3 Reasons NOT to Pay Off Your Mortgage Early
With the current housing crisis, many homeowners are considering paying extra each month on their mortgage to pay their loans off early. People work hard every month to come up with extra dollars looking for big savings in the future. But is it really worth it?
Let’s look at the facts:
The case for:
(The numbers in the following example were created using a mortgage amortization worksheet template which may be found online or in the spreadsheet software that came with your computer.)
The case for paying off your mortgage early is usually explained as follows:
Assume you have a 30-year mortgage for $100,000 at fixed 4.75% APR. Your monthly payment – excluding taxes, insurance, etc. – would be $521.65. By the time you pay off your mortgage 30 years later, you would have paid a total of $87,793 in interest. Instead, you opt to pay an extra $100 a month towards the principal on your loan. This extra amount reduces the interest you pay to $59,351 and causes your loan to be paid off 102 payments early.
Your total savings are $28,441:
$187,791 (total payments expected with original loan) – $159,350 [($521.65 + $100 extra payments) x 257] = $28,441
What could be wrong with that?
The case against:
As attractive as those numbers look, there are several issues which makes this less of a good deal than you might think. Let’s look at them in detail.
1) How long will you live in your home?
Studies show that, on average, people tend to change houses every 5 to 7 years. If you don’t plan on living in your house for the next 30-plus years, there is no financial advantage to paying ahead on your mortgage. All the extra money you pay each month will be returned to you when you sell the house. It’s kind of like getting a tax refund; it feels like a bonus, but you’re just getting your own money back at a 0% rate of return (more on that later).
2) Don’t forget inflation.
The savings you achieve by paying extra on your mortgage don’t happen all at once, but rather over time and in the distant future. In this case, paying an extra $100 on our mortgage starting in month 1 causes us to stop making payments in month 257 – over 21 years later. We know that we live in a world where inflation is a reality: the purchasing power of our money decreases at some rate over time. However, many people who argue for paying extra on a mortgage are treating the money they get back 21 years in the future as having the same purchasing power of today. Unfortunately, their values are quite different.
In the U.S., inflation has increased at an average rate of 2 – 3% yearly. If we assume an increase in inflation of 3% per year, our $521.65 mortgage payment 21 years from now will be equivalent to a payment of $276.30 today. By year 30, that value has dropped to $212.02. Put simply, we are paying $100 to save around $250, not $521.65. If we inflation-adjust the extra payments over time and the total savings over time, the net present value (how much paying extra saves in today’s dollars) equals $6,030.61 ($24,969 in savings – $18,938 in extra payments). That’s a lot of extra work for not much return.
3) Your extra payments earn a 0% rate of return.
This is probably the most important point people overlook. Every extra dollar you spend paying down your mortgage early earns you no money in return. The value of your home increases or decreases based upon changes in the housing market, not how much money you put into your mortgage each month. Let’s say you opt to put the extra $100 each month into an investment product which earns an average annual return of 8%. By the end of 30 years, you would have accumulated about $148,015 in your investment fund. Compared to the $87,793 you paid in mortgage interest over this period, you are $60,222 ahead. Not only do you have more money, but this gives you cash you can access over those 30 years should you need it for medical bills, emergencies, or other unexpected expenses. If all your money is tied up in your house, you will have to sell it, or take on more debt, to get access to the cash.
Is it never a good idea to pay off a mortgage early?
There are some circumstances in which paying your loan off early makes sense. For example, if you are nearing retirement, you may want to pay extra so you don’t have a mortgage payment to contend with every month. If paying your loan off takes five years or less, the effects of inflation and potential investment earnings are negligible, so you aren’t doing yourself a disservice. Also, if you pay private morgage insurance (PMI) on your loan, and your loan originated before the tax law changed to make PMI payments tax deductible, there may be an advantage to paying ahead until you’ve created enough equity to eliminate those extra payments.
What should I do instead?
Invest your money. Time is your best friend or your worst enemy when it comes to investing. Don’t use the next 20 or 30 years paying extra on a mortgage when you could be doing something that can create real economic benefit for yourself. Increase your 401(k) withholdings at work, or open an IRA account. Contribute extra to your child’s college education fund, or add to your cash reserves, so you don’t have to rely on debt during tough times.
A great way to get ahead on your mortgage is to look into refinancing options. In our current, low-interest rate environment, it may be possible to refinance a 30-year loan into a 20- or 15-year loan without increasing your monthly payment. The lower interest rate and shorter time horizon will reduce the total interest paid on the loan without tying up any extra cash. For example, let’s assume you started with a 30-year, $100,000 fixed rate mortgage at 5%. After five years, you would have a loan balance of $91,282 and be expected to pay out $69,601 in interest over the next 25 years. If you refinance that loan into a 20-year fixed at 3%, not only would you pay your loan off 5 years earlier, but your monthly payment would be $26 less each month, and you would pay $39,152 less in total interest.
Like any decision, there are many factors that influence how we spend our money. It is important to consider all your options before committing your hard-earned extra money to your home loan. By anticipating how long you will live in your home, and understanding what investment or refinancing options are available, you can make the best choice for how to handle paying off your mortgage.
Nice Blog with Excellent information
computers
October 25, 2011 at 9:39 pm
Your site has affected me in a very good way . thanks
Rental Miami Beach
October 29, 2011 at 7:02 am
Your logic sounds great on paper but it is totally flawed. Here is why:
Option 1: Investing $100 in your house earns $4.25 annually (i.e. the interest you are not required to pay).
Option 2: Investing $100 in a stock earns $6.80 annually (i.e. $8.00 less $1.20 paid in taxes assuming 15% tax rate).
While option two seems like the better pick, it is highly unlikely that you will find a 8% return. Over the past ten years (2002-2011), the return on the Dow Jones Industrial Average has been 3% annually.
Also, Option 1 is a zero risk investment (i.e. you earn a guaranteed rate). Option 2 has an element of risk. There is a high probability that you will not get a 8% return or even loss money.
Accept the fact that the 90′s are over and take the guaranteed 4.25% return.
John
February 7, 2012 at 7:39 pm
For the sake of simplicity, taxes were left out of the article. But including taxes in the argument only increases the complexity. By prepaying on your mortgage, you also reduce the amount of mortgage interest you can deduct on your tax return, which can offset some of the savings. Also, the investments can be made through a tax-advantaged plan such as a 401(k), where your earnings grow tax free, a traditional IRA, where your contributions are deductible and earnings grow tax-free, or a Roth IRA, where the earnings and distributions are tax-free.
Your argument also ignores the time value of money; the $100 you pay today does not equal a $100 savings in the future. In fact, paying extra on your mortgage undermines one of the primary advantages to fixed interest rate debt: your payments become cheaper over time with inflation. By paying ahead, you are spending more of today’s “expensive” dollars rather than tomorrow’s “cheaper” dollars. And while it might seem that paying extra into your mortgage is riskless, it is subject to many risks including inflation risk, liquidity risk, and market risk.
As far as market returns go, the market is subject to cycles, and any time series of data will show below- or above-average returns. There are other investment vehicles beyond the DJIA or S&P500 that have continued to perform even in today’s economic environment. Besides, the only relevant time horizon is the one that matches the period of when you would be paying off the mortage; the market returns 25 or 30 years from now should be your greater concern.
For most Americans, their 30′s and 40′s are the prime years for accumulation of retirement savings since that allows market gains to benefit them the most. Diverting those dollars into paying off a mortgage early means more money is spent later playing “catch-up”. With interest rates still low, refinancing remains the most attractive solution for those wishing to reduce their monthly payments and save interest without additional cash outflows.
Real Life 101, Inc.
February 7, 2012 at 9:08 pm