Let’s talk about a somewhat controversial subject, at least in financial planning circles: paying off your mortgage early.
A great deal of conventional wisdom says you should never pay a mortgage off early. Well, I’ve gone against that conventional wisdom. Twice. I don’t know if that means I lack conventionality or I lack wisdom, but it seems to have worked out well.
First, I’ll explain why I thought it was a good idea, and then I’ll address some of the common arguments against paying your mortgage off early. Finally, I’ll give you some advice about what to consider if you face this decision.
It seemed like a good idea at the time… and still does
When I reached the point in life where I started to accumulate some meaningful savings, I was confused about what to do with it. It happened to be at a time when both the stock market and the bond market had made huge runs. I didn’t fancy the idea of putting the money into an overpriced market, so I was at a loss with where to put it all. My wife and I discussed it and, without hesitation, she asked, “Why not put it into the mortgage?”
Why not? Well, I was aware of a few reasons why not (but more on that in the next section). Personally, though, when I thought about the choice between putting money into some overheated financial markets or putting it into the roof over our heads, it seemed logical to do the latter.
What we got out of it immediately was a feeling of satisfaction and peace of mind. We’ve always looked at debt as something that you don’t simply try to manage, but something you strive to get out of as soon as possible. That may sound terribly old-fashioned, I know. But years later, having witnessed a housing crisis in which too many people lost their homes because they had failed to build equity, I can tell you I’m even happier for having played it safe.
Why not? Here’s why not…
The following are three reasons financial planners often give for not paying off a mortgage early, followed by my arguments against those reasons.
- You’ll lose the tax deduction. Yes, mortgage interest is tax deductible, but do the math. If you have a four percent mortgage and you’re in a 25 percent tax bracket, you’re effectively paying 4 percent to save 1 percent. Also, the deduction on interest you pay will be somewhat offset by taxes on what you earn by having the money invested instead, which leads to the next point…
- You’ll miss out on investment opportunities. This was a popular argument in the 1990s when investments seemed to go straight up. It holds less water now, though. While mortgage rates are low, at around 3.5 percent, CD and savings account rates are even lower. Bonds are below 2 percent across most of the yield curve. As for the stock market, well, let’s just say it’s had a rough decade. You can take your chances, but remember that by investing borrowed money, you are essentially leveraging your portfolio, which increases your risk level.
- Don’t tie up liquidity. This is a fair argument. A house is an asset, but not a very liquid one. You shouldn’t put so much capital into it that you have no money left over for unexpected expenses, emergencies, etc. On the other hand, when people have liquidity, they tend to find a way to spend it. Putting money into your house helps to make sure that money saved stays saved.
Questions to ask before acting
Of course, virtually no financial advice applies universally. Facts and circumstances matter greatly. Here are three things to consider before you pay off a mortgage early:
- Are there prepayment penalties? Actually, it’s best to ask this question before you sign up for a mortgage. If you can minimize prepayment penalties, it will give you more options down the road.
- Is your income solid? This is essential for making sure you don’t run into a liquidity problem by putting too much into your mortgage too soon.
- Have interest rates fallen or risen? If interest rates have risen (and assuming you have a fixed-rate mortgage), you might do better by investing at higher rates while continuing to pay a low rate on your mortgage. If rates have fallen, you face a choice of paying down the mortgage early or refinancing, which leads me to my final suggestion.
Not sure? Consider a hybrid strategy
If interest rates have fallen since you got your mortgage, consider a hybrid strategy of refinancing to a shorter-term mortgage. This will allow you to get an even lower interest rate (15-year rates are lower than 30-year rates) and pay down your mortgage faster without immediately tying up your liquidity.
In the end, as you ponder this decision, just remember that having these options is an opportunity, not a problem.
Great comments, I like the 30yr fixed and then try and pay it off 15yr espically on rental property. If your house is vacant for a month or so pay the normal amount when its rented add to principal and bring it to a 15 yr. I have never liked debt, leveraged or not, that said I have a equity line that is always their if I need it.
I have some retired friends with a paid off house and have not saved enough for retirement. They are house rich but cash poor. Their options seem to be HELOC, Reverse mortgage, sell and move/down size. Retirement income does not justify a large enough mortgage to live off. Shouldn’t this be one of the considerations to paying off a house VS fully funding a retirement?
I like your method! Slightly less conservative but very smart.
–Stephanie
For us – what makes the most sense is to split the difference. We’re putting money towards additional principal payments on a monthly basis. This will turn our 30 year mortgage into about 16 years. At the same time – we’re investing an equal (or usually greater) amount in the stock market and other investments. The reduced interest payments on the mortgage provide a guaranteed rate or return, while the market provides an unknown, but likely higher rate of return.
Not withstanding all of the tax based reasoning put for in the previous posts, I have found that it comes down to people’s psyche about whether they pay down (off) their mortgage or try to maintain a balance for tax purposes. It sort of correlates with the author’s thought process on why he paid off the mortgage-safety. There is definitely a group of people out there who want to be debt free first. In spite of any level of savings or investing or tax benefits, etc. It’s almost a manic response-payoff everything first. They almost always quote the same reasoning-“If you run into any financial problems, we won’t have many bills to pay”
For me, I waited until we were about at that “standard deduction” (ie; no longer itemizing) threshold and really kicked things up a level after that point. My goal is to be debt free by 33, so I can focus on other investments (like a cabin, or my kids’ education). I wouldn’t advise paying off the morty early unless you have a 6 month cushion and no other higher-interest debt (like a car or credit card loans).
@Jay @ effumoney
Almost everyone thinks they are “middle class,” just like almost everyone thinks they are above average. In neither case can it be true as often as people think it is.
What I like about this discussion is that it proves there are reasonable arguments to be made on both sides. The takeaway here is to never put too much stock in cookie-cutter advice on issue like this – you have to look at it in the context of your own circumstances.
I have not regretted paying off my mortgage. I could always get another one, if truly advantageous, so far, I see no good reason.
Inflation and interest rates, you can’t talk about one without acknowledging the other (this snipe is for TommyZ and Jonathan).
Anyhow, we have a 30 year mortgage, but pay it like 15…it gives me the most flexibility/options.
IF inflation gets bad (high), I’m already locked into a low rate.
In today’s investing environment, I’m very happy to take the guaranteed, risk-free 3.5% pre-tax return on ‘investing’ in my mortgage.
Lance – true, inflation is a big factor, however, if the dollar goes down 3.5% it’s logical to argue that the price of everything else (including houses) goes up 3.5%. So if you plan to pay off your house and move, it’s better to pay it off early.
@Mark
Median income is also geographically specific, in the town I live in the median income for a family is $128k
They left out my biggest argument to not pay it off early… inflation. If inflation averages 3% and your mortgage rate is 3.5% you’re effectively paying .5% for your mortgage because the dollars you use to pay in the future are inflated dollars, not today’s dollars.
I guess “normal” wasn’t a good word for it, I was thinking something like “person with around median income” which is something like 55K.
Forgot about the state income and property taxes, I guess that would make it pretty easy to hit the standard deduction.
Most people with mortgages do get a tax deduction for the interest. From IRS statistics when I looked in 2009, about 38 million people claimed the deduction and about 48 million people had mortgages. So thats about 80% of the people with mortgages get some tax break from the mortgage interest. For most people the combination of state income tax, property tax, mortgage interest, charity deductions and other things combine to exceed the standard deduction. Its not just the mortgage interest but the sum of all of them. Some of those 38 million people may not get the full benefit of the mortgage interest. e.g. if your standard deduction is $11,900 and their state income tax and property tax add up to $8,000 and the interest is $5000 then their itemized deduction would be $13,000 but with or without the mortgage interest only gives them another $1,100 deduction versus the standard rather than the full $5,000.
Well I don’t know if “normal” is the word I would use to describe people who can or cannot take the mortgage interest deduction.
If you are single the standard deduction is $5,950 and if you are married it is $11,900, it only makes sense to itemize if you have more deductions than those limits.
Depending on where you live it can be very easy to hit those limits and go way beyond. I live in NY which is a high tax state my state income tax withholdings are $5,600, last year my wife and I went beyond the married standard deduction with our state income taxes alone. My property taxes are $14k; those also meet the threshold all by themselves. My house was last appraised in July 2012 for a refi at $775k (I paid $645k in 2009), I have a mortgage with a balance of $389k and HELOC with a balance of $80k (so I own about 40% of my house), and my blended rate is 3.22% with a payoff date of 2030. My annual interest charge is around $15k. Between income taxes, property taxes and mortgage interest my itemized deductions are nearly $35k before considering medical, charitable giving etc…
In NY this is quite “normal”, we get paid more to justify the higher COLA and the ratio of earnings to expenses is more favorable in NY for me (I am a financial software engineer), so it all evens out. My choice to live in NY is not financial, my family is here as is my wife’s, we have lived here our whole lives and wouldn’t move to a less expensive part of the country as we love it here.
You might think based on those numbers that makes us wealthy, however in NY we are average middle class, comfortable but not wealthy by any means.
My understanding is that normal people that don’t have a massive house or lots of charitable giving or medical expenses won’t exceed the standard deduction if they itemize. In that case, the mortgage tax deduction won’t do a thing.
I bought a house in January so I still haven’t done my taxes to see if I have enough deductions to itemize.
This is always a very personal decision, mathematically it doesn’t make sense to pay off a low interest long term mortgage, in fact it makes sense to borrow for as long as possible at the lowest rate and take the full term to pay it off, on an inflationary basis and with the tax deduction and liquidity concerns it is a no brainer.
The mathematically driven result is an emotionless decision, and paying off your mortgage to own your house outright is very emotional so more times than not we make the financially incorrect move to satisfy us in other ways. Being mortgage free might help you sleep better at night so that is worth more than the investment returns you might have left on the table.
I want my cake and to eat it too, I have refinanced twice the first time just for rate improvement, the second time for rate improvement and a reduction in duration. I also overpay my mortgage every month by about 20%. However I do not put all my extra money in my mortgage which I could pay off in full, I just put in enough to feel good about how early I am paying it off and still having enough money to put into more lucrative investments as they become available.
Paid our house off 9 months ago, what a great feeling. Paid it off 14 years early and saved a ton on interest. You have to be careful when talking to others complaining about the housing market or refinancing problems and they ask you about your mortgage and you tell them you don’t have a mortgage anymore. It came down to a sure thing at 5.5% gain and having a place to live for early retirement. Granted that we are only 40 years old it gives us one less cost.