Wharton finance professor Michael R. Roberts reexamines whether, in the current financial climate, homeowners would be better off investing their excess money rather than using it to pay down their mortgage.
In this opinion piece, Wharton finance professor Michael R. Roberts reexamines whether, in the current financial climate, homeowners would be better off investing their excess money rather than using it to pay down their mortgage.
A little more than two years ago, I made the suggestion that people should reconsider paying off their mortgage. Feedback from readers was constructive and thought-provoking. Since then, interest rates have skyrocketed along with inflation, raising the question, “How does this new economic environment bode for paying off one’s mortgage?” I’d like to revisit the topic and address some of the points I didn’t cover in my earlier piece.
Whether your opportunity cost is higher or lower than your mortgage cost will determine whether you should pay off your mortgage early. That opportunity cost was less than the majority of mortgage rates two years ago, when interest rates on safe investments were almost zero. Therefore, in order to defend allocating additional funds to savings rather than mortgage repayment, homeowners had to assume some risk and adopt a long-term perspective.
Well, everyone’s opportunity cost skyrocketed over the last year. The Federal Reserve’s monetary policy has raised the federal funds rate by 5% since March 202022 in an effort to combat inflation. Today, in May 2023, we can invest in Treasury bills, all of which earn over 4. 5%. Several high yield savings accounts and CDs are offering over 4. 5%, as well.
If your mortgage rate is below 4. 5%, say 3. 0%, then paying down a mortgage early is quite literally turning down extra money and safety. The 3. 0% interest expense you’re saving is less valuable than the 4. 5% you could be earning even after accounting for taxes. And, the savings accounts, CDs, and T-bills are backed by the U. S. federal government, whereas your equity in real estate is not. [1].
Unlocking the Secrets to Early Mortgage Payoff and Interest Savings
Many homeowners are drawn to the idea of owning their home outright and being liberated from the burden of monthly mortgage payments. However, can you really save a lot of money on interest over the course of your loan by paying off your mortgage early? If so, is that the best way to accomplish this goal?
The answer, like most things in finance, is not a simple yes or no. It depends on a multitude of factors, including your financial situation, the terms of your mortgage, and your overall financial goals.
The Power of Early Mortgage Payments
First, the good news: making early monthly mortgage payments can actually lower the total amount of interest you pay over the course of the loan. This is due to the fact that interest has less time to accrue the earlier the principal balance is paid off.
Here’s a simple example to illustrate the point:
- Loan amount: $150,000
- Interest rate: 6%
- Loan term: 30 years
If you make only the minimum monthly payments, you’ll end up paying a whopping $173,757.28 in interest over the life of the loan. That’s on top of the $150,000 you borrowed initially.
Now, let’s say you decide to pay an extra $100 every month towards your principal. By doing so you’ll knock off 81 months from your loan term and save a significant $45,586.71 in interest.
But is it always the best option?
Although there is no denying the possibility of saving money on interest, paying off your mortgage early isn’t always the best financial move. Here are some factors to consider:
1. Your Financial Situation:
- Emergency fund: Before you start throwing extra money at your mortgage, ensure you have a solid emergency fund in place. Aim for at least 3-6 months’ worth of living expenses to cover unexpected situations.
- Other debts: Do you have high-interest debt, like credit card balances or student loans? It might be wiser to prioritize paying those off first, as they typically carry much higher interest rates than mortgages.
- Investment opportunities: Are there other investment opportunities that could potentially yield higher returns than the interest you’d save by paying off your mortgage early?
2. Mortgage Terms:
- Prepayment penalties: Some mortgages come with prepayment penalties, which can negate the financial benefits of paying off your loan early. Carefully review your mortgage agreement to see if this applies to you.
- Interest rate: If you have a low interest rate on your mortgage, the amount of interest you’ll save by paying it off early might not be significant enough to justify the effort.
3. Your Financial Goals:
- Retirement planning: Are you on track with your retirement savings goals? If not, it might be more beneficial to prioritize those contributions over paying off your mortgage early.
- Major purchases: Do you have any upcoming major expenses, like a down payment on a new car or a dream vacation? It might make more sense to save for those goals first.
5 Mistakes to Avoid When Paying Off Your Mortgage Early:
- Not considering all options: Don’t rush into paying off your mortgage early without exploring other investment opportunities that could potentially yield higher returns.
- Not putting extra payments towards the principal: Ensure your extra payments are specifically directed towards the principal balance, not just the next month’s interest.
- Not asking about prepayment penalties: Be aware of any prepayment penalties associated with your mortgage to avoid losing money.
- Leaving yourself cash-poor: Don’t neglect building an emergency fund while focusing on paying off your mortgage early.
- Extending your loan term when refinancing: Be cautious when refinancing, as extending your loan term could end up costing you more in the long run.
Deciding What’s Right for You
Ultimately, the decision to pay off your mortgage early is a personal one. There’s no one-size-fits-all answer. Carefully weigh the pros and cons, consider your financial situation and goals, and consult with a financial advisor if needed. They can help you create a personalized plan that aligns with your unique circumstances.
Additional Resources:
- Rocket Mortgage: https://www.rocketmortgage.com/learn/pay-off-mortgage-early
- SmartAsset: https://smartasset.com/mortgage/mistakes-to-avoid-when-paying-off-your-mortgage-early
Remember, the key to making informed financial decisions is to do your research, understand your options, and choose the path that best aligns with your individual goals and circumstances.
Argument 1: Paying Off My Mortgage Early Reduces Income Uncertainty
Your ability to pay your mortgage could be taken away from you if you lose your job or are forced to take a job that pays less. Consequently, you could lose your home. Paying off a mortgage quickly eliminates a significant expense and mitigates this concern.
However, consider two scenarios.
Scenario 1: You utilize your surplus funds to reduce your mortgage early, and as a result, you become unemployed. This is a bad idea, unless you want to live out a scene from Game of Thrones for a few months until the sheriff kicks you out. Why? You have no savings. You have nothing to pay bills — utility, maintenance, tax, grocery, medical. So, you can take advantage of your debt-free house for a few months while you pray for steady weather, practice hunting so you can provide for the family, and hope for moderate weather. Sadly, this won’t last long because you will eventually be forced to leave your home and have it auctioned off by the state due to unpaid taxes.
What about all that home equity? To access it, you have two options. One option would be to obtain a reverse mortgage, but the terms would not be as advantageous as those of a first lien mortgage, and this would negate the benefit of early mortgage payoff. As an alternative, you could sell the house, but doing so would negate the benefit of lowering your mortgage early in order to retain your house. Even worse, should you be compelled to sell your house, you will need to hope that the market is favorable to sellers and understand all of the costs involved in doing so (agent commission, transfer and title fees, etc.). ), and not let your financial distress adversely affect your ability to negotiate the sale price.
Scenario 2: You have money saved up and can use it to get by while you hunt for a job or a better one. Better yet, barring a fortunate break in the local real estate market where your home’s value increased dramatically, you have even more money than you would have if you had paid down the mortgage earlier because your savings were earning more interest than the mortgage was costing you. Lastly, since you can afford your mortgage payments, you might be able to keep your house or at least avoid having to sell it under duress.
The comparison’s main argument is that, in the event of a job loss or other unfavorable income shock, choosing to pay down a mortgage quickly does not mean choosing to stay in your current residence or not. The decision is to pay off a low-interest loan and lock money away in a risky, illiquid asset or to save money and invest it in a high-interest, safe, liquid option. It’s hard to argue, on financial grounds, for the former.
Argument 2: Paying Off My Mortgage Early Reduces Interest
The amount of interest you pay overall over the course of the loan is decreased when you pay off a mortgage quickly. This logic is also behind arguments favoring shorter maturity mortgages.
For example, a $500,000 mortgage at 5% over 30 years has monthly payments of approximately $2,684. Over 30 years you’ll pay a total of $966,279 or $466,279 of interest. With monthly payments of $3,954 and total interest of $211,714 over the loan’s life, a 15-year mortgage with the same rate appears to save $254,565. While this sounds impressive, the calculation and figure mean nothing at all unless your savings plan consists of shoving cash under your mattress.
Due to opportunity cost, a dollar of interest in thirty years will be significantly less expensive than a dollar of interest today. How much? At a current savings rate of 4. 5%, that $1 of interest 30 years from today is worth $0. 27 today. It makes no more sense to add money that you pay (or receive) at different times than it does to add different currencies. We wouldn’t add 100 U. S. dollars and 100 British pounds and say we have 200 “currency. ”.
So, homeowners have to recognize the opportunity cost of money. We will have more than enough money in the future to cover the interest expense if we start saving now at an interest rate higher than our mortgage payment.
Do This To Pay Off Your Mortgage Faster & Pay Less Interest
FAQ
Does paying mortgage early in month save interest?
What happens if I make my monthly mortgage payment early?
Does interest go down if you pay off early?
Does paying your monthly mortgage payment early help?
Should I pay off my mortgage early?
Each month that you make a mortgage payment, some money is going toward interest — so the fewer payments you have, the less you will pay in interest. Paying off your mortgage early could save you tens of thousands of dollars. (Just make sure to clarify with your lender that all extra payments will just be going toward your principal, not interest.)
Should you pay off your mortgage 4.5 years early?
On a $150,000, 30-year loan with a 6% interest rate, a single extra payment every year will help you pay off your mortgage 4.5 years early, saving 56 months’ worth of payments. 3. Refinance To A Shorter Loan
Do you owe more interest if you pay down your mortgage?
You owe less in interest as you pay down your principal, which is the amount of money you originally borrowed. At the end of your loan, a much larger percentage of your payment goes toward principal. You can apply extra payments directly to the principal balance of your mortgage.
Should you pay more on a mortgage each year?
In effect, you’d make an extra mortgage payment each year. You can also pay more toward your monthly loan balance. For example, if your loan’s minimum payment is $2,000, you can set up a monthly payment of $2,200. Each month, the extra $200 will pay down your loan’s principal and help you pay it off more quickly.