Phase 8 – Pay Off Your Mortgage

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.

Analysis

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:

Year Interest Paid
1 $7,935.92
5 $7,325.90
10 $6,412.70
15 $5,297.72
20 $3,936.33
25 $2,274.08
30 $244.48

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.

pay off your mortgage

A chart showing normal, constant extra payment, and stacking extra payment scenarios. Assumptions are a 30-year, $200,000 loan amount, at 4%. The blue line shows the effect of a $100 extra payment every month for the life of the loan. The green line shows the effect of starting out with an extra $100/month payment, then stacks an extra $50 on the payment each year.

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.

Action Steps
  1. Decide whether paying down your mortgage is the best option for you.
  2. Start by adding an extra amount to your monthly payment.  Remember: automate, automate, automate!
  3. Every time you get a raise, bump up the extra payment a little bit.  The amount is less important than being consistent.

8 thoughts on “Phase 8 – Pay Off Your Mortgage

  1. Lucas Escalera

    I believe paying off the mortgage is the way to go. I just retired at 56, and have a mortgage off 308K. I have 1.4M in my retirement account. Should I take the 308K out and pay the mortgage? All advisors say not to for 1) the tax deduction, and 2) the penalty for early withdrawal.

    Your opinion is appreciated.

    1. Will Post author

      Congrats on the retirement, Lucas. Retiring at 56 is quite a feat and I’m guessing you had to invest consistently throughout your career to get there. Truly a role model!

      I’m going to agree with the previous advisors you spoke with. The penalty incurred from taking early distributions wipes out a significant amount of savings that you’d save on mortgage interest. Another thing to consider is how reducing the principal within your retirement accounts will affect cash flow. If you’re using the “4% rule” to withdraw from your retirement portfolio, a $300k reduction of principal means you would go from a $56,000/year to a $44,000/year withdrawal rate… Though the elimination of your mortgage would surely soften the blow. There would also be a pretty significant tax liability if you were to pull out all $300k in one year to pay off your mortgage.

      If paying off your mortgage faster is something you’d like to do, then perhaps space it out over a few years (after you turn 59.5 to avoid the early distribution penalty) to avoid a big income-tax hit as a result of the distributions.

      One final thought is that there is some pretty extreme pessimism in the markets at this time which means only one thing to me: it’s a bad time to sell!

      1. Lucas Escalera

        Thank you. I will reconsider my mortgage pay off strategy. In addition to my investments (which are allocated to 89% bonds, and 11 % S&P 500; and I may want to buy more stocks as the market bottoms out), I have income from a pension.

        Would you agree that I should use my pension and a monthly distribution from the investment to implement a stacking strategy that will pay off the mortgage in @ 5 years?

        1. Will Post author

          If you’d like to pay off your mortgage off soon, then I think your 5-year stacking strategy would work very well. You could put on a twist on it though to maximize performance. Instead of stacking in a dollar amount, stack your payments by selling a predetermined a number of shares each month (increasing every year to make the “stacking” part). The amount that you pay down each month will fluctuate with the market, but you’ll net a higher average price. Here is a great article from the NY Times on the science of selling shares of equity: NYT – Science of Selling.

          Spreading out the accelerated payments gives you an opportunity to minimize tax implications from selling shares out of your 401k by keeping your income below a specified marginal tax rate. Something interesting to ponder would be if your mortgage rate is higher than what you earn from your bonds–you’d essentially be making better use of the money.

          One other note: I did don’t realize that you were collecting a pension. Depending on your circumstances, this may be an exception to the 59.5 year rule for 401k distributions. You can read more about it from the IRS website here: Exceptions to Tax on Early Distributions. Scroll to the bottom.

  2. Penny @ She Picks Up Pennies

    Sometimes I read posts like this and realize just how right-brained I really can be. I just double my payments every month and then put in whatever side hustle money that I’ve earned as well. It would not make nearly as neat of a table, graph, or chart…but it’s working!

    As for the order of investing/mortgage pay off, we’re kind of in a weird situation. My husband and I both put 10% of our salary towards our pension (no choice) and max out our Roths. But we’re not doing anything over than that right now. Instead, we’re trying to frantically pay off our mortgage debt. It might be a bit of a cowardly way out…BUT I’m pretty happy with it currently. We reevaluate every 6 months :)

    1. Will Post author

      Hey, whatever works right? Definitely not a cowardly way out, just sub optimal from a pure math standpoint. Personal finance is about so much more than math though.

  3. dana

    Hey cool blog, I like your graphic. I might be doing this the wrong way round, my step 8 is step 4 except we have no debt. We have 46k left. earn 80k a year, i am 40. I am enjoying paying off the mortgage, it is really FUN! So there is something to be said for that right? Also mine is a 5.95% – seems pointless to refinance with only 46k left right?so in that case, i am better off selling some commodities and paying it off in 2 years.. a return of 5.95 on 46k? not bad? I am not good with numbers but that is what i am doing currently. I also put 1k in there a month, this month was 2k yay! i already have a 403b with 5% and 7% employer match. I intend to look into the Roth thing you mention, see if i should do that instead of putting my percentage up. Not sure.

    1. Will Post author

      Thanks, Dana. Glad you’re enjoying paying off the mortgage :). There is absolutely something to be said for paying down a debt that is costing you 5.95%. That being said, don’t neglect your retirement accounts! If you’re getting your full match already in your 403b, then a Roth could be a good move for you. If it were me, I would be putting $450/month in my Roth (low-cost index fund!) before paying off my mortgage. When you retire, you’ll have a tax-free source of income. You’ll still be able to put $500+ per month towards the house with this kind of strategy. What kind of assets are you planning on selling to help pay off the house? I think that would be a great idea, but I wouldn’t sell off my retirement assets in order to pay down my house faster.

      Overall, it seems that you’ve got the most important part figured out: your attitude. With a few small tweaks, you could improve things even more!

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