Should I Pay Off My Mortgage Early?

Let me warn you right from the get-go. You’re hearing this from a guy that is pretty darn close to totally anti-debt. Now that I’ve disclaimed my bias, let’s discuss briefly an early mortgage pay off. Should you do it? Maybe.

I discussed a lot of the issues with mortgages, interest, saving that interest, tax-deductible interest, etc. in a discussion on the 15 vs 30 year mortgage question.

We’ll just breeze over the issues once again here, then you’ll be armed with the information you need to answer that immortal question: Should I pay off my mortgage early?

Alright. Everyone needs a roof over their head. There’s a cost involved there, whether you own your home outright or are still trying to pay off the mortgage. You need shelter. That’s a fact of life.

It is relatively easy to get quite a bit of money from the bank and be pretty well leveraged with your mortgage. I mean, you can get a loan-to-value of 5% ($5,000 down on a $100,000 home) pretty easily these days. I would say an LTV below 10% is pretty highly leveraged. This can be very advantageous with a mortgage.

Mortgage rates are extremely low right now. This is cheap money! That is another advantage to a mortgage.

Your interest is tax-deductible. This makes an already cheap interest rate even cheaper!

The disadvantages of a mortgage? The interest cost is huge. For a $120,000 home, you could easily be looking at $170,000 total interest on a 30-year mortgage! Another disadvantage is the fact that you lose that monthly cash flow. If your home were paid off you could put those monthly “payments” to good use in an investment. Also, there is a lot of peace of mind that comes from not owing anybody anything. And you wouldn’t.

Consider the following scenario before you decide if you should pay off your mortgage early. Let’s take Ron, who is just crazy about owning his own home. He has an emergency fund in place with 3-6 months’ expenses. So he just goes to town paying off his 30 year mortgage in 13 years by paying an extra $300 per month. The result? In 13 years his mortgage is paid off.

But what could he have done with that $300 over the last 13 years? Invested it in the S&P 500. What would it have grown to? Without calculating all of the numbers, we can be reasonably assured that it would have amounted to a lot more than the interest he saved when he decided to pay off his mortgage early (alright, alright, his investment would be worth just above $95,000 invested at 10% for 13 years).

The general rule is this: if you have to decide between the early mortgage pay off or investing that surplus cash into something else, you would financially choose the one with the highest return (your after-tax interest rate is your rate of return because every dollar you spend paying it down is a dollar you don’t have to pay interest on). So if you can invest that $300 at 10% in a tax-conservative (low turnover) S&P 500, or save 6% after-tax, you would always choose to invest the money.

Is that 10% guaranteed? Heavens no! But over the long-term you’d be hard pressed to make an argument otherwise. Is that 6% return guaranteed? Heavens yes! That must be included in your decision to pay off your mortgage early.

Dave Ramsey has a decent approach to this. You need to make sure your foundation is well-laid before you consider paying off your house early. And this is coming from a guy that is about as anti-debt as you can get. He counsels his listeners and fans to follow his baby steps 1-5 before paying off the house. Why? Because steps 1-5 include getting together an emergency fund, getting rid of all debt except the house, investing 15% in retirement, contributing to college funds for kids and then finally paying off the house early.

What this amounts to is that if you are already sitting on 3-6 months’ expenses in cash (money market, savings account, i.e. liquid), you don’t have any debt except for your house, you’re contributing 15% towards retirement (taking advantage of those possible 10% returns from the stock market and the great tax benefits that come along with investing for retirement), you’re even planning on helping your kids out with college, and you still have excess cash left over to pay off your mortgage faster? Man – go for it!

Forget about the possible 10% return of the S&P – you’re already making a killing contributing consistently 15% of your income – make a guaranteed return of 6% on that excess cash. And when you’ve paid off the house, take that payment you were making and go on a cruise. When you get back from the cruise, start socking it away for retirement.