Should You Pay Off Your Mortgage Faster?

I have to admit to being conflicted. The numbers say no. The psychology says yes. Let's examine both.



Most first mortgages out there are between six and seven percent, and tax deductible at a marginal rate of about 28%. If you're one of those folks with something in the low fives or even below, enjoy it while you've got it, because the odds of getting something better when you move to a more expensive home or need to refinance are pretty slim.



I'm going to do the numbers based upon 6 percent, with 28% marginal deductibility. This has limits; to wit if your mortgage interest gets to be low enough that you don't hit the threshold where it is worthwhile to itemize, but instead take the standard deduction, that deductibility didn't do you any good. But above that threshold, which is most people, every dollar in interest you spend gives you back 28 cents. I'm also going to assume a 30 year fully amortized mortgage.



Obviously, you don't want to pay an effective 4.32 percent interest rate for no good reason at all, but this does not take place in a vacuum. If you didn't use that money to pay down your mortgage, you could use it to invest elsewhere. For instance, let's assume you could make 8% net on average if you invested this money elsewhere. This is a reasonable average when you consider ordinary income, capital gains, and possibly a certain amount of tax deferment.



Now, some people might think to add in the difference in interest paid, but that is not correct. The payment is constant. Whatever you didn't pay in interest was already applied to principal. To count it again would be double counting.



Let's say you've got $100 extra per month, and a $400,000 loan. I'm going to go yearly 10 years out, then at 5 year intervals. The median time in a property is about 9 years, which means a whole new set of decisions about which property to buy. This is only a valid experiment so long as all of the starting assumptions stay constant, and when you have a whole new set of decisions about which property to buy and for how much, all of that goes out the window, as it is no longer controlled only by the variables chosen at start. Truth be told, refinancing should probably halt the experiment as well.



For the below, I have just summarized the differences. Extra principal is how much more you've paid the loan down with the extra amount, if you did so. Tax cost is the total tax cost of the interest you didn't pay. Investment is how much the money you'd have if you didn't pay the extra, but socked it away in an investment account. Gain/loss is the net result, positive if you came out ahead by making the payments, negative if you should have invested the money.

Year 1 2 3 4 5 6 7 8 9 10 15 20 25

Extra Prin $1,233.56 $2,543.20 $3,933.61 $5,409.78 $6,977.00 $8,640.89 $10,407.39 $12,282.85 $14,273.99 $16,387.93 $29,081.87 $46,204.09 $69,299.40

tax cost $11.12 $43.66 $98.92 $178.31 $283.33 $415.55 $576.64 $768.40 $992.70 $3,218.31 $8,083.64 $16,153.28 $28,545.04

investment $1,353.29 $2,593.32 $4,180.58 $5,772.56 $7,496.67 $9,363.88 $11,386.07 $13,576.10 $15,947.91 $18,516.57 $34,934.51 $59,394.72 $95,836.66

gain/loss -$130.86 -$211.07 -$345.89 -$541.09 -$803.00 -$1,138.54 -$1,555.32 -$2,061.65 -$2,666.62 -$3,380.20 -$8,996.28 -$19,472.46 -$37,638.11

As you can see, the numbers come out fairly strongly for not taking the extra and making payments.



However, the psychology says yes. There's a major sense of accomplishment in paying off the property. Furthermore, once you don't owe the money, you've got it in the form of equity, as opposed to cash, which is all too easy to spend. In fact, most folks will fall off either the investment wagon or the extra payments wagon over time. Money you don't owe cannot be called due. If there's a temporary setback in the market, extra payments make it that much less likely you'll ever be upside down or in an impacted equity situation, although you could also apply the cash from the investment account to your equity or to the rest of your finances, to keep from having to do a cash out refinance. Finally, there's the reduced stress from being mortgage free for (in this case) thirty six months earlier, if you are one of those rare people who manages to pay their mortgage off.



Now, I also have a spreadsheet that compares the net financial result between never refinancing, refinancing every 5 years and keeping a target of paying all loans off in 360 months from the time you bought, and refinancing every 5 years but making the minimum payment. In the majority of cases, the last situation comes out better, largely due to the effects of leverage, but leverage is always a two-edged sword. If things go the way you want, it makes them even better. If things don't go the way you want, it makes them even worse. There are lots of folks getting bit hard by over-leveraging real estate right now. The usual numbers say that making larger payments is likely not the best use you have for the money. But there is a certain psychological comfort in owing less and paying off the mortgage sooner, and occasionally, making larger payments might mean you end up able to sell or refinance when you need to, without those potentially nasty consequences of being upside-down.



Caveat Emptor