Should you pay off your mortgage early?

Paying off your mortgage early is an obvious plan for some and a foolish proposition for others.

The naysayers argue that at the low mortgage rates we have locked in, paying off a mortgage is less advantageous than seeking a higher return on capital elsewhere.

The proponents say that paying down debt reduces risk and improves cashflow; this tradeoff between return rate and risk is worthwhile.

As residential mortgage rates creep higher, the question of mortgage payoff will become louder as more people purchase their next homes.

Paying off a mortgage provides incredible returns

Mortgage payments are not composed of simply principal and interest. For many, the mortgage payment is actually composed of four parts: (1) Principal; (2) Interest; (3) Taxes; and (4) Homeowner’s Insurance, sometimes abbreviated PITI. The taxes and insurance payments typically are held in escrow until they become due, at which point they are paid.

Mortgage principal is not repaid in the most intuitive way. When borrowing to purchase a home, the repayment is normally amortized over a certain time period such that the interest and principal portions change over the life of the loan. The payments are structured so that the interest is front-loaded.

In the course of the article, I used mortgage calculators to show how you can achieve returns of over 500% in less than a year by paying extra toward your mortgage.

Why are mortgage payments front-loaded with interest?

Consider that many people do not ever pay off their homes but may instead refinance, move, or default. If you were the bank, how would you ensure that you received compensation fairly for taking the risk of lending a large amount of money for the purchase of physical property?

You would make sure the property was insured against loss (this is the homeowner’s insurance paid by the borrower).

And you might take your fees upfront. That’s what mortgage companies effectively do when they amortize the loan.

The magic of amortization tables

If reading about amortization tables sounds like watching paint dry, you’re in good company.

The words are boring. And yet the math is staggering, so I want to highlight how having a mortgage can be shockingly expensive, particularly in the first few years.

A few days ago, we closed on a small property in Georgia with a 30 year fixed loan at 6% APR. In order to secure this rate, I paid for points, which are essentially fees the lender charged to reduce my interest rate.

In short, here are the stats.

Total purchase price: $240,000

Loan amount: $180,000

Interest rate: 6%

Monthly payment: $1,079 (principal and interest only)

When you close on a house, one of the documents the lender is required to show is the amortization table, which lists each mortgage payment and shows how the payment is applied to the mortgage principal.

I have only purchased homes in a low interest environment; I know that loans are front-loaded but SOME of the mortgage payment always goes towards principal. However, at 6%, the amortization table is eye-popping.

Of each $1,079 I pay to the bank to repay my loan, less than $200 is applied to the total loan amount. The grand majority, of my payment, or $900, is applied to interest.

What that amounts to is this: over the next three months, I will pay over $3000 in monthly payments to the bank. But I will only pay down my mortgage by $541 in that time.

In order to pay down only $10,000 of principal, it will take me FIVE YEARS of payments. In that time, I will pay nearly $45,000 interest.

What If I Paid Extra Toward My Mortgage?

If you’re like me, you looked at that table and thought the solution would be to skip the early years. Did you know you can do that? You can jump ahead on the amortization table by making large lump sum payments toward the mortgage balance.

In other words, if I took $10,000 out of my savings and dropped it into this mortgage on the day it closed, I would instantly shave $45,000 of interest payments over the next five years. That’s a 4.5x return immediately.

And the next day, when I owed $169,619 on the mortgage, the monthly payment would be allocated differently.

This gets interesting if you have the ability to apply a large lump sum payment more than once.

What if I applied another $10,000 to the mortgage principal? That is, what if soon after closing, I paid $20,000 towards the principal?

At that point, I would have accomplished over seven years (!) worth of payments and saved myself $74,419. That’s a slightly lower return of 3.7x. And now if I do nothing else, I will pay off my mortgage in 23 years rather than 30.

Paying off mortgage early with extra monthly payments instead of lump sums

Not everyone has an additional $10,000 sitting lonely in the corner gathering dust. If making a large lump sum payment isn’t realistic, can you accomplish the same thing with making additional monthly payments?

For example, $10,000/12 = $833.33. What if I paid $834 every month as additional principal towards my loan?

The result? In ten months, I will have accomplished the $10,000 reduction in principal balance. That’s $8340 investment to save $45,000 interest payments. That’s a 5.4x return.

What if I keep these $834 extra payments on board forever – how long will to pay off this home? Less than 11 years. The total cost of interest is $62,500.

Compare that to the total cost of interest if you had never paid a dime extra toward the mortgage. I will have saved $146,000 interest. What’s more, I will never have to pay towards this loan again after 2033 and will get to keep the $1079 principal an interest in my pocket.

Should you pay your mortgage off early

I am not a banker, accountant, lawyer, or financial analyst. Because of this, I can’t give you official financial advice, so take this for what it’s worth.

You should not deplete all cash reserves to pay off a mortgage early. Neither would I recommend solely focusing on paying off a mortgage at the expense of ensuring strong liquidity. If you don’t have 2-3 months of living expenses saved in cash and at least six months in a brokerage account, make that your focus first.

After all, if you have an emergency such as lost job, blown tire, or home repair, you won’t turn to your partially paid off mortgage for help.

But if you’ve already laid your financial foundation and still have excess, then I would strongly suggest exploring mortgage payoff, particularly in the early years of a high interest mortgage.

Use an amortization calculator like the one at bankrate to help you run scenarios and make the optimal decision for your family or business.

Will I be paying off my investment property mortgage early?

Yes.

We are choosing to do this because we are buying investment properties to create financial independence. I have written about this elsewhere, but I believe all physicians should seek to achieve financial independence.

Having a clear vision of the purpose and goal is imperative in making decisions of this magnitude. After all, there is opportunity cost associated with allocating income towards mortgage payments that I haven’t discussed.

Scenario #1: Invest instead of pay loan down

Using an investment calculator, I can see what would happen if instead of putting $834 towards my mortgage, I invested the money. Here I’ve made an assumption that I’m starting with $100 in my investment account and have found an investment with an expected annual return of 8%. I’ll say that I make this investment for 11 years, because that’s the time it took me to pay off the mortgage in the alternative scenario.

At the end of 2032, or 11 full years of investing, I will have $139,057 saved. On the home, over this 11 years I will simultaneously pay $111,000 of interest. But I will only have achieved principal payoff of $34,000.

Scenario #2: Pay off investment property

Compare this to the mortgage pay-off scenario. At the end of 11 years, I will have paid off my home ($180,000) and have paid $62,000 interest. Over the life of the 30 year loan, I will also have an interest savings of $146,000.

What’s more, I will have a paid off investment home that will put far more than $1,079 in my pocket monthly. Currently the home rents for $1,800.

If I ever want to retrieve my liquidity, I haven’t lost the $180,000. I can sell my home to retrieve the cash. In the meantime, if the home has appreciated, there’s another opportunity for gains.

Put this way, I will definitely prefer to pay off my home early. I’m looking for cashflow in the future. I’m looking to de-risk and de-leverage in order to feel more financially secure.

That’s my scenario. I hope you found this helpful in thinking through your own decisions.

Thanks for reading.