Should you pay your home mortgage off early, or should you invest those funds into the stock market, CD, or other investment? Mortgage payoff vs investing?
That is an excellent question, and one that I have recently researched thoroughly. Through all of my extensive researching and number crunching, I’ve come to figure out these basic facts:
- Whether or not you should pay off your mortgage early depends on your own financial situation (for some it makes sense, for a few, maybe not).
- There are a lot of considerations that aren’t so obvious when considering investing vs paying off mortgage–and these are very important, and I’ll cover these in detail.
- Paying off your mortgage early also depends on market conditions, which as of this initial writing (2/5/13), they aren’t so great.
- For most people, including me, it would be wiser to pay off your mortgage early–or at least make a few extra payments as a mix in your overall portfolio.
- I’d only invest in something else if you can earn 10% more than your current mortgage (or more) with minimal risk. Why 10%? Because that 10% your making will really be far less once you pay all of your taxes and fees. In other words, if your mortgage is 5%, and you hope to invest 7% in the stock market, I’d immediately pay off the mortgage instead, because after taxes, fees, and so forth, you’ve probably made far less than 7%.
- If your company matches 401k up to a certain amount, go ahead and max that amount. In other words, if you could get a 401k and your employer matches dollar for dollar up to 4%, then put the full 4% of your check in, as the employer will match it, giving you an effective 100% match on your money (not including extra earnings your investment may or may not make). Then, invest the rest into the mortgage (assuming you don’t meet one of the “when to not pay your mortgage off” requirements below.
Having said all of that, this article will be very comprehensive and cover all of the pros and cons of paying off your house earlier (either by making extra mortgage payments, or in a lump sum). Let’s start with a short list of “pros and cons”
Benefits of Paying Off Your Mortgage Early
- You won’t have to deal with a mortgage company monthly or yearly, including dealing with yearly property taxes and/or house insurance (many require you to provide proof of coverage). You’ll also save on stamps, letters, and checks if you pay this way each year (which only amounts to a few bucks in a given year, but still, every penny counts).
- You’ll save (earn) exactly the amount of interest you pay each year (my interest rate is 4.75%). So if you pay off 5,000 per year on your mortgage, you’re essentially saving/earning $237.50 in interest charges. Or if you owed $50,000, its like investing it in a permanent CD at 4.75%, which will pay you $2,375 yearly. This is all 100% tax free, with no forms to fill out, and no hassles. Trust me on this, cutting out an expense is much better than earning money of the same amount. If you can cut out $500 per month, that is better than earning 500 a month. Why? First, earning that much money isn’t always going to be guaranteed, but cutting out the expense is. Next, that 500 will be taxed. This can have huge consequences and significantly reduce that $500 to a lot less (I’ll cover that later).
- You will enjoy 100% savings on that interest saved, as opposed to being surprised by extra taxes or investing fees–which is the case with ANY investment or earnings.
- It’s essentially risk free investment, because even if something DID happen to your house, you’d still owe the mortgage too. And you always have insurance on it as a safety net. And you will always need a place to stay, and houses probably aren’t going to get cheaper since they’ve bottomed out, and the population continues to rise (demand).
- It can be very rewarding mentally knowing you have a home that is fully paid off.
- 100% of all foreclosures happen to people carrying mortgages. When you pay it off, you can tell the banks to get lost.
Cons of Paying Off Your House Early
- You’ll have to give up cash you could have used for other investments, savings, vacations, new cars, or whatever else. Of course, this only applies if an investment pops up that could have earned you far more than your current mortgage—and for most people this won’t happen.
- You can lose the mortgage interest deduction, but this only applies to those who itemize, and even then, it isn’t usually a significant savings and you’d still fare better paying it off. Would you rather pay $5,000 on your mortgage each year to save $2,000? If so, please email me. I’d love to swap $2,000 for 5,000 with you =). The fact of the matter is this: Most people don’t even claim it anyway, because the standard deduction is a much better choice for the average earning person. In fact, it has never been a benefit for me to claim a mortgage deduction, so I’ve always used the standard deduction instead. It’s not only easier, but it has always been higher for me. If you do itemize, you can still itemize if it makes sense. You just won’t claim a mortgage deduction on that part. Nevertheless, for a fraction of the population, it may not make sense to do this, so crunch the numbers to see if you itemize. In any event, as the years pass, your interest deduction will become less and less as you pay down your mortgage anyway.
- It can be difficult getting the money back out of the home once it’s paid off, but this really only applies if you plan on moving regularly. Plus, you can always re-mortgage or re-finance it later if you hit a bump in the road financially, or need some cash.
- Your bank may not earn as much money that year. But hey, you will be saving money in interest, so that’s okay.
Common Illogical and Silly Arguments Against Paying Off Your House
- “Inflation makes it better to not pay off your mortgage, because in 20 years your payment will be like nothing.” What? So I’m going to shovel away thousands to the bank each year with the hopes that one day my $585 payment will be peanuts? Sorry, that’s the most silly argument I’ve ever heard. When I pay off my mortgage, I get INSTANT 100% savings of the same rate of my mortgage, which is tax free. That’s better for the short and long term. Not to mention that my house should appreciate (especially since it was a killer deal on a foreclosure far below market value, and I’ve fixed her up).
- “You’ll still have to pay property taxes and insurance.” So what? You’ll have property taxes and insurance whether you pay off your mortgage or not. Would you rather pay a total of $10,000 in mortgage payments and $1,000 in property taxes, or just 1,000 in property taxes? I’d rather only pay property taxes and insurance, which is what will happen when my mortgage is long gone.
- But, My Mortgage Tax Deduction…Even when itemizing your deductions on your tax return (as opposed to taking the standard deduction), you will still probably come out far better by paying off your mortgage. Many people don’t even claim it anyway (I never have), and tax regulations over the years makes me feel it will eventually be phased out in the future. So unless you are earning a really good return in the market or with some other investment, you’ll probably come out better paying of the mortgage and simply not claiming the deduction. Nevertheless, you should crunch the numbers and see what will happen. Keep in mind that it only reduces your taxable income, and deductions are not nearly as effective in reducing your tax bill as tax credits.
- I Can Earn 10% in the Market…People often quip that “Statistics show that the stock market has earned about 10% average return over a long period of time.” My reply is simple: That was before the liberal takeover in politics, which historically cripples economies. There is no proof the 10% rate will continue. Second, that 10% may not be too impressive when you deduct capital gains taxes, state taxes, brokerage/mutual fund fees, and lose certain tax deductions/credits if your income reaches a certain threshold. So watch out. If an amazing investment opportunity shows up, then mortgage your house or take out another loan if you are that confident in it.
- Mortgage Rates are at Historic Lows: Yes, mortgage rates are pretty low right now, but for how long? Paying off your mortgage will still likely earn you more than you can earn in any CD, savings account, or other safe investment right now. Unless you are earning a stable, secured investment regularly, then it makes a lot of sense to pay off a mortgage–even if it is low. Even if savings accounts get up a percentage point or two above your mortgage, consider the taxation which will reduce it.
- But Shouldn’t I Diversify? Diversification is great, and I’m not suggesting you necessarily have to put ALL of your investment or money into paying off your mortgage. My wife still uses a 401k because her employer matches a chunk of it, and it is a good way to diversify a bit. I also invest in other things too. But I’m focusing the bulk on my mortgage, and once that’s gone, I’ll worry about diversifying even more. If you want to invest in some bonds, stocks, mutual funds, etc–then do it. I’d just have realistic expectations and consider shifting a bulk to your mortgage.
- What If I Want to Move One Day? If you plan to move a lot (see below), then you probably shouldn’t buy a house anyway (unless you know you can make money on it). But let’s say you live there, pay off the mortgage, and want to move. You have the following options: Sell it and get a lump sum, keep it and rent it out for an income, or buy a second home (which you can now afford since you don’t have a mortgage anymore, and either sold or rented your old home out). See, no problem.
When You Shouldn’t Pay Off Your Mortgage Early
- If you plan to move around a lot, or within 5 years or so, you may not want to since you won’t get that cash back until you sell—and you may need that cash when shopping for a new place. Personally, I love my house and my area, and plan to live in it a long time (probably my whole life). Living in the same house over the long haul is a great idea, because you will remove the fees of buying a house (closing costs, loan fees, etc. can add up to almost $3-7,000), and you’ll get it paid off much earlier than constantly moving and paying more. In fact, if you do plan on moving, it may be better to rent for the short term anyway.
- If you have no savings at all, then you may want to hold off. I recommend keeping at least 6-12 months of savings in a high interest account, just in case you experience an emergency or huge unexpected expense. Or if this shaky government makes more insane liberal regulations that cripple the economy and leave us all destitute. Once you build that up, you can start to pay extra on your mortgage.
- If you can earn far more (SAFELY) from another investment— then it makes more sense to do that, but it needs to be a LOT more than your mortgage rate. For the average person with a job or business, they probably won’t have any glamorous stock pick or idea that can earn them more than 10% ABOVE their current mortgage rate. But if you can invest in your business, invest in supplies you buy regularly, or if you are the next investing guru, and that adds up to 10% MORE than your current mortgage, then by all means, it makes more sense to earn more cash doing that. A great question to ask is this: Is there an investment so great right now, that I’d mortgage a house to invest in it? Yes, if you could have invested in Microsoft or Google, perhaps you’d earned better. But how common is it for that to happen? Not much.
- If you can pay off higher interest expenses or Debt, DO THAT first!! If you have ANY payment of interest that is more than your mortgage (such as a credit cards, car loan, medical bills, or whatever), then by all means pay that off first. Example: Have a school loan at 7%, but your mortgage is 5%? Pay off your school loan. Have 11% credit card debt, and a 4% mortgage? Pay off the credit card. Take whatever you are paying the higher interest on, and start chipping away on that first for sure. Then tackle the mortgage until you are 100% debt free. It makes no sense whatsoever to carry debt unless either you have no other choice, or you can make far more in other investments than that debt will cost.
- If you could lose some benefit by having a mortgage, that far outweighs the savings of the mortgage itself. In other words, if you will lose a $20,000 a year scholarship because you have an asset that’s paid for, or anything else that will be MORE than the amount of mortgage interest you pay in a given year, then don’t do it. Although this probably isn’t a big concern for most people, but I could imagine a scenario or two in which it may be an issue.
- If you will get penalized–Some mortgages penalize you if you pay it off early. You need to read the fine print and see if you have any penalty for doing so, and if so, what. For me, I have no such penalty, so I can pay it off when I want. I still suspect that for most people, the penalty is minor and it would still be a huge benefit to pay it off early. Nevertheless, read the fine print!
Why I Decided It is Best to Pay Off Your Mortgage Early
As I was considering what to do with portion my savings, I pondered it a long time.
I could invest in a cd, savings account, or money market, but right now rates are only about 1% or so (which is terrible). Rates will likely go way back up once the market levels off, but this will be a while in my estimation. In fact, before the market tanked, I had a CD that only gave about a 4.85% yield, which I was then taxed on (oh how I wish we could CD rates at about 10% or like those good old historical cd rates). So paying 4.75% on my mortgage is a much better savings than a CD right now.
You can also shift funds to a 401k or other retirement account. You an certainly do this as a diversification method, but consider also that the funds are not guaranteed either, and the returns may not be impressive. What’s also bad about this is that the government has their sticky hands in it, and can penalize you big time if you withdraw the funds before retirement age.
I could also put that into the stock market or a mutual fund. The only problem? Stocks and mutual funds carry a lot of risk. Some people have experienced a huge decrease in their portfolio with the current market conditions. You may make a 10-12% return over a very long term (decades), but you may only make a 3% return, or even worse: LOSE 100% of your money. Not so with paying off your mortgage. You get INSTANT savings, with virtually no risk, and a guaranteed return of the amount you owe.
What’s even worse, even if you do manage to make a good return in stocks/mutual funds (say 10%), you’d have to keep up with all of your investments and account passwords(hassle), pay additional federal taxes on any earnings you realize (and capital gains rates are going up!), possibly pay state taxes on that investment (my state does this even though it doesn’t have a personal income tax in the state, but most states even have a personal income tax), and what you’re left with is a paltry return.
What makes all of this even worse is this fact: Not only will you be taxed on your investment earnings, but you may also be phased out of certain deductions/credits, which could reduce your earnings even more. The IRS is getting more and more stiff with the tax deduction phaseouts once your income hits past a certain level. So you better watch out, or else if your income reaches a certain level, you could lose those benefits.
Let me just summarize this entire section by simply saying this: You need to really crunch the numbers and see what you’ll really make off your investments after you discount the following:
- Federal Capital Gains taxes or income taxes
- Loss of federal tax deductions due to high earnings, which may be significant
- Liability of State taxes (either personal tax returns for the state or any capital gains taxes your state may enforce)
- Risk (while savings accounts and CDs have minimal risks, stocks and mutual funds are a risky investment). You may lose it all.
- Fees you have to pay to your investment manager, mutual fund fees, etc.
Deduct that from your “10-12 percent market return,” and then see how great your return really was. It probably was not much more than paying off your mortgage, if at all. And you probably encountered a lot of stress and aggravation dealing with it over the years. Pay off the mortgage instead!
How I Earned 11.65% Return Guaranteed
So as I considered all of the above, I also noticed something else: Not only was I paying 4.75% on my current mortgage, I also had PMI (Private Mortgage Insurance). This is an extra amount you have to pay if you didn’t put down a full 20% of the house. Usually once you pay the house down to 78% of its value, this is cancelled by your mortgage company anyway.
So I calculated the amount required to pay it off, and it amounted to about 6.9% interest return by paying off the PMI early. Otherwise, I’d had to pay on it for nearly 4 more years, at about $522 per year just for this alone, and the sum to take down to cancel the PMI wasn’t much at all.
So when I made the extra lump sum to pay down my mortgage early (I still owe some by the way), I essentially earned 6.9% (PMI was cancelled), plus the 4.75% on that payment in mortgage interest, for a total TAX FREE earnings/return of investment of 11.65%. WHOA! Cha-ching. That was awesome.
Again, I had no “fees,” and no hassles at all.
Now that I have the PMI out of the way, I plan to work hard to pay it off as early as possible. It was a 30 year loan (fixed rate), and I hope to have it paid off within a total of 8 years or so. I’m almost half there now.
Don’t get me wrong, I still invest in my own business, and also invest in high yield savings accounts for emergencies, and a small amount in my 401k, and my best investment is that I tithe 10% to God (like John D. Rockefeller did). But each year, if I have no other investment opportunities, I plan to drop a chunk down off the mortgage.
Should You Pay Off Your Mortgage Early?
So should you pay off your mortgage early? Or should you invest your money in the market?
Well, unfortunately, you’ll have to look at your own financial situation to determine that answer. But I pray that this article has given you ample points to consider. For me, it was a great decision to start paying my house off early instead of investing in risky investments. When I looked at the $4,000 in interest I paid on my mortgage statement, I thought about all I could have done with that money. That was $4,000 in interest burned…for what? For the convenience of paying for a home over time. Well, unless I have a crazy awesome investment that’s safe, I’m on a mission to pay this mortgage off as soon as I can.
Granted, you can always set aside an amount to invest in stocks, bonds, mutual funds or whatever—if you really want to. But I think a great case can be made for paying off a mortgage early–even with the lowest mortgage rates in history!
Consider it a guaranteed savings in this paltry economy, that an also offer you peace of mind of having your home paid in full. If the market swings around, or CD’s go through the roof, then by all means, you can funnel your investments into that. Or if the opportunity of a lifetime comes up, then mortgage your house and go for it.
But if you have nothing better to do, I would pay off my home as soon as possible. It just makes the most sense for me right now.