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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.
Many people argue vehemently that you must pay off your mortgage as soon as you possibly can. Their case boils down to this:
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.
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.
As you can tell, I’ve intentionally tilted these assumptions toward supporting the case for faster payoff.
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.
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%!
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.
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.
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%!
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.
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.
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.
About the author:
My career has had many unpredictable twists and turns. A MSc in theoretical physics, PhD in experimental high-energy physics, postdoc in particle detector R&D, research position in experimental cosmic-ray physics (including a couple of visits to Antarctica), a brief stint at a small engineering services company supporting NASA, followed by starting my own small consulting practice supporting NASA projects and programs. Along the way, I started other micro businesses and helped my wife start and grow her own Marriage and Family Therapy practice. Now, I use all these experiences to also offer financial strategy services to help independent professionals achieve their personal and business finance goals.
Connect with me on my own site: OpherGanel.com and/or follow my Medium publication: medium.com/financial-strategy/.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.
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