A Mortgage Forever? Think Again

Nervous about the stock market? Frustrated by low bond yields? Consider taking some of your investment dollars and using them to pay down your mortgage.

Now I know what you’re thinking: “My mortgage interest rate is only 4%. I can make a better return by investing.” 

And you’re correct…kind of.

It’s true that you can earn more by investing your money wisely over the long term. In fact, there are certainly things you should do before chipping away at the mortgage—like paying off credit cards, investing in your 401(k), and setting up an emergency fund. 

It’s also true that making extra mortgage payments won’t earn you dazzling returns. If your mortgage rate is 4%, your effective rate of return is going to be . . . 4%. 

But there are still some very compelling reasons to minimize your mortgage.

1 - Put your cash to work

Are you putting your hard-earned cash to work? Many people aren’t. In fact, it’s not uncommon to find upper middle-class Americans holding anywhere between $50,000 - $100,000 in cash. This occurs despite emergency fund requirements that are much lower. (The CFP Board encourages 3-6 months of spending needs in an emergency fund). 

Others let their money sit idle in CDs or money market funds. Yet cash sitting in these investments loses value to inflation every day. Instead, use that money to make 1 or 2 extra house payments per year and attain a guaranteed return.

2 - Earn a higher return rate

Not all investors invest wisely. According to Dalbar’s annual study1, the average investor from 1996-2015 achieved only a 2.1% return. During this same timeframe, S&P 500 investors saw gains of 8.2%. The reason for this large gap was investors’ inability to stay the course with a low cost well-defined strategy, combined with futile attempts to perform market timing. 

With this in mind, a guaranteed return of 4% by paying off the mortgage sure beats the 2% average by many investors. And, for conservative investors who would otherwise buy bonds or money market funds, the 4% guaranteed rate of return might sound rather appealing.

3 - Enter your golden years debt-free

Not that long ago, retiring with a mortgage was unthinkable. When that last payment was made, homeowners celebrated. Neighbors even held mortgage-burning parties.

For investors with 30 years of retirement ahead of them, the number one fear is running out of money2. If you work to pay off your mortgage early, you can retire knowing your biggest expense is soon to be eliminated or is already gone.

4 - Increase your tax savings

If you’re concerned about losing your mortgage interest tax deduction by paying off your home loan early, I’ve got good news. As it turns out, the interest tax deduction is highly over-rated when it comes to retirement. By not having a mortgage payment at all, you could save even more on taxes in your golden years.

How does this work? Consider this example.

Mary and Bob are in their late 40s and have a 30-year, $500,000 mortgage. It saves them $4,000 a year in taxes. If they pay off their mortgage gradually between now and retirement, they could still save $3,000 in annual taxes now. Once in retirement, assuming they are using IRAs to cover a large part of their expenses, they would save closer to $7,500 a year due to reduced IRA withdrawals. 

In the “keep paying for 30 years” scenario, the tax savings from mortgage interest over the life of the loan equates to about $60,000. In the “pay off the loan early” scenario, the tax savings would be closer to $110,000—nearly twice the savings of keeping the loan.   

5 - Retire early

Studies show that Americans are 20% more likely to retire before age 65 if their mortgage is paid off.3 No doubt this is due to the confidence in knowing your home—which amounts to 20%-30% of your pre-retirement spending—is paid off.

If you’re feeling conflicted about what to do, start by making one extra mortgage payment this year. With some lenders, you can do this by paying a little extra on each mortgage payment, or by paying more payments each month.

As an example, let’s say you borrowed $500,000 using a 30-year loan at 4% interest. If you added $300 to each mortgage payment, you could save yourself $77,518 in interest and pay off the loan 6 years early.

If that one extra payment a year feels pretty good, next year take part of your pay raise or annual bonus to make two extra payments. 

Paying off a mortgage early is not for everyone. First, you’ll want to ensure you have eliminated all higher interest debt, are maxing out tax shelters like 401(k)s (LINK TO TAX SHELTER ARTICLE), and have college savings completely on track. 

If all other savings opportunities are going well and are invested wisely, then take a look at reducing your mortgage. For those who are conservative and contemplating a CD at 2% interest, lopping off a chunk of your mortgage might be a much smarter move. In the hunt for guaranteed return, your answer might be literally at your front door.

1.  Dalbar.  Quantitative Analysis of Investor Behavior Study, 2015. utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior. Returns are annualized (and total return where applicable) and represent the 20-year period ending 12/31/15 to match Dalbar’s most recent analysis. 

2. AICPA, American Institute of CPAs, “Running Out of Money is Top Retirement Concern, Says AICPA Survey of Financial Planners”, Oct. 6, 2016

3.  Urban Institute.  “Older Americans in Debt Are More Likely to Work.” May 2016 Powerpoint. 

All investing involves risks.

Historical investing performance does not guarantee future returns.