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3 Reasons NOT to Pay Off Your Mortgage Early

with 14 comments

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.

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Written by Real Life 101, Inc.

January 31, 2011 at 12:44 pm

14 Responses

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  1. Nice Blog with Excellent information

    computers

    October 25, 2011 at 9:39 pm

  2. Your site has affected me in a very good way . thanks :)

    Rental Miami Beach

    October 29, 2011 at 7:02 am

  3. 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

      • Does Real Life 101 work for the banks???

        Utter rubbish, there is one real fundamental flaw in your argument. You have assumed that I will do absolutely nothing with all the extra cash I save once I no longer have mortgage payments. Once I have repaid my loan early I then re-invest the money I have saved on mortgage payments and make clear profit.

        The question is really a lot more straightforward than this article – If I invest the money rather than pay off my mortgage will I get a better rate of return than the interest rate I am paying on my mortgage?

        Oh and 8% annual return on an investment product? I would love to see that.

        Halfadozenmarsbars

        September 13, 2013 at 5:54 pm

      • This where understanding financial principles, particularly as they relate to investments, is important. Most people grossly underestimate the power of time when it comes to investing, and the mortgage example is a perfect example. Many people have the same idea as you: when I’ve paid off my debts, I can start saving. But if you take a closer look at the numbers, that’s not a winning proposition.

        Assume you have a $100,000 30-year fixed-rate mortgage at 3.5%. This costs you $449.04 per month; we will ignore property tax and homeowner’s insurance costs because you will continue paying for those things after the mortgage has been paid off. If you decide to pay an additional $100 each month against the principal balance, you will pay off your mortgage in 261 months – or just under 22 years. If you invest that money instead – ideally in a tax-deferred vehicle like a 401(k) – you will EARN 22 years of interest on those funds. An 8% rate of return is typically used for planning purposes because that represents the historical average market return on a blended portfolio of stocks and bonds. Assuming this rate, you would have $69,968.10 in your account after 22 years.

        The question is, can you make up the difference if you start investing AFTER you’ve paid off the mortgage? If you invest the full mortgage payment of $449.04 each month for the next 99 months (the remaining term of the mortgage that you are saving), you will have $62,678.75 in your account at the end of that period. The person who had been investing all along will have $149,035.94 in their account after 30 years, and they only spent an extra $18,355 in interest over the 30 year period to have over DOUBLE the money in their investment account.

        The point is that time is your best friend or your worst enemy when it comes to investing. If you wait until later to start, you have to use more of your own money to reach your goals. If you start earlier, the market returns do the work. With mortgage interest rates still at incredibly low rates, it doesn’t make sense for young adults to put off starting an investment plan to pay extra against their mortgage. Even if market returns are less – averaging as little as 5% annually – investing over full term of the mortgage still generates almost twice the profit.

        Real Life 101, Inc.

        September 17, 2013 at 4:42 pm

  4. Finding a loan to buy commercial or residential house is often a headache. Finding reminders and data like this assists individuals within a variety of ways.

    lighthouses for sale

    March 14, 2012 at 2:57 am

  5. Refinance I believe is going to be the best way. I paid off all my debt (about $60k) through rigorous discipline and cutbacks. After that I decided to aim at my mortgage I looked a lot online about such matters and found some of the same stories and suggestions as here. If you are serious about wanting to save money on your mortgage and trying to pay it off early, I would suggest a re-fi at a lower interest rate. I had a 155k loan at 5.50% (which really isn’t bad at all) however, with lenders offering record low interest rates I couldn’t pass it up. I refinanced the house at 3.00% for 15 years and the savings is enormous. With the lower interest, I also was only paying an additional $200 a month. At the end of my original loan I was going to pay $150,416.31 in interest which is about the value of the original loan! According to what I have heard growing up it was common to pay 2,3 or even 4 times the price of your house when you are done. With the refi my new end of loan interest total only comes to $37,629.93 for a savings of $112,786.38. Thats only paying $200 extra. Now I had to cough up 6k in order to get the loan done (which makes the savings now $106,786.38 and I suppose I could have rolled that into the loan but I was really excited about paying off my debt and wanted to put my money to good use.

    Sure, if I put my money in an account that made 7.0% for the life of 15 years (show me that one) I could have $64,349 in my account but then I would still have 15 years of a mortgage with all of that original interest as well. The 64k doesn’t even cover half of that original interest.

    What makes the 15 year work so well is that you generally get a lower rate, you loose a lot of the compound interest effect that scare investors from paying off their houses, also, and this was key for me, you don’t have to worry about how much extra a month you pay because you have already set that up when you restructured the loan. Now all you have to do is pay your mortgage and know you are doing right with your money.

    However, there is always the budget you have to work with. After paying pay bills aggressively I found that I could swing this payment. It’s not wise to try to pay more than you can handle simply because of all the unknowns. Another piece of advice would be to make sure that you have a large cash reserve before you refinance so you can not only afford the cost of the new loan but also afford to be without a job for 6 months to a year.

    Credit cards are going to be the worst thing for you. Get rid of the balances as fast as you can. Here is where I completely agree with John. Credit cards are a guaranteed debt. You are guaranteed to pay this interest. Any money you try to invest when you have CC debt is almost always going to be an exercise in futility. You are wagering that you can beat %15 to %28. Reducing CC debt is like gaining those percentages. I used to pay $120 a month in interest alone and all my cards were at 2.9%! Thats just tossing money away.

    I think I have gotten off the subject but that is my $0.02

    Ben

    Ben

    December 7, 2012 at 3:37 am

    • We agree that refinancing is the way to go, and we mention that in the article. The ideal scenario would be to combine the two: refinance to a shorter-term loan at the same monthly payment as before and use your extra funds to start investing. This would be the best of both worlds: pay less in interest while earning more in interest.

      And of course, credit cards are just nasty. In fact, if you had credit card debt plus a mortgage, our advice would be to spend all of your extra funds paying down your credit cards for the same reasoning. You cannot find any investment opportunity that would earn more interest than you would be paying in debt. It’s critical to get rid of all high-interest debt first before you start investing.

      It’s always better to be EARNING high interest rates rather than PAYING high interest rates!

      Real Life 101, Inc.

      September 17, 2013 at 5:20 pm

  6. From your logic why not take out a loan for $200,000 for a $100,000 house (if a bank would let you). Then invest all $200K into the stock market and after 30 years later pay off your mortgage. Mortgage=4.75% stock market=8%…you earn 3.25% on the $200K borrowed money – It sounds good right?

    Heck, why stop there…Borrow even more to make more!!!! The reason? Because of RISK. Who in their right mind would borrow money to invest it in hopes of making money? No one!

    Jerry

    December 10, 2012 at 12:38 pm

    • To your point, banks won’t let you do that. The point here is not to borrow money to invest, but rather what to do with your discretionary funds; i.e.: extra money you can choose to invest or use to pay extra against your mortgage. In this case, it makes more economic sense to invest your extra dollars in opportunities that pay a higher interest rate than pay off debts at a lower interest rates.

      And to your latter point, “Who in their right mind would borrow money to invest it in hopes of making money?”, the short answer is every bank and business in this country. The only reason you can get a mortgage in the first place is because the bank is borrowing money from its depositors, and “investing” it in borrowers. They do this because they earn a higher rate of return – the mortgage interest rate- than they pay to their depositors – CD or deposit account interest rates. That’s how they make money. This practice is also seen in the bond market where businesses and other organizations borrow money from the investing public to put into projects expected to generate profits in excess of the cost of financing.

      Seeing a pattern here?

      Real Life 101, Inc.

      September 17, 2013 at 4:51 pm

  7. Interesting thoughts. Wouldn’t agree 100% but I can see there can be benefits to holding back paying extra off your mortgage. In Australia only tax charged on rental properties is tax deductible so it makes more sense to here.

    I personally think that the concept of people being given tax incentives (or rewarded if you will) for owning more than one house is rediculous. If anything, people should be punished more severly so that the rich don’t get richer.

    I’m also not 100% sure about the inflation thing. I agree with the concept of the value of money depreceiating over time, but when you pay extra off your mortgage it is not cash that you are putting your money into. It is something tangible. Property. That, as mentioned above is also subject to fluctuations but is generally seen to increase in value over time to my understanding so you can’t just use a simple sum and show a figure far to the extreme of what you potentially could lose if you pay extra.

    All interesting points none the less.

    Wes Wright

    January 22, 2013 at 9:55 pm

    • Good points about the differences in countries, Wes, and it’s possible that the tax situation may make this less desirable. But I don’t think you quite understand the concept of inflation.

      Inflation happens no matter what you do with your money. What we were trying to show here is that the dollar savings you expect to see in the future are not worth as much as the dollars you are spending today. In the US, the inflation rate has been traditionally around 2.5%. This means the cost of goods and services in this country tend to rise about 2.5% each year on average. Some costs – like college tuition and automobiles – go up at an even higher rate, but the 2.5% number captures the average change. Let’s think about how this works with a tangible product.

      I like to drink soda. Let’s say my past self – back when I was a small child – wants to leave me money to buy soda in the future. When I was a 10-year-old kid, it cost 50 cents to get a can of soda from a vending machine. So I leave $5 in a jar for my 30-year-old self to be able to buy 10 sodas ($5/.50 = 10). But when I arrive at age 30, a soda now costs 75 cents per can. My $5 will only buy 6 sodas ($5/.75 = 6.67). This is because of inflation; the price of the soda has increased, so the value of what I can buy with my $5 has gone down. Put another way, $5 will be worth less to me 20 years in the future than it is to me today because it will buy fewer goods and services.

      This effect can be calculated. Let’s say by paying an extra $100 per month, you expect to pay off your 30-year mortgage in just over 22 years. This will save you a $449.04 mortgage payment each month, but you have to wait 22 years to get those savings. Just like with the soda example, the $449 you get 22 years from now will not buy the same amount of stuff $449 buys today. In fact, it will be worth about $260.83 in today’s dollars, if inflation is expected to be around 2.5% each year. If inflation is higher – around 3% – it will only be worth about $234.35 in today’s dollars.

      Because you had to pay $100 to save the equivalent of $260.83, your net savings is $160.83. You’re still saving money, but the savings are not as significant as the promised future amount of $449 might have suggested.

      With regards to the property, it’s important to understand that the value of house doesn’t increase when you spend extra on your mortgage. That’s not an investment in property; that’s paying off debt. In fact, the property value can go down even after you’ve poured thousands of extra dollars into your mortgage. The only value that changes is your equity – the difference between what your house is worth and what the balance of your mortgage is. The only way to cash out that equity is to borrow against it – via a second mortgage or a home equity line of credit (i.e.: more debt) – or to sell the property. By investing those extra dollars, you have access to liquid cash; you can sell those stocks at will to use your earnings without losing your house or taking on more debt.

      Real Life 101, Inc.

      September 17, 2013 at 5:15 pm

      • I hear what you’re saying. Although one of the options you provided as a different solution to paying extra was to stock up cash reserves. But that is under exactly the same inflation bubble as paying extra off your house. Money in the bank is lost money, which I do think you also mention in a round about way.

        I suppose the main point i was making is that money on the mortgage is a sure thing. You know your mortgage is going down and you will have no debts once it’s paid off. Whilst shares may be liquidable to more of an extent, you are still bound to the simple fact that people seem to forget with shares. To sell shares, you need to have an interested buyer which then relies on the company having projected growth otherwise no one will want them.

        Plus in Australia we are also subject to capital gains tax on shares being sold, so that makes a slight dent on any money invested also. Not that that unto itself makes it not worth it because it is percentage based.

        But I hear what your saying. All good points.

        Wes Wright

        September 19, 2013 at 8:03 pm


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