As we prepare financial plans for our clients, a common question is whether to pay off a mortgage in advance of the due date. There are several factors to consider when making this decision.
We have two learning objectives for this post:
- To understand the concept that avoiding paying interest is effectively the same as earning interest
- How to quantify the decision to make advance principal payments or to pay off a mortgage
The idea of being “mortgage free” is attractive to many, especially as they approach retirement. Most use mortgages to facilitate the purchase of a home. In recent years, the very low level of interest rates has made mortgage financing very inexpensive.
The cost of utilizing a mortgage is the interest rate charged by the lender. For purposes of this post let's consider the prevailing mortgage rate to be about 3%. By paying off a mortgage, either through making periodic advance principal payments or by paying off the mortgage in one lump-sum payment, you are avoiding the payment of the interest charge and effectively earning a yield of 3%. In other words, avoiding paying an interest expense is the same as earning the interest.
Aside from the peace of mind of owning your home free and clear, is paying off a mortgage early a good idea? Financially it is a pretty easy calculation. If you can invest your cash and earn a higher rate of return that the bank is charging you in mortgage interest, then investing makes sense and continue to pay the mortgage payments on the normal schedule.
But, if you leave the cash in a low yielding money market or certificate of deposit that is earning less than you are paying in mortgage interest, you would be better off paying down the mortgage. Of course, we can’t be certain that our investments will earn more than the mortgage interest rate and paying down a mortgage that is charging 3% is the same as earning a guaranteed return of 3%. Again, avoiding paying interest is the same as earning interest.
Another question that commonly arises is the idea of the equity in your home making you money. This is a misconception. Home prices tend to rise over time but do not rise faster or slower based on the home being owned free and clear versus a home with a mortgage. Home equity does not provide a “return on investment”.
The decision to pay off your mortgage should be based on the math described above, avoiding paying interest is a guaranteed return equal to the mortgage interest rate, and the peace of mind benefits of being debt-free.
For those who want to develop a mortgage pre-payment plan there are many free calculators online where you can specify the amount of additional principal and the frequency of the payments to see how long it will take to pay off your mortgage. One of these is here: https://www.mortgagecalculator.org/additional-payment-calculator/
It is a good idea to call your lender to make sure your mortgage does not have any pre-payment penalties for early payment before sending in the additional principal payment. It’s also a good idea to ask the lender how you should document the additional payments. Most will automatically credit any additional payments toward the principal loan balance, but it is still a good idea to check.
At Integra Capital Advisors we include mortgage concepts in our financial planning process to help our clients make the right decision for them. Call or at (941) 778-1900 or visit www.integracapitaladvisors.com today to set a time for a complimentary introduction meeting.