Pay Off Your Mortgage ASAP, but then Again, Maybe Not?

Like almost every homeowner in the US, I purchased each of my homes with a mortgage.

Like almost every person with a mortgage, I had to decide if I wanted to make extra payments toward principal, paying off the mortgage sooner, or divert the extra cash to savings and investments.

The Case for Paying Your Mortgage Off ASAP

Many people argue vehemently that you must pay off your mortgage as soon as you possibly can. Their case boils down to this:

• As long as your mortgage isn’t paid off, if you can’t make payments you’ll lose your home
• Paying off your mortgage as soon as you can minimizes your interest costs
• Paying extra toward principal is a sort of savings, and as soon as you finish paying off your loan, you can divert the entire payment toward investing

Assessing the Case for Early Payoff

The first point has two elements. One is financial, which we’ll analyze with actual numbers in a bit.

the other is psychological, which means it depends on what makes you less uncomfortable – knowing you minimize the time until you own your home free and clear, or knowing you’re making the best financial choice and objectively speaking, the safer one (more on this below).

The second point, minimizing interest costs, only looks at the negative financial aspect of a loan. If our analysis shows you’d end up with less money as a result of paying the higher interest, they’d be right. If, on the other hand, the numbers show you’d end up further ahead despite the higher interest, this point is moot.

The final point is certainly a fair one. However, if you’re disciplined enough to pay extra toward principal, you should be disciplined enough to invest that extra cash. Then, you harness the power of compounded investment returns for far longer than if you’d divert some or all of that extra cash to accelerating your mortgage payoff.

Again, the proof will be in the numbers.

Which Is the Better Choice – By the Numbers

To come to a definitive conclusion, I ran the numbers using an Excel spreadsheet. The following show the results, but first, let’s look at some assumptions.

My Assumptions

1. The initial balance of the mortgage is $500,000
2. The interest rate of the mortgage is 4% (this is conservative, as current rates are running about 1% lower, which makes it less expensive to take longer to pay off the loan)
3. Inflation runs at 2% a year (this is conservative, as higher inflation would whittle away faster the value of the dollars still owed, making it better to pay off the loan as slowly as possible)
4. Stock returns run at 8% a year, or about 6% above inflation (this is about 1% lower real return than stocks have returned in the past century)
5. The real value of the home stays constant (this is also about 1% lower than real returns of residential real estate in the US over the long term)
6. You don’t itemize, and thus don’t gain any tax benefit for the mortgage interest paid (this is conservative, especially if you are a high earner and live in a high-income-tax state)

As you can tell, I’ve intentionally tilted these assumptions toward supporting the case for faster payoff.

The 1^st Analysis – You Can Pay Off the Loan in 10 Years

Table 1 shows 5 cases where you have $5062.26 available each month, and split that amount between the mortgage and investing.

In the first case, you’d pay off the mortgage in 30 years.

In the second, payoff occurs after 25 years.

In the third, after 20 years.

In the fourth and fifth, after 15 and 10 years, respectively.

Table 1. Five cases, with payoff in 30, 25, 20, 15, or 10 years. In the first case, the monthly investment amount stays constant for the 30 years. In the other 4, the investment amount changes as soon as the mortgage is paid off.

In Table 2, we see the total interest you’d pay over the life of the loan, the value of the portfolio you’d amass over 30 years, and the difference between the two. For each of the three measures, we see the value in nominal dollars and the real, inflation-adjusted value.

Unsurprisingly, the faster you pay off the loan, the less you pay in interest, whether in nominal or inflation-adjusted dollars.

However, taking as much time as possible to pay off the loan gives you a larger ultimate portfolio balance, and even in terms of the difference between the portfolio balance and the interest paid over the life of the loan.

Accelerating the payoff by just 5 years, reduces your ultimate portfolio value by about 5%. Accelerating the payoff by 20 years results in a portfolio balance reduction of more than 25%!

Table 2. The total interest, final portfolio value, and the difference between them, in nominal and inflation-adjusted dollars for the 5 cases.

In Table 3, we look at the relative safety of the 5 scenarios. Clearly, the more slowly you pay off your mortgage, assuming you invest the rest of the available cash, the more quickly you reach safety, whether in the sense of having enough set aside to cover 6 monthly payments, or enough to fully pay off the loan.

Table 3. The number of months needed to reach complete safety (i.e., portfolio value is higher than the remaining loan balance), or to have enough for making 6 months’ worth of the minimum payments, for the 5 cases.

The 2^nd Analysis – You Can Pay Off the Loan in 20 Years

However, assuming you have enough to not only pay the mortgage, but also set aside another $2675 a month is fairly extreme. Most people wouldn’t be able to carve such a large amount out of their monthly budget.

This brings us to my 2^nd analysis, where you don’t have enough to retire the loan in 10 years, but you do have enough to pay it off in 20 years.

Table 4 shows 3 cases where you have $3029.90 available each month, and split that amount between the mortgage and investing.

In the first case, you’d pay off the mortgage in 30 years.

In the second, payoff occurs after 25 years.

In the third, after 20 years.

Table 4. Three more cases, with payoff in 30, 25, or 20 years. In the first case, the monthly investment amount stays constant for the 30 years. In the other 2, the investment amount changes as soon as the mortgage is paid off.

In Table 5, we see the total interest you’d pay over the life of the loan, the value of the portfolio you’d amass over 30 years, and the difference between the two. For each of the three measures, we see the value in nominal dollars and the real, inflation-adjusted value.

Again, unsurprisingly, the faster you pay off the loan, the less you pay in interest, whether in nominal or inflation-adjusted dollars.

However, taking as much time as possible to pay off the loan once more gives you a larger ultimate portfolio balance, and even in terms of the difference between the portfolio balance and the interest paid over the life of the loan.

Accelerating the payoff by just 5 years, reduces your ultimate portfolio value by about 19%. Accelerating the payoff by 10 years results in a portfolio balance reduction of more than 42%!

Table 5. The total interest, final portfolio value, and the difference between them, in nominal and inflation-adjusted dollars for the 5 cases.

In Table 6, we look at the relative safety of these 3 new scenarios. Once again, the more slowly you pay off your mortgage, assuming you invest the rest of the available cash, the more quickly you reach total safety, and the faster you set aside enough to cover 6 monthly payments.

Table 6. The number of months needed to reach complete safety (i.e., portfolio value is higher than the remaining loan balance), or to have enough for making 6 months’ worth of the minimum payments, for the 3 new cases.

Important Caveats

The above-described analyses assume that inflation and stock returns are constant at the assumed annual levels. In reality, they’re anything but constant. However, unless you’re extraordinarily unlucky, you should see something not too far from these average numbers over the course of 3 decades!

If we change the assumptions such that the difference between investment returns and mortgage interest is smaller, the math would start tilting less in favor of investing and more in favor of accelerating mortgage payoff.

Two major psychological aspects come into play here. First, you need to be comfortable enough with the risk level of a portfolio that tilts heavily (even 100%) to equities. If your portfolio is split 60/40 with bonds, for example, your investment returns will drop, and the result would start tilting in favor of prepaying the mortgage.

Second, if you feel more comfortable with the shorter-term risk of losing your house because you’re temporarily unable to make your mortgage payments, rather than with the longer-term risk of carrying the mortgage for many more years, you might prefer the early prepayment option, regardless of the above analyses.

The Bottom Line

Even with our assumptions tilted to favor prepayment of the mortgage, the results show that in rational terms, investing rather than prepaying mortgage principal is the financially preferred option.

However, this entails higher investment risk, which you have to be comfortable with. You also have to carry the loan for many more years, though doing so allows you to more quickly reach the safety of being able to make payments from your investment.

As in all things personal finance, the answer to the question, “Which is the right choice?” starts with, “It depends.” In this case, it depends on how comfortable you are with the psychological factors that arise from picking the option that is financially smarter.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.