Should I Pay off My Mortgage?

mortgages
May 4, 2020

When you have spare money that you don't need for the remaining term on your mortgage, paying off the mortgage can seem like an attractive choice. Owning your home outright can feel very good and bring you the peace of mind that comes with being debt-free. However, the satisfaction of paying down debt has to be weighed against the drawbacks of parting with your money. With today's interest rates at a record low, you might be better off refinancing your mortgage and investing your cash instead.

How can you repay your mortgage early?

You can pay off your mortgage faster either by making a lump sum payoff, or by paying extra in your mortgage payments. Check with your bank on the conditions and restrictions for paying off the mortgage early and making extra payments.

One way to repay the mortgage early is by simply pay off the outstanding amount and any penalty imposed by the bank. This eliminates the debt amd saves interest cost, but leaves you with less cash that you could use for other opportunities. Another way is to pay an extra amount in addition to your normal monthly payment. This amount pays off a part of the debt. Over time, these extra mortgage payments can result in earlier payoff of the loan. This saves you interest cost, because for the remaining months you will be charged interest for a reduced outstanding balance.

How do you work out how much money you will save by paying off the mortgage?

You can use our mortgage savings calculator to find out the savings from paying off the loan or from paying extra on some months in the year.

How do extra mortgage payments reduce your interest cost?

When you make an extra payment, you avoid the interest cost of the extra payment amount for the remaining term of your mortgage. In addition, more of the monthly payment in subsequent months gets allocated to the repaying the loan, which can cause an earlier payoff.

Suppose you have a mortgage with 3% interest and 10 years left in the term, and your outstanding balance is $100,000. Let's compare paying off $1,000 now, with sticking to the normal payments plan. Our extra payments savings calculator, makes this comparison easy by showing you the differences in payments each month, along with the resulting savings and new payoff date.

Scenario:

  • $100,000 outstanding balance
  • 3% interest
  • 10 years to go

Without extra payments:

  • Loan paid off after 120 months
  • $15,872.91 in interest payments

With $1,000 extra payment now:

  • Loan paid off on 119 months
  • $15,527.81 in interest payments
  • Savings of $345.05

Paying $1000 to save $345.05. Isn't this interesting?

How will you see this saving? The last payment you make, on month 119, would be $585.00 which pays the interest and the remaining balance. If you had not made the $1000 extra mortgage payment, you would instead pay $965.61 on month 119, and still owe $961.92 to be settled on month 120 along with $2.40 interest. Here are the differences:

WithWithout
Month 1-$1000$0
Month 119-$586.17-$965.61
Month 120$0-$965.61

When you add up the columns, you see the difference is $345.05, and $345.05 is 34.51% of your $1000 payment.


"A penny saved is a penny earned."

Benjamin Franklin

Your $1000 payment acts like like an investment that pays 34.51% in 10 years. It is the same as investing the $1000 and getting back $1345.05 in 10 years. After using this $1345.05 to cover the last two months, you are in the same state as if you had made the extra payment instead.

Are there other options where you are better off not making the extra payment to your mortgage?

What other things can you do with a $1000 instead of using it for an extra mortgage payment? You've guessed it! One option is to spend the $1000. You could also let the $1000 sit in your bank account for 10 years, but the interest rates on saving accounts are very low these days. Your $1000 would get eroded by inflation unless you earn sufficient interest.

Another option would be to invest the $1000. You will need to find an investment that has a 10-year expected return of better than 34.51%, after tax. Let's consider some investment options.

Paying off the mortgage vs. investing in Treasuries

U.S. Treasuries are backed by "the full faith and credit" of the US government, and are considered the safest investments available. We need to find out the needed annual yield for a 34.51% return in 10 years. That is easy to calculate:

(1+yield)10=1.34511+yield=1.34511/10yield=0.030091=3.0091%\begin{alignedat}{3} (&1 + &\text{yield}&)^{10} \quad &=& \quad 1.3451 \\ &1 + &\text{yield}& \quad &=& \quad 1.3451^{1/10} \\ & &\text{yield}& &=& \quad 0.030091 \\ & && &=& \quad 3.0091\% \\ \end{alignedat}

As of writing, the 10 Year Treasury Rate is below 3.0091%. It has not been at that level since late 2018.

If the return from risk-free investments is not enough to match the savings from paying off the loan, you can also consider investments with a reasonable amount of risk, according to your personal risk tolerance level.

Paying off the mortgage vs. investing in high quality bonds

We can crank up the risk a notch and look into an investment in high quality corporate bonds. An easy way to invest in a diverse basket of bonds is via Exchange Traded Funds (ETFs). Lets consider the LQD Investment Grade Corporate Bond ETF. The investment return depends on a variety of factors such as interest rates and market demand, and there is no guarantee that you won't lose your money.

For the 10 year period until the end of 2020, an investment in this investment grade ETF would have returned roughly 78% before tax. Taxation can vary depending on your country and circumstances. Unless your tax rate is higher than 55%, you would net a higher return than with making the $1000 extra payment to your mortgage.

This investment involved some risk. For example, you would have experienced a dip of about 19% during the corona crises that took a month to recover from.

If your risk appetite allows, you could instead take on riskier investments that have a better yield. Let's compare with investing in the stock market.

Paying off the mortgage vs. investing in stocks

Like with investment grade bonds, you can invest in stocks via ETFs. This way, you buy into a diverse basket of different stocks which is less risky than investing in only one stock. Over the 10 year period until the end of 2020, the IVV S&P 500 ETF returned about 260% before tax. The worst drawdown was during the COVID-19 crises, where your investment would have lost 34% and taken around five months to recover.

Paying off the mortgage vs. the realm possibilities

There may be other, more rewording investments out there, available to you. For example, you could use your capital to buy another property, or payoff a higher-interest debt, or contribute to your pension, or maybe even start a business.

"Money in your pocket is better than money in someone else's (the bank) pocket"

Takeaways

Before deciding to pay off your mortgage, or make extra payments, it's important to consider whether this is the best choice given the other options available to you. You can find out your savings when paying off the mortgage, or making extra payments, and then check whether a better return is possible when investing according to your personal risk tolerance level. Consider also other options like using the money to buy another property or pursue a business opportunity.

Pros of paying off debt

  • You save in interest costs. There is no risk of loss like with investing.
  • You no longer have to pay the monthly payment for the mortgage, and this leaves you with a higher cash flow.
  • It becomes easier to sell your home when there is no mortgage on the property.

Cons of paying off debt

  • You lose some liquidity. If you don't have enough money left in you emergency fund, then you could run into financial difficulties in case of an unexpected event. It is usually recommended to keep an emergency reserve of at least three to six months of living costs.
  • You can't use the money for other, higher yield opportunities.
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