Sooner or later, nearly all homeowners ask themselves “Should we pay off our mortgage early”? The question is almost deceptively simple to state, but can be surprisingly complicated to answer. The reason for the complexity is that merits of “pre-paying” a mortgage balance involve multiple considerations, including-
- The current interest rate on the mortgage, whether it is fixed or variable, and how it compares with market rates of interest.
- The size of the mortgage balance remaining as well as how much time remains until it matures.
- Your expected retirement date and how it compares with the time left on your mortgage.
- Your income tax bracket, which determines how valuable the tax deduction on interest is to your household (if you itemize deductions).
- Expected rates of return on investments that would ‘compete’ with funds directed toward extra mortgage payments.
- Other debt that might be retired first as well as the interest cost of that debt.
- The intangible, emotional benefits of being debt-free and owning your home outright.
While all factors listed above are important, I want to emphasize the importance of item 2 (the time remaining until maturity) and present a framework for how to think about the mortgage prepayment decision.
Let’s imagine two hypothetical homeowners: a young couple with a brand new 30 year mortgage vs. an older couple with just 5 years left on theirs. Furthermore, we will assume that the interest rate is 4% on each mortgage, there is no other debt outstanding and that both couples claim the standard deduction on their taxes. Each couple has $20K in discretionary cash savings and both are trying to decide whether to apply it toward their mortgage balance or simply add it to their overall investment portfolio.
You can think of a mortgage pre-payment as earning a guaranteed (“risk-free”) return equal to the interest rate on the mortgage, in this case 4% per year*. That 4% is earned for the remaining duration of the mortgage, because you prevented interest from being charged on that amount from now until maturity. When you decide to “pre-pay” a portion of your mortgage balance, you apply the extra amount to the principal balance, which also has the effect of shortening the time remaining on your mortgage.
Can the older couple earn more than 4% (after-tax) on their investments for the next five years? Maybe, but not without taking some risk. Five year CDs are currently offering around 3% per year and five year US Treasury bonds yield 2.45%. Investing in the stock market might return more than 4%, but stocks are simply too volatile an asset class to make accurate return estimates for such a short time frame. Compared to other short-term investment options today, it’s hard to beat a guaranteed 4%.
The calculus is somewhat different for our younger couple – can they earn more than 4% on their investments during the next 30 years? Again, not without taking some risk, but our young couple has the benefit of time on their side. With decades of compounding ahead of them, they are much more likely to be better off investing at least some of that $20K in a globally diversified portfolio of equity securities with an expected return well above 4%.
The key point to remember is that investment time horizons affect the appropriate level of risk in a portfolio. When portfolio withdrawals are decades in the future, the capacity to take risk generally expands. By matching the time horizon of competing investments with the time remaining on the mortgage, the pre-payment decision hopefully becomes a bit clearer. In general, for more ‘seasoned’ mortgages, the right decision may begin to tilt toward paying off your mortgage early as the time to maturity shortens.
*Assuming you stay in your home for the full duration of the mortgage