Paying off your mortgage early can seem like a great idea.
However, others argue that if you invest the money you would have used to pay your mortgage off early, you will likely end up with a higher net worth in the end.
Consider the following situation to figure out whether paying off your mortgage early is the right decision for you.
It should easily show you which option you prefer.
What Would You Do In This Situation?
Let’s pretend you owe $200,000 left on your 30 year 4.0% fixed rate mortgage. You have 25 years of payments left.
Somehow you come across a big stack of cash or, more realistically, get a check for exactly $200,000, just enough to pay off your mortgage.
What would you do with it? If you only had the following two options, would you pay off your mortgage or invest the money?
The answer to this question should tell you whether or not you should pay your mortgage off early.
Pay Off Your Mortgage Early
Paying off your mortgage early would be the safer option for most people. You would get a guaranteed 4.0% rate of return on your money and you wouldn’t have to worry about having a mortgage payment ever again. Granted, you’d still have to pay for insurance, taxes and other housing expenses, but you’d never make another interest and principal payment again.
Another point worth serious consideration is the fact that a home’s value will not remain static. Historically, housing prices have kept up with or exceeded the rate of inflation, which is good news if you pay off your mortgage.
However, recent memory reminds us that housing prices can crash, too. Due to the fact that a buyer and a seller must come to an agreement for a transaction price, when prices drop you could lose a lot more than you would think should you need to sell your home quickly.
Of course, using the cash to pay off your mortgage has downsides as well. By paying off your mortgage in full, you’ve locked up your cash in an illiquid asset.
If you need some of that money for an emergency or any other reason, you’ll have to sell or remortgage your house. Neither of these options can be done quickly and both require major expenses.
You’ll also lose out on the mortgage interest tax deduction. However, this tax deduction is really only for rich people anyway, so it may not affect you.
Invest The Money
Investing the lump sum is the other option. Investing has the potential to give you an overall higher return as stock market returns have generally outpaced 4% by a fair margin over long periods of time.
This option also allows your money to be more liquid should you need to access some of it for any reason. While selling when stocks have lost value would be a real possibility, you could at least only sell part of your investment rather than all of it like you would have to with a house.
Of course, human tendencies of buying high and selling low could easily demolish your return. If you aren’t a skilled investor, and by that I mean leaving your investments alone during market crashes, paying off the mortgage early may produce more reliable returns.
You would still be stuck with a monthly mortgage payment, but if you ever changed your mind later you could always sell your investments and pay your mortgage off at a later date.
Considerations That Must Be Taken Into Account
Keep in mind, this whole analysis depends heavily on a couple factors that not every person would be able to consistently enact.
First, the person must invest every single penny they would have used to pay off their mortgage early. Many people don’t feel the same passion for investing that they feel for paying off debt.
People may put more toward paying off their mortgage than they would put into their investments. If that’s the case, it may make sense to pay your mortgage off early.
The second factor you must consider is your risk tolerance. If you don’t feel comfortable holding investments over a long time period through both bull markets and stock market crashes, paying off your mortgage debt is a safer, guaranteed return. If you sell when markets crash, you could end up with less money in the end than if you just paid your mortgage off early.
Finally, if your mortgage interest rate is anywhere above 6% or you have a variable rate mortgage or some other type of exotic mortgage, paying off your mortgage early may be your best move. Fixed rate mortgages reduce interest rate risk, allowing you to invest over long periods of time and grow wealth through arbitrage.
What Will We Do With Our Mortgages?
In the end, it really depends on your personality and risk tolerance to determine whether or not paying off the mortgage early is the right move for you.
Personally, I don’t believe we will be paying off our mortgages early. However, if we do, it will likely be after we’ve invested enough money to be able to pay the mortgage off with the hit of one sell button.
Of course, we’ll have to remember to factor in the taxes on our investment gains or else we would be hurting when we filed our tax return the next year.
Which camp do you fall in? Would you want to pay off your mortgage early or do you take the more logical approach of letting investments grow? Where do you think people would mess up the most in each situation? I’d love to hear your thoughts in the comments.