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Paying Off Your Mortgage

Most Americans have a strong desire to pay off their homes. In a country wallowing in debt up to its eyeballs, getting the biggest debt you’ll likely ever take on paid off can be a pretty exciting idea. Believe it or not, people haven’t always been so eager to pay off their mortgages; it’s certainly not a new trend, but it helps to understand the reason the idea of owning your home free and clear is so popular these days.

Now, you’re probably thinking, “why understand the reasoning behind paying off your mortgage, its simple, to reduce your debt, pay less interest, and be safe from the potential of losing your home if you lose your job.” Well, it seems simple, but in many cases, the numbers work out in favor of not paying off your mortgage. How can we explain, then, the overwhelming support in favor of paying off a mortgage that may actually be helping most homeowners in the first place? To do that, we need to understand the reasons behind the wave of excitement over becoming mortgage free as well as the numbers that show whether or not becoming mortgage free is something that will benefit you.

Why Pay Off Your Mortgage?

For most Americans, there are three main reasons for paying off their mortgages:

  1. A mortgage is a debt, and debts are risky by nature.
  2. A mortgage is an expense, and paying off your mortgage cuts out a large monthly expense.
  3. Because of the length of time it takes to pay off a mortgage, most homeowners will pay an enormous amount of interest over the life of their loans.

Let’s examine these one at a time…

A Mortgage is a Debt, and Debts are Risky by Nature

The Two Major Risks Associated with Mortgages:

  1. If some major negative financial event occurs in your life, such as a job loss or major illness, you run the risk of being unable to make your mortgage payments and the bank could foreclose on the property.
  2. For borrowers with interest rates that may adjust during the life of the loan, when caught in a real estate market downturn, you run the risk of not being able to refinance if your home’s value, and hence available equity, drops significantly. If your interest rate adjusts to a point that you cannot afford to make payments without refinancing, you may have to sell or the bank will foreclose on the property.

A Mortgage is Expensive, So Paying Off Your Mortgage Cuts Out a Large Monthly Expense

This is pretty simple, the more money you have, the more freedom you have to do what you want. For most Americans, paying off their mortgages will relieve them of their largest monthly expense, giving them more freedom to do what they want.

Also, income generally drops at retirement when workers begin living off pensions, social security, savings, etc. Having the mortgage expense eliminated by that time frees up a large expense.

Mortgage Interest Is Expensive

Since the term of a mortgage is generally around 30 years or more, you can expect to pay an enormous amount of interest over that time. In fact, on a $200,000 mortgage, at 6%, over 30 years you’ll pay over $231,000 in interest…more than the property even cost to begin with!1

Getting that mortgage paid off quickly certainly helps save interest. Even as little as $100 extra per month in the above example would save almost $50,0001.

Why Not Pay Off Your Mortgage?

Now let’s reexamine the reasons why homeowners want to pay off their mortgages and see why you may not want to pay it off.

Debt Allows You to Leverage Other People’s Money

Debt always carries some risk with it, but debt is the only way to leverage the often-talked-about principal of “Other People’s Money.” If you have $100,000 in cash to invest, at 6% per year you’ll reap $6,000 in gains. Now, if you have $100,000 cash to invest and you add to that $100,000 of someone else’s money in the form of debt, you can reap $12,000 in gains the first year with the same $100,000 of your own money. By taking on debt, in this case, you double your cash on cash return from 6% to 12%. As long as you’re paying less interest on the money borrowed than you’re making from the investment, you come out ahead.

Bank Make Money with Arbitrage, and So Can You

Arbitrage, with regard to mortgages and investments, is a concept that refers to borrowing money at a lower rate than you can make from it through investment. For example, if I can borrow money at 6% and invest it at 8%, I have a 2% positive gain on that money. If my $200,000 mortgage at 6% costs $1,199 per month, and, instead of making an extra $100 payment each month on the mortgage, I invest that $100 at 8%, I can gain $8 per month, as opposed to the $6 per month I would save by applying that money to my mortgage at 6%.

Mortgage Interest is Expensive, But You Have to Consider the Bottom Line

Sure, making an extra principal payment of $100 per month in the above example would save $50,000 in interest charges over the life of the loan, but by investing that extra $100 per month at 8% for those same 30 years, I can make almost $150,000. That would give me enough to pay the extra $50,000 in interest on the mortgage and still have almost $100,000 left over.2

Mortgage Ideas to Consider Beforehand

Opportunity Cost

Whether or not you should pay off your mortgage depends on a number of factors, and you really have to do the math to find out if it’s in your best interest. When considering the options, always keep in mind a key term…Opportunity Cost.

Opportunity Cost is defined by Investopedia.com as:

“The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.”

And…

“The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment – say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6% – 2%).”

Whatever you do with your money, there is always an opportunity cost. Instead of spending $5 a day no a Starbucks latte, you could just invest that $5 a day. $5 a day at 8% over 30 years is around $225,000. So, you could say the opportunity cost of 30 years-worth of daily Starbucks lattes is $225,000, even though, over those 30 years you’d actually spend only $54,000 at Starbucks. Over 30 years you could spend $54,000 at Starbucks and have nothing to show for it, or you could spend that same $54,000 over 30 years on an investment and have $225,000 to show for it. That’s opportunity cost.

So, before you decide to pay off your mortgage, you need to calculate the opportunity cost of doing so. Find out what else you could do with the money you’d put toward paying off your mortgage and run the numbers.

Acceptable Risk

A large portion of your decision for or against paying off your mortgage will lie in the level of risk you personally find acceptable. Here are some of the risks you should consider…

The Type of Mortgage

If you’re on a 30 year fixed rate mortgage and are debating whether or not you should put extra money toward payoff, or invest, this won’t be a factor for you….either way, your mortgage rate and payment are going to be fixed for the life of the loan.

If, however, you’re on any type of loan without a fixed interest rate, you need to consider the fact that your interest rate will fluctuate. The calculations can get pretty complex at this point, but a simple technique you can use is to run the numbers 3 times. The first run, assume your interest will pretty much stay the same. For the second calculation, assume the interest rate will hit its cap (most adjustable rate mortgages have an interest rate cap); this is your worst-case scenario. Finally, run the numbers assuming the interest rate will hit its floor (most adjustable rate mortgages also have an interest rate floor); this is your best case scenario.
Now, if you want the numbers to be really accurate, you need to factor in any projected refinance costs. For example, if you’re on a 30-year fixed, interest-only mortgage, and plan to make interest only payments and invest the difference, keep in mind that the interest-only feature on most of those mortgages are only available for 10-15 years, after which point you have to start making principal and interest payments; in other words, the payment will go up significantly if you don’t refinance. So you’ll need to factor the cost of refinancing every 10-15 years into your calculations.

Investment Options

You should also consider the investment options available to you and their associated risks. In the examples above I used 8% for the investment rate. A question you need to answer is, can you even find an 8% investment, and if you do, can you realistically expect that return to at least remain stable over the life of the investment? For example, the S&P 500 has averaged just over a 9% gain per year over the past 30 years, so 8% is certainly a reasonable estimate of what you could expect, but some people lose money investing, and others make quite a bit more than 8%; it all depends on your knowledge, experience, ability, etc. Only you can make the call as to whether or not you can pull investment returns that will outweigh your mortgage costs.

Market Conditions

Real Estate is, always has been, and always will be a highly cyclical industry; meaning there are a lot of ups and downs and those ups and downs are more pronounced than other industries. You need to have an understanding of your own personal understanding of the Real Estate market. Will you be able to see a bear market before it arrives? During a bear market, will you be able to recognize when the market’s bottomed out? And during a bull market, will you be able to recognize when it’s reached its peak? You don’t have to be Warren Buffet to recognize these things, especially since markets don’t usually turn on a dime. If you keep your eyes and ears open and you’ve provided yourself enough of a safety margin, you should be able to prevent major market swings from damaging your plan.

On the other hand, you need to be able to recognize when this is completely outside of your ability. Only you know yourself well enough to make the call. If you don’t think you can predict market conditions before they have a major impact on your plan, increase your safety margin. You can do this any number of ways, one of the best is to ensure you always have some equity in the property. It’s much more risky to hold a 95% LTV mortgage than one at 60% LTV. Your ability and knowledge of Real Estate and market trends will determine how much of a down payment, in this case, you’d need to make in order to lessen your risk to an acceptable level.

Methods to Pay Off Your Mortgage

So now that you’ve gotten this far and you’re still thinking about paying off your mortgage, here are some of the most common ways to make that happen.

Bi-Weekly Payments

Our bi-weekly payment calculator can show you the benefits of a bi-weekly payment plan. On a bi-weekly payment plan, instead of making one payment per month, you make two. The amount of your monthly payments don’t change, instead, the benefit lies in the fact that making 12 monthly payments of $1,000 totals $12,000 a year, whereas making bi-weekly payments of $500 means that you’ll make 26 payments of $500 each year, which totals $13,000.
The reason for the difference lies in the fact that there are 52 weeks per year and 12 months per year. Bi-weekly payments will have you making 26 payments per year, and monthly payments will have you making 12 payments per year. Since bi-weekly payments are half what monthly payments would be on the same mortgage, you end up making the equivalent of one extra monthly payment each year on a bi-weekly plan.

Extra Payments

You may not want to commit to a bi-weekly plan, so instead you can opt to make extra payments whenever you have some extra cash. Our Loan Length Calculator can show you the effect of making extra payments on your mortgage.

Mortgage Terms Less than 30 Years

By far the most common fixed-rate mortgage term is 30 years, but you can opt for a 10, 15, or 20 year fixed rate mortgage. Our mortgage payment calculator can show you the difference in payment amounts with various term lengths.

Mortgage Acceleration Plans

Mortgage acceleration plans are becoming more and more popular these days. One such plan is called the Money Merge Account. We won’t go into the details of these plans here, but many people find them useful. Before looking into them, you should know that there is some debate over whether they are truly beneficial to homeowners, but we’ll leave that up to you to decide.

Investment as a Means to Paying Off Your Mortgage

You should also know that there is a middle ground between paying off your mortgage and investing your extra cash; you can do a combination of the two. If you’re keen on the idea of being mortgage free, instead of making extra principal payments, you can invest that extra cash until it reaches a certain amount, at which point you can either pay off a chunk of your mortgage with the investment proceeds and do it again, or simply wait until the amount in your investment account(s) equals your mortgage amount and pay it off entirely. Obviously, the same investment risks described above are a factor in this option, but it is commonly used as a method to early mortgage payoff.

Conclusion

Ultimately, it is quite possible to build wealth without ever paying off your mortgage. If you chose to not pay off your mortgage, you can certainly have more money in the long run. However, the decision should be examined carefully using all of the information we’ve gone over in this article. If your main goal is to eliminate risk, or come as close as possible to eliminate risk, you’ll want to pay off your mortgage as fast as you can. On the other hand, if you’re someone that can accept a level of risk, no matter how small, investment alternatives should be looked at and your personal level of acceptable risk should be factored in.
Our mortgage and financial calculator section has some great calculators that can help you on your way to calculating what’s best for you.

Sources:

  1. Calculated using the Free Debt Calculator
  2. Based on $0 starting balance, compounded monthly

Tags: Mortgage Finance 101

12 responses so far ↓

  • 1 Empowering Women - Issue 15 | A Modern Goddess Online // Apr 27, 2008 at 9:47 am

    [...] up is John from Truthful Lending who offers a range of tips on paying off your mortgage.  These are great for everyone, whether you live in the US or [...]

  • 2 One Huge Carnival Of Leads To Making Money Online — Cheap Keywords // Sep 27, 2008 at 12:45 am

    [...] Crenshaw presents Paying Off Your Mortgage – Will It Save You Money? posted at Truthful Lending dot Com, saying, “There’s been quite a bit of debate lately [...]

  • 3 Abbe Waldman // Feb 12, 2009 at 12:23 pm

    As a realtor for over 26 years I found this to be a very well written article that really examines all sides regarding whether or not to pay off your mortgage. I would like to refer my clients to this article to read when they are weighing their options on this matter. With interest rates at an all time low, and the stock market so volatile it makes it a little tougher to make this important decision as to where to wisely put your money. I also think that ones age and long term financial goals, and what the real estate market is doing in your area has to be factored in as well. All reasons to contact a team of advisors before making your mind up as to what to do. Great article!

  • 4 JC // Apr 22, 2009 at 4:41 pm

    Nice article.

  • 5 Clint // Nov 7, 2009 at 4:38 am

    As always, no one tells the full story. In your example above we talk about 6% vs 8% in terms of paying an additional $100 on a mortgage. What you FAIL to acknowledge, sir, is that (in the case of a $100,000 loan) the mortgage was shortened by nearly 9 years. Now let’s take the FULL mortgage payment (~$552) and invest THAT for the 8 years we saved off the mortgage.

    The result is an astounding $88,000, PLUS the freedom of having no mortgage debt. To be fair, we must compare THAT number to your number with the CORRECT amount of years accounted for, which is 21. Your number is now $65,851.

    You financial “geniuses” are steering THOUSANDS of people in the wrong direction with your forced ignorance of the facts of what you are saying.

  • 6 First Time Homeowners // Dec 3, 2009 at 7:35 pm

    Thank you so much for this article. As very first time homeowners in Hawaii (a modest townhouse near Honolulu) we recently realized that most of our monthly payments are going to interest. It was astounding and really gave us pause. After closing on our home in May 2009 my spouse and I are considering putting it on the market by the end of 2010. Partly because we may very well move overseas to Southeast Asia. And partly because the amount of interest we’re paying and would have to pay over 30 years is mind boggling. So thank you for laying everything out and confirming the realities of home ownership and a mortgage.

  • 7 Funny about Money // Jan 25, 2010 at 6:50 pm

    Invest the money you wouldn’t pay toward principal at 8 percent? Where on earth are you getting 8 percent?

    IMHO this reasoning is just wrong. On a $211,000 mortgage at 4.3% we’re paying something over $1200 a month toward a house we’re copurchasing. If we paid that off, the $1200/month that we would not have to pony up would represent a de facto return on investment. $1200 x 12 = $14,400, a 6 percent return. That’s significantly better than I can get in a moderately conservative investment right now, and it puts a roof over his head or rental income in our pockets. Then let’s say we take the freed-up $14,400 and invest that: wouldn’t that further increase our return on the $211,000 used to pay off the mortgage?

    Additionally, if the real estate market ever returns to normal, one would add the 3 percent to 6 percent p/a increase in property value to the 6 percent return, creating a modestly respectable return on the $211,000 and getting out from under a crushing interest rip-off.

    Real estate mortgages are rips, especially for those who are not wealthy enough to profit from the tax advantages, which are marginal at best for most of us.

    I paid off the mortgage on the house I occupy years ago — thank god! If I’d been stuck with a mortgage payment when I was laid off and faced with the probability that I will never land another decently paying job, I would surely have lost my home. As it was, investing the large amounts of cash that otherwise would have been sucked up by P&I payments over the years left me with an adequate early retirement income, no urgency to search for a job greeting Walmart shoppers, and little likelihood that I will find myself sleeping under a freeway overpass.

    For the average middle-class and working-class earner, it’s insane not to get out from under a mortgage at the earliest possible moment.

  • 8 John // Feb 7, 2010 at 12:07 pm

    @Funny:
    Average return of Dow from 1900 – 2009 was 9.4%, and that includes the crash of ’29 amongst several others. So 8% is a modest number.
    Source

    Compounded Annual Growth Rate of S&P 500 between 1871-2009 was 8.9% [Source]

  • 9 Truth // Jun 22, 2010 at 7:54 am

    “Average return of Dow from 1900 – 2009 was 9.4%, and that includes the crash of ‘29 amongst several others. So 8% is a modest number.”

    Only if you can invest for 109 years, and history is guaranteed to repeat itself immediately. Why don’t you look at recent abysmal figures, instead of picking and choosing from all history?

  • 10 David Rumbo // Mar 26, 2012 at 1:37 am

    Where you getting 8% these days .

  • 11 John Martin // Apr 12, 2012 at 2:18 am

    That post was written in 2008.

  • 12 j. smith // Nov 26, 2012 at 12:05 pm

    the mail wrote an interesting article on paying off an interest only mortgage. i wonder if any one can remeber it and may have a copy