Paying Down a Mortgage Early: Pros and Cons
As Kim and I look forward to our future, we regularly consider a variety of investment and savings options to help us achieve our financial goals. Earlier this year, we decided to make paying down our mortgage balance ahead of schedule a component of our overall investment strategy. After weighing the pros and cons of the decision, we’re still feeling good about it and will likely continue with the strategy throughout next year. Here’s the pros and cons as we see them. Feel free to weigh in with your own observations.
Pros & Cons of Mortgage Pay Down
Pros:
- Guaranteed return on investment. Our mortgage rate is 5.75%. We’re in the 25% marginal tax bracket and itemize our deductions sufficently to take advantage of the full tax break. This means our guaranteed return is reduced to 4.32% on all of our principal payments. This return fairs favorably against the 30 year T-Bond, which is yielding only 4.2% before taxes, and a 3.15% after taxes.
- Peace of mind. There’s a Proverb in the Bible that says the borrower is a slave to the lender. I think that Proverb has a lot of wisdom wrapped up in it. Being a borrower puts you in a position of obligation to another. Owning your house outright removes that obligation, and gives you greater mental freedom.
- Built in discipline. It’s hard to get money out of your home (you must refinance unless you have HELOC). As a result, its easier to forget about the money you’ve invested in paying the mortgage.
Cons:
- Other invesments offer higher returns. While this year has been terrible, historically the stock market has outperformed our modest 4.32% return. Of course, with higher returns comes higher volatility & risk. As I noted, for a comparably risky product (the guaranteed 30 yr. T-Bond), early pay down fairs better.
- Other investments offer tax advantages. For instance, investing in a 401K, Roth IRA, or municipal bonds allows you to avoid taxes either on the front or back end of your investment. Since mortgage loan interest is tax advantaged, it may be better to exploit all possible tax-advantaged investment options before paying down a mortgage early.
- Your investment is tied up. Once you pay down your mortgage early, the money is returned to the mortgage company and it is difficult to get access to those funds again (you must refinance). As a result, it’s hard to re-purpose your investment if you decide to be more aggressive.
Why We’re Paying Down our Mortgage Early
The bottom line for us came down to the psychological aspects of looking forward to debt-free living, coupled with viewing early pay down as a better conservative component of our investment strategy. Also, we’re already making near maximum use of the most popular tax-advantaged contribution vehicles (e.g., 401K).
If interest rates skyrocket in the next 10 years, we may find that we regret not having our money in some kind of inflation-protected security. We’ll be forced to live with our ongoing 4.32% return, despite other vehicles that might safely offer double that in the future. If that does happen, though, we’ll at least shift future investments into inflation-protected securities.
What do you think? Do you pay down your mortgage balance early? Why or why not?
Photo courtesy of WoodleyWonderWorks.
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6 Responses to Paying Down a Mortgage Early: Pros and Cons
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November 13th, 2008 11:40 am
Did you have any timeline considerations for your paydown decision?
I’m not confident I’ll be in my house more than five years from today (bought just over a year ago). Would this have an impact in the pros/cons?
Maybe by paying down more till I sell I get my loan rate back as “profit” at time of sale?
November 14th, 2008 1:32 am
Hi Chris,
Paying down the mortgage will net the ‘profit’ you describe when you sell your home. It’s not really profit of course, just money you already paid to the bank that you won’t have to pay them at settlement, so it becomes “cash to the seller” at settlement.
You can think of the time period until you sell your house as the term of the investment you’re making in paying down the mortgage. For instance, if you’re planning to sell in 10 years, you are effectively making an investment where the yield is the %rate on your mortgage for 10 years. In our case, since we’re planning to stay for 10-15 years, we’re getting 4.32% on our money for 10-15 years.
Plus, when we go to sell the home, we’ll have more cash at settlement because we won’t owe the bank as much. That means we can make a bigger down payment on the next home, or use the money for the kids’ colleges, etc. Now, if instead of investing in the mortgage, we bought a comparable asset like T-bonds, we wouldn’t make as much return on the money.
November 18th, 2008 3:07 pm
I’m paying mine down as fast as I reasonably can. Partially because I have an aversion to carrying any kind of debt but also for the cash flow. While I may be able to earn more elsewhere (questionable in this market), I dislike paying interest to someone else even more that I like earning it. Also, having my mortgage paid off just gives me more flexibility as to how I spend my money. I can invest if I like it but if there is a month where I want to or need to make a large purchase I’ll be able to make that call without having the fixed expense of a mortgage and having to finance large expenses. It will also free funds up for large expenses later in life like helping my kids with college tuition. (They are currently 3 years and 6 weeks)
November 23rd, 2008 1:00 am
Rob — Sorry I missed this when you originally left the comment. Yeah, there’s definitely something nice about having the flexibility. I think this gets back to the psychological aspects of obligation for a monthly payment. Its just easier not to owe someone a monthly payment… gives you tremendous flexibility and freedom.
March 25th, 2009 10:59 am
Hi! I have a school project that discusses these pro’s and con’s.
I am “buying” my first house of R650 000 (I’m from South Africa) and want to take out a mortgage bond. Now, if I pay for a bond of 20 years, compared to paying off a bond of 30 years, what are the pro’s and con’s? I thought that you might be able to help with this.
Pro’s for 30 year bond are: More cash flow; more flexibility to apply money
Con’s for 30 year bond are: Pay much more ( If you work it out, another R625 000 about extra!)
But I cannot really think of any others.
If you have time, please can you explain some more to me. I would really appreciate your help very much!
Thank you
March 28th, 2009 11:14 pm
Rhoni – I can say you’re probably one of the furthest visitors we’ve ever gotten to our site. Welcome! You’re analysis is correct.
The only advantage of a 20 year bond would be the lower interest rate (if it has a lower rate). Otherwise, you should get the 30 year bond and pre-pay on the loan. Make sure there are no “pre-payment” penalties on the 30-year bond. In the U.S., there are no prepayment penalties by law; not sure in S.A.
Good luck!