Should you pay your mortgage off early?

It seems like every year I end up having three or four discussions with various people about the merits of paying off your mortgage early.  It can be a relative, a client or even a casual acquaintance who will ask my opinion during the course of the conversation on their strategy to pay off their mortgage early.  It comes up so often that I figured some of my readers may also have the same question and that it would be helpful to address it here.

Before I list the reasons why I believe it isn’t always in your best interest to pay off your mortgage early, let me say that owning your home outright is a very noble goal that everyone should aspire to achieving.  The problem for many people, especially younger people, is that they are often working towards achieving multiple financial goals simultaneously.   And when they focus on one goal such as paying off their mortgage early, it often comes at the expense of funding other financial goals like retirement or a child’s college education.   So despite the conventional wisdom that says you want to own your home outright, here are a few reasons why you may want to pay down your mortgage at the normal 30 year pace.

Investment Returns:  Houses are both a source of shelter (physical necessity) and an investment, and for many people are a superior alternative to renting.  But as an investment your house is a poor substitute for a well-diversified investment portfolio.  Housing markets can experience periods of boom (remember the 1990s?) and periods of bust (2007 should still be fresh in everyone’s memory).  But according to the S&P Case-Shiller home price index, historically you are looking at a 2 to 4% annual investment return range on your house.  And since inflation has historically run at a 3% clip annually, your house’s appreciation essentially keeps pace with inflation.

Liquidity:  Compared to a lot of other investment vehicles, your home is a very illiquid investment option.  With regular investment accounts when you need access to money, you or your financial advisor places a trade and you have access to the money you need in a week or less.   To take money out of your house, you either need to sell the house or obtain a home equity loan or home equity line of credit.  Both are significant transactions in terms of time and cost, and take much longer than a week under most circumstances.

Foreclosure Risk:  Owning a house is an unique opportunity to capture 100% of the house’s appreciation while possessing less than 100% of the ownership (equity).   But there is a downside to this opportunity.  You can own 99% of the house’s equity through payments you have made to the lender, but the lender will begin legal proceedings the first time you miss your mortgage payment.  And if you eventually do face foreclosure, you risk losing 100% of the equity you have in the house even if your outstanding loan is a very small percentage of the original mortgage amount.

Financial Leverage:  When my wife and I purchased our home two years ago, we were able to secure a 30 year mortgage with a 3.50% interest rate.  With the tax deductibility of mortgage interest, we are probably borrowing at a cost closer to 3%.  Now assume that I can invest in a strategy that gives me an expected return of 7% (over time).  Every dollar that I don’t use to pay off my mortgage costs me 3.5% in interest charges (really closer to 3% with tax savings), but I can earn 7% on that dollar.  That puts me 3.5% ahead by investing the dollar and not repaying the mortgage early.  And if I use that dollar to repay my mortgage earlier?  I’m robbing myself of a 3.5% gain (over time).  That is what is known as financial leverage:  borrowing at a lower cost and earning a higher rate of return on the borrowed money.

The Power of Compound Returns:   There is no middle ground with compound returns; they either work for you or against you.  When you pay off your mortgage early, you are allowing compound returns to work against you.

A simple example can illustrate just how costly being on the wrong side of compound interest can be.  On one hand we will look at Ken who is paying his mortgage off at the normal 30 year pace, and investing $500 a month in an account that has a 7% annual investment return.  On the other hand we have Stacy who is putting an extra $500 a month towards her mortgage payment of $1,200 a month and not investing anything extra until the mortgage is paid off.  In year 21, when the mortgage is paid off Stacy will then invest the original $1,200 mortgage payment and the extra $500 a month in an investment account that earns a 7% annual investment return.  Who will be further ahead at the end of 30 years, neglecting taxes?

If you plotted the information from the example into your own spreadsheet you will see that Ken has an investment account worth $606,438.25.  By comparison, Stacy has almost exactly (but not quite) half of what Ken has with her investment account worth $301,585.43.  Both have paid off homes, but Ken has more than twice as much in his investment account than Stacy has in hers.

As you can see, there are many variables and considerations when determining whether to pay your mortgage down early or not.  I have listed five reasons why it may not be in your best interests to pay your mortgage down earlier, but there is no absolute right or wrong rule to follow.  If you want to maximize your wealth you may want to reconsider paying your mortgage down early.  If you get peace of mind from knowing that you own your home debt-free, then that is the right strategy for you.