Should you prepay your mortgage?

Perhaps no topic in personal finance causes people to make strong opinions as much as the topic of prepaying a mortgage.key-123554_1280

One of the reasons this topic might come up so often is because the math behind the answer changes every few years as interest rates change.  This is strange though, because the biggest factor behind your decision to prepay is usually an emotional one, but it’s unlikely you’ll ever meet your retirement goals by investing your money based on emotions.

Emotions may be front and center because of the marketing that goes behind your decision to buy a house in the first place.  Often you hear you’ll hear that your house is the biggest investment you’ll ever make.  It shouldn’t be, the biggest investment you make should be in your retirement and gaining your financial freedom.

The math for this is easy.  Assume you want to buy a $250,000 house, and you have 20%, or $50,000 to put down.  You then take out a loan for $200,000 at 4.25% interest.  Using a mortgage calculator, you learn your payments are $983.88 a month (assuming no taxes or insurance).  Luckily for you, you were planning to spend $1,500 a month, so you have an “extra” $516.12 a month to spend.  Should you invest it, or use it to prepay your mortgage?

If you prepay, you’ll pay off your mortgage 179 months early, almost cutting the repayment time in half (15 years and 1 month).  Since you expected to pay $1,500 a month on your mortgage over 30 years, and you’ve paid it off on 15 years and a month, you now have 14 years and 11 months to invest $1,500 an S&P 500 index fund averaging a rate of return of 7%.  At the end of 30 years you’d have a paid off house and $479,846.42.

If you instead invest the extra $516.12 a month in an S&P 500 index fund averaging a rate of return of 7%, and take the full 30 years to pay off your mortgage, at the end of the 30 years you’d have a paid off house and $625,989.82.

That’s pretty significant, $479,846.42 versus $625,989.82.  It’s a difference of $146,125.40, or 23.3%.

There are a couple of things to consider.  The first is that many people get a mortgage tax deduction.  It’s a great deduction, but remember it’s never worth paying $10 to get $1 in return.  Anyone who disagrees, for every $10 you send me, I’ll send you $1 in return!  The second is, depending on what you’re investing in, you’ll be paying taxes on the gain.

Think 7% returns are too high?  Here is the return after paying 15% capital gains tax each year at different interest rates.  This is pretty pessimistic, as it’s unlikely you’d pay that much in taxes each year.

Int. Rate No prepay Prepay
1% $212,420 $287,406
2% $243,860 $307,869
3% $281,075 $330,024
4% $325,205 $354,015
5% $377,621 $379,999
6% $439,971 $408,146
7% $514,233 $438,640
8% $602,781 $471,679
9% $708,466 $507,481
10% $834,708 $546,277

Imagine you’re not investing in a Roth IRA, not maxing out an HSA if you have one, or not contributing the maximum to your 401(k).  This is the same chart, but without the tax penalty above.

Int. Rate No prepay Prepay
1% $217,555 $290,900
2% $256,183 $315,488
3% $303,300 $342,487
4% $360,910 $372,140
5% $431,496 $404,716
6% $518,134 $440,511
7% $624,637 $479,846
8% $755,723 $523,079
9% $917,235 $570,597
10% $1,116,395 $622,829

As you can see, the decision to prepay your mortgage is an emotional one in more than one way.  If you invest conservatively and don’t expect to earn more than 4% in interest, you should consider prepaying.

Also, consider the maximum you can invest in certain accounts each year.  Currently you can invest $458.33 a month in a Roth IRA, so if you wait until you have your mortgage paid off to contribute, you’ll lose out on 15 years of tax-advantaged growth.  If prepaying prevents you from investing in tax-advantaged accounts, you may really be limiting your potential returns.

What are some other factors to consider when making this decision?

If you bought a $500,000 house, take out a $400,000 loan, and pay it down to $300,000, then lose your job and have to move, and the housing market collapsed where you live, what will you do?  If you invested in an index fund you can wait for the market to recover before selling the investment, you may not have that luxury with a house.

Another well publicized example is the effort in taking money out of your house.  It’s possible to get a HELOC or do refinance, but it’s easier to sell a few shares of an investment if you have an expense you can’t cover another way.

Another is that prepaying your mortgage provides you with a guaranteed return.  Prepay your 4.25% mortgage by $100 and you save $4.25.

Prepaying your mortgage is also better than letting money sit in a savings account, better than a CD, better than a money market account, better than many bonds, and can be almost the same as stocks, depending on how bad you pick them and how much you invest with your emotions.

A final consideration is if you put all of your money into your house, what happens if you ever want to move?  Where will the money for a down payment on another house come from?  It’s always great to have options.

Like many things retirement related, there’s no single best answer, but it’s really important to have facts to base your decisions on.  If you can’t sleep at night because of the debt on your house, you might want to take a step back and figure out why that is.

What do you do with extra funds, invest them, or use them to pay down a mortgage?

If you have any questions or comments, you can reach out below or continue the discussion in the forum.  If you are interested in receiving a notification of new posts, you can subscribe here.

7 Comments


  1. From another perspective the better question to ask is this: If you had no mortgage would you be willing to take out a new mortgage to invest it in something else? For most the answer should be NO! The risks are virtually the same as in the scenario presented in this article, where you presently have a mortgage and must decide whether to pay it off early.

    Reply

    1. Thanks for the comment. You bring up a really good point, if folks wouldn’t be willing to take out a mortgage to invest the money, they should pay off the mortgage as quickly as possible. What I’d really like people to think about is *why* they wouldn’t be comfortable doing this. In general I think the reason is they don’t trust the markets, and I personally don’t think it’s possible for most people to enjoy a financially secure retirement without investing.

      I actually put my money where my mouth is, and refinanced when rates were at their lowest to buy a rental property. I invested the rest of the equity I had built up in an S&P 500 ETF. I thought long and hard about this, but in the end realized the only reason *not* to do this was based purely on emotions.

      If someone has a $500,000 house that is paid off, and gets a $400,000 mortgage and invests the money, they aren’t as concerned about what the local real estate market does. If values collapse and the house is now worth $250,000, they could walk away if they had to and give the house back to the bank. They would still have $400,000 in the market, which admittedly would probably also have gone down in value since the real estate market seems to follow the markets in general. My investments have grown by double-digit percentages while real estate near my hasn’t budged much in the last decade.

      If someone had a $500,000 house that goes down in value to $250,000 and they sell it for $250,000, they’re out $250,000. If they have a $500,000 house with a $400,000 mortgage that the bank has to sell for $250,000, they are only out $100,000. Of course, this is assuming people had to move. They could also ride out the crisis and hope values return to previous levels.

      I’m not encouraging people to walk away from mortgages! Just providing an alternative point of view. Having a house paid off does give folks a certain flexibility, and it’s important for people to measure what that’s worth against the worth of more money at retirement.

      Reply

      1. Your response is objective and thought-provoking.
        The idea of putting one’s primary home at risk to ‘play’ in any market is too scary for most, even if they realize this means far less diversification in their portfolio. Putting the question in these terms pushes the risks closer to the reader’s face.
        Leveraging one’s home to come out ahead in investments is filled with both promise and risk. A big part of one’s decision about paying off their mortgage early should probably hinge on whether they plan to sell their home to down size or draw down for living expenses after retirement. There is certainly the risk of having to sell in a bad market if those needs have a specific time frame.
        The idea of extricating oneself from mortgage debt by simply walking away may be flawed. Apart from the moral argument, such action would lock in their equity loss if one lacks liquidity to let them wait for market recovery. Going into foreclosure is akin to selling in a bad market, which goes against the precept of buying low and selling high. And let’s not ignore that many states have laws not gentle on those walking away from their mortgage, along with unfavorable tax consequences, where one’s other investments become exposed. Another real risk is disruption and embarrassment when displaced.
        As we have seen, all markets go up and down. By paying off my mortgage early, my primary aim is to be less susceptible to a forced sell in a bad market. There are also BIG tax advantages when one realizes the profit from their primary residence that we should cling onto. That tax benefit is very popular thus unlikely to be taken away. The same degree of popularity may not exist for tax benefits of other investment gains, and thus more apt to change.
        The wise old adage of “a bird in the hand…” is applicable. And yet I must admit one could also apply the opposing adage of “nothing ventured, nothing gained”.
        I am risk adverse. My personal adage is “the better plan has fewer if’s”. The best question is ask is: “Where would you be right now if there were no markets”.

        Reply

        1. You have many informative ideas in your comment. I like the idea of folks who are young putting more money into the market and letting it grow, instead of putting it all into the house. That’s good diversification; they probably don’t have a lot of equity, nor a lot of retirement funds. As you get closer to retirement, and more risk-adverse, it might make sense to cash in some of those investments and pay down or off the mortgage. The upside of this strategy is you cash-in your gains on your own terms. If the market is down, there’s no rush to pay off the loan. If the market is at a record high, maybe you feel better locking in some of those returns. From a diversification standpoint this also makes some sense, as now you probably have a larger nest egg, and it’s not all in the market. Some might be in bonds, some in stocks, and some tied up in real estate.
          To answer your question about where I’d be if there were no market to invest in, I would need more information. If that meant there are no stocks or bonds, and the only avenue for investing is savings accounts, CDs, and Treasuries, I imagine I’d have no debt, and, depending on the decade, few prospects at a long and comfortable retirement! Thank you for sharing your perspectives, it’s great to hear another viewpoint on this topic.

          Reply

      2. Great article. Glad I found this website! This research is helping me clear my head about the future. I’m 25 and live well below my means.

        Do you think a paid off rent house you own free and clear is a better investment than the stock market? Seems like the rental income would even exceed the stock market returns (on average at 7%) of the same money! A $250,000 house that rents at $2,000 a month would be almost a 10% return! I like the stability of rental income, provided you have a good tenant and don’t mind some handiwork! At least I know and can control that better than the stock markets…

        Reply

        1. I’m glad you found the site. I usually don’t think of things as either/or when it comes to financial planning. Investing in the market is great, and owning a rental property is great. If you can purchase a rental with cash, then there’s no reason you couldn’t do both as well.

          There are some advantages to owning a rental outright, but it might be a worthwhile exercise to play with tax software to see how much in taxes you’d owe if you owned the rental outright, and if you had a mortgage. If you own the rental outright, you don’t have to come up with a mortgage payment each month, though would you be spread thin if you had to pay taxes and utilities if you were unable rent it out? You might get $2,000 a month on a $250,000 house, but you’d have income taxes and maintenance costs as well. It doesn’t have to be all or nothing either. I’d suggest running the numbers either way and seeing which you’re more comfortable with.

          Reply

          1. Thanks for the input. I have the income available already to cover the expenses as needed. I’ll look into the tax strategies. I think it would be a good addition to my investment portfolio someday!

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