When mortgage rates are low and the stock market is routinely hitting fresh highs — which has been the situation for most of the past dozen years — it’s easy to understand why investing is a more attractive financial option than prepaying a mortgage. After all, why pay ahead on a 3% loan when you can earn a much greater return in the market?
But with stocks (and bonds) tumbling in 2022, and with mortgage rates rocketing to levels not seen in almost a decade-and-a-half, mortgage prepayment is taking on a new shine. Saving money on interest seems a much better deal than losing money in the market.
But there’s a case to be made for not prepaying, too.
For one thing, most homeowners locked in low rates on their existing mortgages years ago. They aren’t affected by rising rates. Further, the current bear market presents an opportunity to purchase shares while they are “on sale.”
Add one more consideration to the mix: inflation. Fixed monthly payments for current homeowners will effectively “cost less” in the future. That’s because the amount of a monthly principal-and-interest payment won’t change even as prices rise for everything else.
Taken together, these factors suggest that most homeowners won’t see any dollars-and-cents advantage in paying ahead on their mortgages.
Still, the question of whether to prepay a mortgage isn’t reducible to a matter of math. Instead, it involves thinking about one’s “future self,” and about the financial freedom that results from not having a mortgage payment in retirement.
More than money
Although the “strictly financial” case for not prepaying a mortgage is reasonable, we believe most people would benefit from these suggestions.
Set a goal of paying off your mortgage by the time you retire.
The simple fact is that retirement works better without a monthly mortgage payment! Over the years, we have heard from SMI readers who paid off their home loans by the time they entered their retirement years. Each spoke about experiencing a great sense of freedom — the result of no longer having a large, monthly financial obligation.
Even if you’re not planning to retire by age 65, we suggest trying to retire your mortgage by then. It’s possible (if not likely) that your plan to continue working won’t pan out. Although most of today’s workers hope to work past 65 (PDF), relatively few will — at least if the post-65 experience of current retirees is any guide.
Indeed, many current retirees were forced to leave the paid workforce earlier than they intended, often because of health issues or company downsizings.
Put the mortgage-payoff goal in its proper place.
Wise money management involves setting priorities. Although paying off a mortgage early is a good idea for most people, other objectives should be higher on your financial-priority list.
First, concentrate on building an emergency fund large enough to cover one month of essential living expenses. Next, focus on paying off non-mortgage debt, such as credit card debt, car loans, and student loans. Then, work on expanding your emergency fund from one month’s expenses to three-to-six months’ worth.
Have all that done? Great! Prepaying your mortgage may still need to wait, depending on your retirement-savings plans (and to a lesser extent, college-savings plans, if applicable). Once you’ve met initial savings and debt goals and your retirement-savings plans are underway, then you can start prepaying your mortgage.
Prepaying has two appealing benefits.
You’ll save a lot of money.
Suppose you’ve just taken out a 30-year, $250,000 mortgage at 5% interest. If you held that mortgage for the entire 30 years, you’d pay a total of $483,139 — including more than $230,000 in interest!
But if you added just $100 to each payment, directed to principal, you’d pay off the loan four years early and save nearly $39,000 in interest. (The higher the mortgage interest rate, the greater the savings.)
You’ll gain peace of mind.
As noted earlier, the sense of freedom people experience from no longer having a mortgage is huge. It’s an emotional factor that can’t be reduced to a price tag.
Bear in mind that even if you have your home loan paid, you’ll still be on the hook for insurance costs, maintenance expenses, and property taxes.3 But being mortgage-free gives you the financial flexibility to (1) withstand economic tough times and (2) readily respond to God’s leading.
Doesn’t my interest rate matter?
Some argue that the case for prepaying vs. not prepaying depends on the loan’s interest rate. The conventional wisdom for homeowners whose rates are relatively low is to not prepay; invest the money instead.
That is not necessarily bad advice. You might out ahead by putting your money in the stock market instead of prepaying on a mortgage. On the other hand, it is possible you will not come out ahead. Stock investing offers no guarantees.
In contrast, every dollar put toward prepaying is guaranteed to advance you financially. The reason is simple. Avoiding a certain amount of interest (by prepaying on a loan) has the same financial effect as earning that amount of interest. In that sense, prepayment on a mortgage generates a “guaranteed return.” Remember the words of Ben Franklin: “A penny saved is a penny earned.”
What about the mortgage-interest tax deduction?
The overwhelming majority of homeowners (almost 90%) don’t itemize and therefore receive no deduction for paying mortgage interest. For those who do itemize, the mortgage-interest deduction restores only a portion of the cost of paying interest. Depending on one’s tax bracket, each $1 paid in interest might yield a deduction equivalent to 20 or 30 cents.
Remember, too, that interest makes up a declining portion of a mortgage payment as a loan ages, so the amount of interest one can claim lessens over time. That means the “benefit” of paying mortgage interest, never that strong anyway, wanes as the years pass.
Slow and steady
Here is one caveat about paying off a mortgage early: Don’t overdo it. Some people, in their zeal to get debt-free, wipe out their emergency fund or raid a retirement account to pay off a mortgage. That could lead to being “house rich, cash poor,” with lots of money locked up in a home but few liquid assets.
Instead, it’s smarter to take a slow-and-steady approach that uses available cash flow. Set a long-term goal of eliminating your mortgage by age 65 and move toward it bit by bit. Later, if your overall financial situation improves and you have more cash available, you can accelerate your plan and pay off the mortgage even earlier.
Prepaying a mortgage may not always make the most “mathematical” sense. But this isn’t solely a “dollars and cents” matter. It’s about the future peace of mind you’ll enjoy when you enter retirement with your mortgage debt paid in full.