Brad Tinnon

Brad Tinnon

Should You Pay Off Your Mortgage Early? Part I

Recently I received a mailer from my mortgage lender that stated if I pay an extra $150 per month to my payment then I would save $24,866 in interest. But is this actually a good idea? This week and next, I’ll discuss four reasons why it’s usually bad advice to pay off your mortgage early.

OPPORTUNITY COST

Today, I will highlight opportunity cost. It is one of the most important reasons why you typically shouldn’t pay off your mortgage early.

Since 2010, 30 year mortgage interest rates have been below 5%. And today, they hover around 4%. This is such a low interest rate that it begs the question of whether or not it makes sense to pay off a mortgage early just to save a low amount of interest.

It’s true that if I pay an extra $150 per month to my loan that I will save $24,866 in interest. But saving interest is not the same thing as making money.

This is a very, very important concept that I’ll explain in a moment!!

Option 1: Invest Money

If I pay extra toward my mortgage, then I lose the “opportunity” to do something else with that $150. If instead I invested that money monthly in an account that earned 6% per year, I would end up with $128,525 at the end of my remaining loan period (roughly 27.5 years). As the investment rate of return increases so does the benefit. At 8%, I would end up with $184,316. At 10%, $269,537.

Option 2: Pay Extra Toward Mortgage

If I pay an extra $150 per month toward my mortgage, then I will pay off my loan in around 20 years; a full 7.5 years sooner than the scenario above. This means that at the 20 year mark, I won’t have a mortgage payment (currently $675 per month) and I can then save that amount plus the extra $150 per month for 7.5 years.  At the end of that time frame I would have accumulated $94,822 at a 6% annual rate of return, $102,979 at 8%, and $112,029 at 10%.

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When comparing the two scenarios, you can see that I would end up with significantly more money by investing as opposed to paying extra toward my mortgage. In other words, it’s not the interest you save that matters, but the wealth you create.

So, hopefully now you can see that that saving interest is not the same thing as making money. Even though interest of $24,866 would be saved if I paid extra toward my mortgage, I really don’t have a pot of money equal to that amount when the loan is paid off. Instead, I simply have a loan that is paid off early. 

There are two very important takeaways here. First, if your investment can earn a greater rate of return than the interest on your mortgage, then it is financially more beneficial to invest your extra money instead of applying it to your mortgage. Second, investing a small amount of money over a long period of time is usually far more beneficial than investing a large amount of money later on in life. 

Another fact supporting investing over paying off your mortgage early, and further benefitting you financially, is that if you itemize deductions on your tax return, then you can claim a deduction for mortgage interest. This effectively lowers the amount of interest you pay on your mortgage.

For example, if your mortgage interest rate is 4% and you’re in the 25% tax bracket, then your effective mortgage interest rate would only be 3%. And now your investment only has to earn more than 3% for it to be financially more beneficial to invest instead of paying extra to your mortgage. This is often times what I describe as an effective way to use leverage (i.e. mortgage debt) to your advantage.

So, if you are exploring whether or not you should pay off your mortgage early, I encourage you to give opportunity a chance. 

Stay tuned for next week’s blog post where I will go through the other three reasons why it’s usually bad advice to pay off your mortgage early.

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Brad E.S. Tinnon
CERTIFIED FINANCIAL PLANNER™
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