May 04

For some people, getting rid of their mortgage is their top priority. After all, it’s by far the largest personal debt one is likely to ever owe, and having no mortgage will free up a nice chunk of that monthly income. That’s why we don’t just pay it off, we burn the mortgage paperwork when it’s paid off.

Is it in your best interest to take your extra money or use it to pay the mortgage off early? This isn’t such a clear cut issue, let explore what might impact your decision.

First, and most important, are you taking advantage of any matched 401(k) your employer may offer? A dollar for dollar match should be grabbed regardless of the rest of your situation. Even ahead of paying off any other debt. Companies usually limit the match to 5-10% of the employees’ gross income, so if you make $50,000, the first $2500-$3000 is matched, and that’s it. Don’t miss this.

Do you have any revolving debt? Credit cards? Store cards? Common sense tells you it’s silly to pay 12-18% interest on this debt, yet make extra payment on a 6% mortgage.

Do you have a proper emergency fund? The real concern at the bottom of this question is can you survive the loss of your job and still keep your home until you find new work? Remember, when you send extra money to your mortgage, it’s a one-way street, you can’t easily borrow it back. Of course you can arrange for a HELOC (home equity line of credit) but not after you are out of work. I view the HELOC as a bit of a slippery slope. It can be responsibly used as a secondary emergency account, but should not be your only source of funds to cover unexpected expenses. Your hot water heater fails, you should be able to pay for it.

In the final analysis, it comes down to one question – Do you feel lucky, punk? I ask this in all sincerity, as in most situations it will requite luck to choose the best outcome. We can look at all the data we wish, time periods when stocks returned over 19% on average (the ’90s) or a decade of less than 1% growth per year (the recent ’00s). You can play with the numbers all you wish, but unless Treasuries are yielding more than your mortgage (adjusted for tax implications) then Dirty Harry’s question will come back to haunt us.

Consider, in the big picture there is little difference between a dollar used to pay down a 5% mortgage or one sitting in a 5% CD. Of course, the big difference is liquidity, but I am talking instead about the return on your money. So, as you get older and look at your portfolio, when you look at your stocks and cash allocation, it may make sense to accelerate those mortgage payments and enjoy the savings of 5-6% vs the 1% you might currently get in CDs. For our situation, we decided that it was wise to refinance in 2004 to a 15 yr, aligning our mortgage payoff more closely to when our daughter would start college.

In the end, you might read some very insightful analysis showing that 5% after taxes is really 3.75% if you are in the 25% bracket, and if cap gain rates stay at 15% (they might) that a fund yielding 4.4% will break even. DVY (The Dow Dividend stock ETF) yields 3.6%, the underlying stock need to grow just 8% over the next decade to let you break even. This is total growth, not each year. But the question remains, are you willing to bet on the markets return over the next ten years? Do you feel lucky?

This was a Money Maven Network wide posting, my fellow mavens discussed this topic as well:
Green Panda Treehouse – Pay Off Your Mortgage or Invest Your Money?
Wealth Pilgrim – Pay Off Your Mortgage or Invest
Money Help for Christians’ Pay Off Mortgage Sooner, Invest, Or Save? The Math Analysis
Len Penzo – 12 Good Reasons Why You Should and Should not Pay Off Your Mortgage Early
Enemy of Debt – Should You Grow Your Nest Egg Or Pay Off Your Mortgage?

Joe

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25 Responses to “Pay the Mortgage Early or Save?”

  1. Neal@pilgrim Says:

    Wow…I spent 2 hours thinking about all the reasons pro and con and didn’t even come up with the ideas you’ve listed. Is it time for me to find another career? Nice job pal.

  2. Len Penzo Says:

    Nice balanced approach, Joe. Most people should rest assured that there really is no “right” answer here, despite what many people would have you believe.

    Yes, you should be able to get better returns elsewhere – but how do you put a price on peace of mind?

    This is one case where I now advocate evaluating the pros and cons of each and then going with your gut.

    All the best,

    Len
    Len Penzo dot Com

  3. JOE Says:

    Ha! I appreciate the complement, Neal. I think too much, or so my family tells me,

  4. Deacon Bradley Says:

    I like that you made sure to point out this was a decision for those with no consumer debt, an emergency fund, and actively saving for retirement. Very important! I can see both sides of the argument for paying down the mortgage debt or investing, but only after your loan to value ratio falls below 80% (to avoid needless mortgage insurance). Had this article been published 3 or 4 years ago I bet there would be a lot more resistance to the idea of investing in your security by paying down your mortgage. heh

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  7. Kevin@OutOfYourRut Says:

    One thing that’s important to consider is that when money is paid down on a mortgage it’s “gone”–that is, there’s no IMMEDIATE benefit to the paydown and you can’t get it back out unless you borrow it back out.

    The money paid won’t reduce your monthly payment, especially if you have a fixed rate loan. As Joe lays out, you really need to be pretty stinking sure of your liquidity before making early payments.

    One advantage to savings is that you can preserve your options for a future date. Not true with mortgage pre-payments!

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  10. Mike @ Green Panda Says:

    I agree that there is no “right answer”.

    the best solution will always be the one that you will feel comfortable with at the end of the day ;-)

    Another factor to consider is your risk tolerance and your investor profile. If you do not want to take any risk while investing, don’t even bother and pay down your mortgage as fast as you can! there are now way you can make more money with investments if you are looking only for Certificate of Deposits or Bonds…

    In order to consider investing instead of paying down your mortgage, you are better off willing to take risk and invest in the market ;-)

  11. RainyDaySaver Says:

    If you’re on good financial footing (getting your 401K match, have a solid emergency fund, have no high-interest/any debt), it comes down to being either a sure thing or an investment risk. I prefer the peace of mind that comes with paying off my debts, rather than risking my investments. If I want to invest, I do so through my 401(k) and other, separate vehicles. But I will still aim to pay off my mortgage early, no matter what.

  12. Financial Samurai Says:

    Hi Joe,

    It’s wise you refied to a 15 yr to match your daughter’s college timing.

    I really believe it’s 60% about duration, 30% about the cost of the mortgage including one’s own tax rate, and 10% on your own mental comfort.

    If the spread is greater than 2% on the mortgage and risk free rate of return, I’m happy to start paying it down. Within 2%, I’d rather not, have keep the liquidity.

    Rgds,

    Sam

  13. JOE Says:

    Thanks. When she was born, the mortgage had 28 years to go. We refinanced to 15 when she had 13 years to college, and I’ve made extra payments so far just to end it in time for school.

  14. JOE Says:

    Agreed. Although if a couple maxes their 401(k)s ($33K) and deposits to IRAs ($10K) that’s $43K total, more if either is over 50. If they still have more money to pay the mortgage faster, good for them. I imagine it’s a small slice indeed that can save that much.

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  18. 2million Says:

    After maxing out my wife and my’s retirement accounts, we diversify our remaining cash via our investment accounts, emergency fund/savings, and paying down our mortgage.

  19. Terry Says:

    I am nearly 40 and in the middle of this dilemma right now. Do I keep liquidity for potential start-up cash/living expenses should I lose my job, or rush to pay down the mortgage while I still hold a steady-paying job? I do challenge the amount of liquidity/emergency fund needed in this job market as being more like a year — not a few months. But paying off my Mortgage in 5.5 years seems pretty tempting. Of course, with the Obama administration, 5.5 years in the future could look radically different.

  20. JOE Says:

    A mortgage with “only” a few years to go is still a mortgage with payments due if you lose your job. Liquidity is still important, more so right up to the point where the mortgage is paid in full.
    I agree that a year’s expenses make sense in this climate. As you get closer to the end of that mortgage, you might consider a HELOC (home equity line) as a source of secondary backup funds. The prime rate is low right now, and some banks are running deals of Prime-X%. Our HELOC (no balance) is 2.5%. We do have the emergency savings, but I sleep better knowing I can tap this if there’s a true emergency.

  21. Financial Samurai Says:

    It’s just basic account really. You can borrow up to $1.5 million now at only 3.75% fixed for 5 years now as of July 10th. You can also lock up 7 yr CD money at 3.55% at USAA and spend the interest proceeds if you wish.

    Good to just match the loan payoff duration with when you want to retire like you said.

  22. Mike Says:

    Nice post. Lots of good points. I’m trying to pay my mortgage off in less than 5 years– before the age of 30! I’m throwing everything at the mortgage– because I already have an emergency fund and invest in the stock market. It’s kind of like the Dave Ramsey method, but super-charged. You can follow my progress on my blog, if you are interested. I can’t wait until my mortgage is paid off. It will allow me so much more flexibility with my professional and personal life! To everyone else out there trying, keep it up!

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  24. jim Says:

    Please give me your input. My wife and I are in our mid-50′s. We’ve got just over $500,000 in our retirement funds. We have about $10,000 in savings. Our kids’ college is paid for (no student debt for them). We have no debt other than our mortgage which is at $150,000 @ a 3.35% interest rate. In a few months we’ll be able to throw $1500 extra into the kettle. My question is – should that extra $1500/month all be thrown at the mortgage or should we split it between the mortgage and building up more of our paltry $10,000 ER fund? Any and all suggestions will truly be appreciated.

  25. JOE Says:

    $500K in retirement is doing rather well, in normal times, you’re looking at over $1M by the time you retire, if not more.
    I’d like to toss out one option – funding a Roth IRA for the first $12,000 you save. Here’s my thinking – Kid done with college, no debt, this is great. Also no other debt, just the mortgage. You may very well go through the next 10-15 years with no need to tap that Emergency fund, but if you did, there are things that can decimate it quickly. If the Roth IRA is an option for you, make the deposits, it’s $6000 per year per person over 50 years old. Treat it as the emergency fund, i.e. you don’t invest it in a risky way, short term, low risk, even though rates are low. When your $10K + the Roths pass the 6 month expenses level, that’s when you put additional deposits toward riskier, longer term investments, such as a mix of S&P index funds, and bond funds. But, you always have 6 months minimum expenses with easy access. The dual-use of Roth isn’t popular right now, but so long as you don’t count it twice in your planning, you’ll do fine. A subtle point, but you are not “tapping your retirement account for emergencies” you are “depositing emergency money in tax favored accounts.” This all assumes you don’t already use IRAs, but are using 401(k) accounts at work.

    Second option – set up a HELOC (home equity line of credit) and take the extra $18,000/yr and pay the mortgage off as fast as you can. I don’t know the remaining term, but once it’s paid, you’ll have the extra cash from no longer having a mortgage, and you’ll be able to handle more issues as they occur. For some people, a guaranteed 3.35% is more appealing than any attempt at getting higher returns right now.

    Last – if the above two ideas are out of your comfort zone, yes, save the money in the Emergency fund until it’s about 6 months expenses, then keep investing toward retirement. Understanding how marginal rates work will help you choose pretax (traditional 401(k) or IRA) vs post tax (the Roth 401(k) or Roth IRA) choices.

    I hope this helped. Thank you for writing.

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