I love thinking about whether or not it is worth paying off your mortgage early. Maybe it is because we are getting close to the stage where we have this option. Or maybe I'm excited about the prospect of not having a mortgage payment.
I've written about this extensively a few times on why we decided to not pay off our mortgage early.
I find it fascinating to hear what people think, and what reasons they give in why they chose the path they are on (or have already completed).
There was a fantastic twitter post by Mark Allan Bovair earlier this month. He went through a list of eight reasons why you should not pay off your mortgage. A few of the points he made were new ideas to me, and thus the reason for this post.
Recently, I also posted a link to my Ultimate Guide on Paying off Mortgage Early vs. Investing on Reddit. I was pleasantly surprised to see it go semi-viral for a short time. It was a nice boost in traffic.
This debate brings out people from both camps. If you've already paid off your mortgage, chances are you have a positive perspective on that decision. If you decided the opposite, you probably are passionate about not paying off your mortgage early.
I think the discussion is healthy and there are valid points from both camps.
Get Your Financial House in Order
Before you decide to make extra payments or dump that money into after-tax investment accounts, you should make sure you are in a strong financial position to move to the next step.
The good news is that at this point, you have an incredibly strong financial foundation that will help skyrocket your net-worth.
The below list is what I would make sure to handle first before tackling the question of how to handle your mortgage.
- You should have some kind of emergency fund. Most people recommend an emergency fund in cash equal to 3-6 months of your base expenses, just in case something major happens.
- Pay off all consumer debt, especially credit card balances.
- Max out your 401k and I'm not talking just about meeting your employer match. Currently, this max is set at $19,000/year. Doing this will lower your taxes, and gives you more options when you reach 59.5 years old.
- If you qualify, max out your Roth IRA accounts. If you are married, this means you can have an account open for each spouse. The current max you can contribute to each account is $6,000/year.
Doing this before you do anything with your mortgage or after-tax investment accounts allows you to start growing these accounts, which hopefully become huge by the time you get to 59.5 years old. Even if you are older, the tax benefits in contributing to your 401k will lower your current tax burden.
Prioritizing these things also gives you the benefit in being able to access your Roth IRA contributions after 5-years, which gives you additional margin if something horrendous happens.
Reasons to Not Pay Off Your Mortgage Early
Below are the strongest arguments in my opinion, in why you shouldn't make extra mortgage payments.
Extra Payments Do Not Lower Your Mortgage Payment
One benefit in paying off your mortgage early is you reduce your monthly expenses. But this benefit doesn't become a reality until you have your mortgage 100% paid off.
You could have your mortgage principle mostly paid off, and yet your full mortgage payment would be the same.
And this is the true kicker. You are basically dumping your cash into an investment that you cannot liquidate until you sell. If for whatever reason you are unable to continue making extra payments, you don't have the option in tapping into the extra equity. Unless of course, you decide to cash out equity from your home. But then that defeats the purpose of what you are trying to accomplish with extra payments and adds additional risk.
This transitions nicely into the next point.
Peace of Mind
One of the top reasons people bring up in why they paid off their mortgage early was for “peace of mind”.
But what feels better? Having a $200,000 mortgage or a $200,000 portfolio?
I would argue that the portfolio gives you more options, in that it is much more liquid than home equity. Also, the extra amount you would have put towards your mortgage has a good chance in growing larger over time. Which means that you most likely will have more money in your portfolio vs. home equity after a period of 5-10 years.
It's true that your home will “hopefully” appreciate over time, but that isn't dependent on your extra payments.
To me, having the option in paying off my mortgage early, or using the funds another way, from a portfolio I'm growing would make me feel much better. Mainly because I know I can access those funds at any point.
But how will I feel when the market goes down? Assuming I don't need to tap into that money (which is what my emergency fund is for), I'm going to want to dump more into the market to pick up index funds at lower prices. I'm not too concerned about my job being tightly coupled with what the market is doing, so even in the case of a market crash, I should still have a job.
A Short Sale or Foreclosure “Could” Mean Less Money
Let's say your name is Bob and you decide to make extra payments towards your mortgage. He's excited about the freedom and flexibility he will gain once his mortgage is paid off.
Bob sits down and figures out that if he makes an extra payment of $1,000/mo, he can have his mortgage 100% paid off in 10-years. This get's Bob excited about the plan, and he moves forward.
A few years pass, and Bob is sticking to the plan. He has already built up a significant amount of equity in his home, and things are going great. Until one day Bob goes into work to find out that he's been laid off.
Luckily for Bob, he has an emergency fund built up that will cover him for 6-months (great job Bob!). However, he is unable to find a job in his local area. And unfortunately, the housing market also ends up tanking in the same time period. Bob not only has burned through his cash reserves but now he can't sell his home for more than what he owes on the mortgage.
Bob makes the hard and what seems like his only option and that is to do a short sale. The problem with a short sale is that he probably will end up paying extra fees, which will reduce the cash he receives. The bank is ecstatic about this, as they are getting more money than if Bob did not make extra mortgage payments.
If instead of making extra mortgage payments, Bob would have invested that money into the stock market, he could have tapped into those funds to extend his emergency fund when he needed it most.
This is one reason I think it is best not to make extra payments, as you are investing in an asset that you can't liquidate until you sell.
Making Extra Payments Reduces Your Options
For all of the volatility that comes from the stock market, any money you dump into an after-tax account can be cashed out at any time.
I'm against using money you have invested in the stock market as an emergency fund, but in the worst-case scenarios, it is an option that can be used. If you burn through your emergency fund, or something horrendous happens, in most cases this is going to be money that you can get access to. The question becomes how much is available at the current time.
This easy access to the cash from after-tax accounts is a huge benefit.
Not Making Extra Payments Doesn't Mean You Can't Pay Off Your Mortgage Early
Often we hear about how making extra payments is the primary way to pay off your mortgage early.
But if instead of making extra payments, you dump those funds into an after-tax account, you can use those funds to pay off your mortgage once you hit that balance.
The longer your timeline, the more you increase your chances of having your investments be worth more than what you owe on your mortgage. Again, this ties into the idea that you have more options if you don't make extra payments. That way you can pay off your mortgage early on your schedule if that's what you decide.
Doing this you have the option in taking advantage of the main benefits in paying off your mortgage and increasing your chances in having more money. But you also might decide to carry your mortgage as long as possible to increase your possible gains.
Reasons to Pay Off Your Mortgage Early
Now let's talk about some reasons on why you might want to pay off your mortgage early.
If you are close to retirement, or maybe within 5-years of retiring, you might want to consider paying off your mortgage early. This could be from retiring early or approaching the more typical retirement age.
Especially if your net worth is not 100% tied to the equity in your home, the risks in making extra mortgage payments might be low.
And getting rid of the majority of your monthly home costs could dramatically reduce your monthly expenses. You still will have to cover homeowners insurance and taxes, but that is still a large amount of cash that gets freed up every month.
When you don't have a regular job, having lower monthly expenses is a huge benefit.
You are Risk Adverse
By paying off your mortgage early, you are guaranteeing a rate of return equal to the interest on your mortgage. In our case that would be 3.265% on our 30-year mortgage. This is money you are guaranteed to save on your mortgage. You'll end up saving on interest charges and reduce the time it takes to pay it off.
If you are at a stage in life where you are reducing risk, it might be best to pay off your mortgage early. Or your mortgage interest might be closer to 5%-6%, and you are not worried about making an extra two percent over the long-term in the stock market. You might also think that the average for the stock market is going to be much lower than your mortgage interest rate (everyone seems to think we are at the top of the current bull cycle).
It is a valid point that paying off your mortgage early is the least risky option. But I want to make it clear that just because you don't make extra mortgage payments, does not mean you can't pay off your mortgage early. It just guarantees that you can pay it off early and save on mortgage interest, based on how much extra you pay towards the principal.
In either case, this might be a reason you decide to pay off your mortgage early.
If you are not looking at a time period of 5-10 years where you will have your mortgage paid off, you might want to think about if you can stomach the volatility that may come from the stock market.
Over long periods of time, you have a good chance of making good money from the stock market. But the shorter your timeframe, the more the risk goes up in exactly what is going to happen over a period of a few years.
This is highly related to risk tolerance, but given a short timeline, it might be best to make extra mortgage payments.
Either Option is a Smart Move
Given our 10-year minimum time frame before we might quit our jobs, not making extra payments seems like the best option for us at this point.
But you might decide to go a different route. And that's okay. Either option is not a stupid move, and it is my opinion that we start to split hairs when we take an aggressive stance with either path.
Both options have their pros/cons and unique risks. and I think it is great when we talk about which option might be best.
With that said, I think the risks in making extra payments from the time you start until when you have your mortgage paid off are often understated. Making extra payments is often described as the path that leads to the most security and peace of mind. But that assumes you can get to the point of paying off your mortgage (which might be a long ways off).
When you don't make extra payments towards your mortgage, you are assuming a positive outlook in the future of the stock market. No one knows for sure what is going to happen in the next ten years, and this could end up making less than your mortgage interest rate. I think for periods of at least 10-years, that risk is fairly low, but it still could happen. Only time will tell.
Whatever you decide, the key is making sure you stick to the plan. As long as you are avoiding consumer debt, either plan should put you in a strong financial position (hopefully).