Should You Pay Off Your Mortgage?
Jay Abolofia, PhD, CFP® is a fee-only, fiduciary & independent financial planner in Waltham, MA serving clients in Greater Boston, New England & throughout the country. Lyon Financial Planning provides advice-only comprehensive financial planning for a flat fee to help clients in all financial situations.
When it comes to housing, the most important financial question is how much house you can afford. The answer depends on your lifetime balance sheet, including how much you expect to earn and spend in the future. A secondary, more tactical, set of questions revolves around financing your home. For example, how much should you borrow to fund the purchase and should you pay off your mortgage ahead of schedule? To answer these questions, you must understand how your mortgage works, what happens when you make a prepayment, and how to compare an “investment” in your mortgage to other similar opportunities.
How your mortgage works
You repay your mortgage on a fixed payment schedule over a specified period. This process is called amortization. For example, a 30-year fixed rate mortgage of $500K with a 3% interest rate involves a $2,108 monthly payment for 360 months. Although the total monthly payment (excluding escrow for taxes and insurance) is fixed for the duration of the loan, the portion of each payment that goes towards interest and principal (i.e., the outstanding loan balance) varies.
The interest portion of each payment declines each month because it is calculated as a percentage of the principal, which declines each month.
Interest Payment = Interest Rate x Principal
The principal portion of the payment increases each month because it is calculated as the total fixed monthly payment ($2,108) minus the interest payment.
Principal Payment = Total Payment – Interest Payment
In the 30-year mortgage example, the first payment is comprised of $1,250 of interest and $858 of principal, while the last (month 360) is $5 of interest and $2,103 of principal.
What happens when you prepay your mortgage?
When you make an extra payment on your loan it goes directly towards principal, triggering a cascade effect that speeds up the repayment of your loan. Think back to the interest payment formula above. Because your monthly interest payments depend on the outstanding loan balance, which is now lower due to the prepayment, all future interest payments will be lower. Lower interest payments mean higher principal payments. Not only does your extra payment go towards principal, so does the future interest you save by making that payment. Ultimately, you pay off your loan faster and pay less in interest.
In the 30-year mortgage example, an extra one-time $50K payment in month 60 will reduce all future interest payments as follows (see Fig. 1). Ultimately, the loan is paid off 47 months early, generating a savings of $49,751 in total interest (see shaded area).
Fig 1. An extra payment in month 60 reduces all future interest payments, thereby reducing the loan’s duration and total interest.
Prepaying your mortgage is like buying a risk-free bond
From an investment perspective, prepaying your mortgage is like buying a risk-free bond that pays a guaranteed rate of return equal to the rate on your loan.[1] The same logic is true when you first buy the home, where a larger down-payment results in a smaller initial loan. For example, when you buy US Treasury Bonds you are lending money to the Feds in exchange for a series of fixed interest payments backed by the full faith and credit of the US government. In contrast, when you “invest” money in your mortgage, rather than receiving interest payments directly (as with a bond), it’s as if the interest payments go directly towards paying down your loan, which increases your home equity.[2] Because of the way your mortgage is amortized, these interest payments yield exactly the interest rate on your loan.
Consider a 3% fixed rate mortgage. Making an extra one-time $50K prepayment is equivalent to “investing” $50K in a risk-free bond yielding a guaranteed 3%. This makes the decision of whether or not to invest excess cash in your mortgage rather straightforward. If the rate on your mortgage is higher than the rate on equivalent risk-free bonds, like US Treasuries, and you want to reduce your overall exposure to risk, you’re better off “investing” the money in your mortgage.[3] Since mortgage rates are invariably higher than rates on US Treasuries, and bond rates have been falling for decades, prepaying your mortgage has consistently been one of your best options to “invest” in bonds (see Fig. 2).
Fig 2. Mortgage rates are higher, on average, than those on US Treasuries by about 1-2%
Sources: Freddie Mac and the Federal Reserve. Data retrieved from Federal Reserve Bank of St. Louis.
Stocks are risky, your mortgage is not
Comparing extra payments on your mortgage to investing in the stock market is like comparing apples and oranges.[4] Stock market returns are volatile and therefore have a large risk premium, whereas prepaying your mortgage yields an essentially guaranteed rate of return. This perspective highlights another important point. While we think of our mortgage as financing our home, it also finances our other investments. For example, investing your cash in stocks instead of prepaying your mortgage is equivalent to borrowing money to invest in the stock market—and the same goes for investing in real estate. This creates leverage, which magnifies gains and losses.[5]
Conclusion
When considering putting extra cash towards your mortgage, think of it like investing your money at a guaranteed rate of return at least as large as the rate on your loan. Ultimately, if you’re holding excess cash and want to reduce your overall exposure to risk, prepaying your mortgage, or taking out a smaller mortgage in the first place, is one of the best investments you can make.
Footnotes
[1] One major difference is related to liquidity. Whereas bonds may be easily tradable and relatively liquid, your home equity is neither.
[2] Note that prepaying your mortgage has nothing to do with investing in real estate. Whether you have a mortgage or not, you already own the property and any associated capital gains or losses.
[3] Because interest on risk-free bonds (like US Treasuries) is taxable, and interest paid towards your mortgage is (at best) tax-deductible, you can disregard taxes when making this comparison. If you can’t fully take advantage of the home mortgage interest deduction, which is not uncommon, this makes prepaying your mortgage an even better investment. For a true apples-to-apples comparison, you would want to compare the rate on US Treasuries with a term roughly equal to the number of years that would remain on your mortgage after you made the prepayment. For example, if the planned prepayment were to shorten the outstanding loan term from 20 to 10 years, you would compare the rate on 10 year US Treasuries to that of your mortgage.
[4] With US stock prices being as high as they are today relative to company earnings, it’s reasonable to expect future returns in the stock market to be relatively lower than they have been in the past. All things equal, this makes “investing” in your mortgage vs stocks even that much more attractive.
[5] Consider that your mortgage, or any debt for that matter, is really just a negative bond. It’s a big liability on your lifetime balance sheet that you have to pay back one way or the other. If you simultaneously invest your cash in risky assets like stocks, rather than paying down that debt, your investment can lose (or gain) money while the debt remains.