments over the life of the loan. Interest is typically one of the largest expenses in homeownership, so eliminating it early can result in substantial long-term savings depending – depending – on the interest rate, duration of the loan, and opportunity cost.
- Emotional Satisfaction: The emotional satisfaction of becoming debt free and owning your home outright can be significant. Fully owning your own place can provide a deep sense of achievement and pride that has is own value, and this can be significant for some homeowners, especially those with a deep aversion to debt.
Drawbacks Of Prepayment
Sometimes, prepaying a mortgage can save you money on interest payments and allow you to pay off your home faster. However, there are scenarios where it might not make sense. Consider the following:
- Opportunity cost refers to the potential benefit lost when choosing one option or course of action over another. If you use savings to pay off your mortgage you miss out on the potential returns of other investments that may earn a higher rate of return.
- Mortgage interest is tax-deductible, and – while the 2017 Tax Cuts and Jobs Act reduced this benefit for most Americans through the increased standard deduction – you can still claim mortgage interest if you itemize, and the TCJA’s benefits are slated to sunset in 2025. If you pay off your mortgage early, you may lose the tax benefits associated with mortgage interest deductions.
- Paying off your mortgage early reduces your liquidity by tying up money in your home’s equity. If you need access to cash for an emergency or unexpected expense you have fewer options to raise funds quickly, or may be forced to turn right back around to tap into your home’s equity.
- Putting additional savings into your home reduces diversification in your portfolio, which increases your risk exposure to the housing market. The real estate market has, in the long-term, been resilient, but it is not immune to fluctuations. We’ve seen this nationally as recently as 2008 and locally in areas such as New Orleans, when Hurricane Katrina made it impossible for some people to sell their homes.
- Paying off your mortgage early may incur additional closing costs, such as prepayment penalties or other fees. If you’re considering paying off your mortgage, be sure to read the fine print on the terms of your loan.
Do The Math
Whether prepayment is right for you depends on a multitude of factors specific to your mortgage and alternate options available to you. The best thing to do is calculate which option provides a better outcome. For example, take a new homebuyer that:
- Purchases a home for $1,000,000 with a 20% downpayment.
- The mortgage on the remaining $800,000 balance is for 30-years at a rate of 5%, making the monthly payment $4,289.
- Let’s exclude insurance, taxes, and maintenance for simplicity, as well. Let’s just talk mortgage, for now, understanding that the owner may be foregoing some tax savings by prepaying.
If nothing changes the homeowner makes their monthly payments and life goes on. By the end of the 30-years they’ve paid $1,544,334. But could they have saved money during the life of the loan by making additional payments?
If the owners put in an extra $1,000 a month right from the first month they would pay it off in approximately 16 years and 2 months, and the total amount paid at the end will be approximately $1,025,930. They save a half million by paying down their loan more aggressively- or do they?
How Interest Rates and Opportunity Cost Affect Prepayment
The biggest factor impacting prepayment of a mortgage is the opportunity cost of those dollars. By prepaying your mortgage you are, in theory, choosing that option as the best available, economically. But what happens if we take that $1,000 extra each month and put it towards an alternative investment?
What happens depends entirely on options available to you, which is why the “risk-free rate” is so important to this prepayment equation. The risk-free rate is the theoretical rate of return that an investor would expect on an investment with zero risk. Since all investments have risk the 3-month Treasury Bill is typically used as a proxy, and that rate is currently sitting around 5.20% or so.
So if you take our example where you have a 30-year mortgage at 5.0% there is little incentive to pay it down since you can get a better rate – albeit only slightly – by putting those funds into most any investment, since the baseline is 5.2%. Take two scenarios:
- Five years into our mortgage interest rates decline to 3.0%. With our mortgage at 5.0% we could either refinance to a lower rate or aggressively prepay it to guarantee ourselves a better return than we might get investing in the next “safest” alternative (those T-bills or a high-yield savings account mentioned above).
- Or, five years into our mortgage interest rates rise to 6.0%. In this case paying off the mortgage early makes no sense, since that money would earn more inside a high-yield bank account (assuming it can match the 6.0% market rate).
In the case of the latter you would have a superior economic outcome of $342,702.25 over the remaining 25 years just by putting that extra $1,000 into the bank account yielding 6.0% versus applying that value to pay down the mortgage more aggressively.
That said, there is one important caveat: Paying the mortgage down more aggressively gives the homeowner a guaranteed return, whereas investing in alternative options may not maintain those higher rates over time. There is no guarantee that the 6.0% rate after five years will remain at 6.0% for the next 25 years. The guaranteed return from prepayment can be worthwhile to many homeowners, as a result. This is why – even though there are mathematical solutions – whether prepayment makes sense or not depends on the owner.
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