Welcome to Phase 8. Let’s talk about different ways that you can pay off your mortgage and what paying it off early can do for you. As we talked about earlier, some people may choose to prioritize Phase 8 over Phase 7 – Save Outside of Retirement Accounts and that’s totally ok!
I think it is a good idea though to take a look at why you may want to pay down your mortgage before investing outside of retirement accounts or vice versa.
Pay off your mortgage before you invest
The “pay off your mortgage first” camp likes to use one or more of the following arguments:
- Paying off your mortgage is a guaranteed rate of return–in the form of interest savings–of whatever your mortgage interest rate is. If your mortgage rate is 4% and you throw a $1,000 extra payment at your balance, you’ll automatically save $40 ($1,000 x .04 = $40). The stock market does not guarantee a return.
- Not having a mortgage payment reduces the risk of a foreclosure.
- It will feel liberating to not have a mortgage payment.
Invest before paying down the mortgage
On the other side of the fence are the people who advocate investing any extra money before using it to pay off your house. Some of their reasons are:
- Over a long period of time, the stock market is likely to yield a higher return on your money than you would save by paying down your mortgage early (especially when mortgage rates are around 4%).
- You’ll lose the tax deduction for mortgage interest.
- Home equity is not liquid. If you need the money, you’ll need to get a home equity line of credit.
- After 15 years, your current payment will seem like nothing when you factor in inflation.
Both sides have some very valid points, but I would like to address a few in particular because I think their signficance is overstated.
Let’s start with the “not having a mortgage payment reduces the risk of foreclosure” argument. The aim of this argument is to convince you to pay off your mortgage faster. At first glance, it seems obvious. If your mortgage is completely paid off, then of course you can’t be foreclosed on–you have no loan! But what if you’re in the process of paying off your mortgage, haven’t completely reached a zero balance, and lose your source of income? In this case, your savings has not increased because you’ve been applying the funds towards extra mortgage payments. As soon as you miss a payment, the bank doesn’t care if you’ve been making extra payments for the previous three years! If this money had been invested in the stock market, you’d at least have some extra cash laying around that is realatively easy to free up. You’ve got your emergency fund to cover you, but what if you’ve got a prolonged period without income? It would be nice to have accesible money laying around. Yes, you could lose a lot of it in the stock market, but chances that you’ll lose more than 50% in a given year are slim if you’re investing in index mutual funds. Personally, I’d prefer to sell at a loss and keep my house if I were in this position.
Another argument that is a little exaggerrated is the mortgage interest tax deduction. If you’re in the 5th year of a 30-year, $200,000, 4% mortgage then the total interest you can deduct from your taxes is approximately $7,325. If your marginal tax rate (read this article about how tax deductions work) is 25%, then this saves you about $1,831 on your taxes (0.25 x $7,325 = $1,831). Sweet! You saved almost two grand. But in order to do this, you had to spend $7,325 in interest charges. This is the financial equivalent of “I ordered a diet coke so I can get a double-cheeseburger”. Sure, if you must pay mortgage interest, it is nice to deduct it, but wouldn’t you prefer not to pay any at all? This tax deduction disappears faster the closer you are to the end of your mortgage since more of your monthly payment is going towards the principal. The same mortgage in the 25th year would have approximately $2,274 in mortgage interest which is less than the standard deduction for taxes. Check out the table below to see how interest vs principal changes over time:
The table above shows information for a $200,000 loan at 4% interest.
The Stacking Method for prepaying your mortgage
You can make constant extra payments towards principal or pay in lump sums, but my favorite method is what I like to call the stacking method. You make a regular extra payment that gets progressively larger each year. It works like this: You start out by paying an extra amount towards the principal.
For this example, let’s say you start off by paying an extra $100/month. Then, each year when you get a cost-of-living wage increase, you bump up your payment amount by something like $50. You’re now paying an extra $150/month towards your mortgage. The year after, you add another $50/month to the payment which means you’re at $200/month.
By timing the increase with your raises, you don’t even notice the difference! As you can see from the chart below, the stacking method has a profound effect on when your mortgage reaches a zero-balance. For a $200,000 loan at 4%, you would have the loan paid off after only 16.3 years versus 25 years for a constant $100/month payment or the 30 years that minimum payments would take.
Deciding to prioritize paying down mortgage debt over investing the money is as much of an emotional choice as it is an analytical one. One key theme of this blog is to improve your finanacial well-being to reduce worry. If paying down your mortgage reduces your worry-levels, then perhaps that is the right choice for you. If you feel that it is a safe bet to make minimum payments on your mortgage so that you can earn higher returns in the stock market, then go for it.
If you can’t decide, then simply do both. Even small amounts invested in the stock market or applied towards your mortgage balance can make a big difference over many years. Consistency is the secret to success.
- Decide whether paying down your mortgage is the best option for you.
- Start by adding an extra amount to your monthly payment. Remember: automate, automate, automate!
- Every time you get a raise, bump up the extra payment a little bit. The amount is less important than being consistent.