Is Paying Off Your Mortgage Early Costing You Money?

by David Ning on 4 November 2011 7 comments
Photo: Yuri_Arcurs

A frequent question that pops into people's minds is whether they are throwing money away by paying off their mortgage instead of investing that sum. In reality, that's the last thing you should think about. Here's why:

The 1.5% Difference

Sure, the return of the stock market is higher than the interests one pays on mortgages, but is your money really earning the return of the market?

Instead of just focusing on what your money could do if you invest that sum in the S&P 500 index, you should really be thinking about the returns of all your assets as a whole because that's the true yield you are getting. This includes the equity in your home, all your savings accounts that are barely earning any interests, the bonds you own, and finally, the stocks that you have in your portfolios. (See also: 5 Creative Ways to Invest During a Weak Market)

But even if you forget about all that and just think of your investment portfolio, the results could surprise you. Say you get a 6% return, with taxes factored in, it would really be more like a 5% gain assuming you will have some long and short term gains as well as taxes on dividends.

On the other hand, your 4.5% 30-year fixed rate mortgage is more like a 3.5% loan with taxes. Hurray you say, because you are still making 1.5% more when you invest the money.

But hold on a second. A 1.5% difference on even $10,000, an amount you could likely come up with to either invest or pay off your mortgage, is just $150 a year. A whole year! I can save that much more just by cooking at home three more times, or by buying less coffee outside.

Think of These Factors Instead

Now, $150 every year for 30 years is very good money, but as we all know, a 6% return isn't a guarantee for everybody. Add the stress that people put onto themselves when they are leveraging, and $150 seems like a ridiculously small amount to be paying for the additional stress.

Instead of the additional money you are getting, think of the other advantages of not paying off your mortgage:

Liquidity — Your investments are more liquid than money tied up in home equity. Depending on how stable your income is, not paying off your mortgage could actually be the more conservative choice.

Asset Allocation — Are your real estate assets at a level that you would like? Remember to factor in just the equity that you've built, as any mortgages or loans that you owe is debt that needs to be repaid. Once you have the answer to this question, then you can easily figure out whether you should pay off your mortgages.

Freedom — This is a very personal question. My wife feels very strongly that we should pay off our mortgages early because she feels much more secure when she is debt free, even if she has the same amount of money in the stock market. I lean towards that side as well, though not nearly as extreme.

For us, being debt free will probably lead us to live a healthier, happier life. But it might not be the same for you, as some people will feel more secure when they have a large balance in their portfolio.

So really, there is no right answer. Do what make sense for your situation and what feels comfortable to you and don't worry too much about wasting money either way.

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Money Beagle's picture

I firmly believe in the intangible benefits of becoming debt free, so even though the numbers might not always add up to make paying a mortgage off early the 'best' goal, for the other reasons you stated (security, less stress), there are definite benefits!

Guest's picture
Rob O.

We just sent in the cashier's check for the payoff on our mortgage about 2 weeks ago. Our feeling was that paying 5% interest versus earning less than 2% on the money we had sitting in a money market account just wasn't good math.

I work with guys who earn twice my salary yet will still be carrying their mortgages for another decade - or two! So yeah, there's an incredible sense of pride!

I want to shout about this accomplishment from the rooftops! But people act rather odd (to put it mildly) when you tell them that you've just paid off the mortgage on a house that you've owned for just under 2 years. They never attribute this to living frugally and planning wisely for the previous 15 years. I figured this out pretty quickly and have since shut my trap!

But yeah, for piece of mind, it was well worth paying off the mortgage. To know that, if anything should befall either my wife or me that there will be one less burden to shoulder. And I feel like this buys me a lot more freedom when I retire from my current job in 2-3 years - I'll still be finding another job, but now maybe there will be less stress on the salary level and I can focus more on doing a job I really enjoy or that is a real stretch for me.

Guest's picture
S

Until very recently my focus was on paying off the mortgage before investing more but then I realized I could do both. Now we take a hybrid approach: investing to build enough money to pay the mortgage. I keep both totals in a spreadsheet and once they overlap I'm going to pull the investments and dump the mortgage. Maybe not the fastest approach to being debt-free but I've done the math and it seems quicker than the alternatives.

Guest's picture

It is great to see someone lay out the options. I say before doing anything map out the real numbers and figure out what your goal is. Eliminating debt or building your wealth. The strategies are different!

Guest's picture
YFS

I tend to do both. I get the safety of removing debt and have the liquidity of investments.

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Jerry

When we paid off our mortgage, my wife and I felt a great sense of liberation.

Guest's picture

People often frame this question as invest OR payoff mortgage. However it is possible to both invest AND pay off the mortgage at the same time. There is a method where you can actually pay off the mortgage provider now, but defer payment for many months in advance. This means that you still have the money to invest (with a chance of beating your mortgage rate). Also as the mortgage payment can be deferred (and paid later) you have a chance to beat inflation.
The question does not have to be either paydown OR invest - you can do both at the same time. Note: you can overpay the mortgage today even if you dont have the money immeadiately available, but you know you will have it a few months time.

It's hard to know exactly what the best final investment outcome will be, so doing both kind of hedges your bets.