There's nothing like owning your own home free and clear. That's a goal near to the heart of almost everyone who has ever held a mortgage. Oh, the things you could do without a mortgage payment!
Paying off a mortgage is a noble goal, and one that can serve you well in retirement. But hang on, there's no rush. Despite the claims that you can save a fortune in interest by paying off a mortgage early, spreading the payments out over 30 years can be much smarter than putting your extra dollars into additional mortgage payments.
The interest paradox
While it is very true that a shorter mortgage incurs far less interest than a longer one, simply paying off your existing mortgage faster might not save you as much as you think. The key factor is that you pay most of the interest in the early years. It takes eight years to pay down the first 10% of the principal when you amortize a loan over 30 years. The rest of what you've shelled out is interest. By the time you are halfway through a 30-year mortgage, you've paid 67% of the interest. By year 20, two-thirds of the way through the mortgage, you've paid 84% of the interest.
Starting to make accelerated payments halfway through a 30-year mortgage will save you very little in interest. It would be better to put those extra payments into a money market account until they are actually due. Let the bank pay you interest instead.
Another problem is the way some lenders handle additional payments. Not all lenders automatically recompute the interest you owe if you reduce your principal faster than they expect. Instead, they follow their amortization table, which divides each payment into a set amount of interest and principal. So even though your balance is lower, the interest you are paying doesn't change. With this type of mortgage, an early payoff amounts to a long-term, interest-free loan to your mortgage company. Yikes!
The paradox is that even if you work it right and do save tens of thousands of dollars in interest, that decision could cost you far more in terms of lost opportunity. The real question is: What is the best use of your money?
Imagine if you will, an anti-mortgage account. Instead of sending a bunch of extra bucks to your mortgage lender every month, you send them to a broad-market index fund.
Let's look at what might happen with a $100,000 mortgage at 7%. You could pay it off in 30 years at $665 a month, or in 15 years at $899 per month -- and you'd save about $78,000 in interest with the 15-year option. But suppose you went for the 30-year option, sending $665 to the mortgage company and sending $234 to an index fund -- your anti-mortgage account. That's the same amount out-of-pocket every month, right?
Fast forward 15 years. Your mortgage has been paid down to $74,018 and you have $106,397 in your anti-mortgage account (assuming an average annual return of 11%). At that point, you could, if you chose, convert your anti-mortgage account to cash, pay the capital gains taxes due, and use what's left to pay off your mortgage. Assuming a federal capital gains tax of 20% and a state capital gains rate of 5%, you'd even have about $5,000 left over -- but don't spend it, you'll be needing new carpet soon.
The anti-mortgage account gives you options. You could cash it in and pay off your mortgage early if you prefer, or you could keep saving and building up your net worth as you pay down your mortgage. Or you could do any of the myriad other things that cash money is good for.
The value of cash
There are two common reasons people cite for paying off their mortgage early: To provide a safety net in case they lose their jobs and to reduce income needs in retirement. The prospect of losing your home because you can't make the mortgage payments is scary -- no doubt about it. And the prospect of devoting most of your retirement income to a monthly mortgage isn't much better. But let's look what happens if you choose to invest instead.
Investing lets you build up a portfolio of securities that are easily converted to cash. Cash can make a lot of mortgage payments if you're collecting unemployment. Cash will also make car payments and buy groceries. Of course, if your house were paid for, you could always raise cash by taking out a new mortgage, except, oops, you're out of work. Bad timing. You might be able to get a mortgage, but not a very big one and not at very favorable rates. To get a decent mortgage loan, you need more than a lot of equity in your home: You also need regular income, which makes owning your home less useful in an emergency than you might think.
Here's an even better idea: Use the earnings from your investments to make your mortgage payments. Yep, that's right. Once your anti-mortgage is big enough to pay off the mortgage at one time, you can use the earnings from the account to make the monthly payments -- and keep the cash!
Here's how. Remember the example above where you ended up with an anti-mortgage account worth $106,000 after 15 years? Let's assume you retired at that point and don't want the burden of mortgage payments. Who could blame you? You could cash out your anti-mortgage account and pay off the mortgage, OR you could keep your money in the index fund and simply withdraw enough every year to make your mortgage payments. If you pull $10,600 out of the account each year, that will cover your mortgage payments and the capital gains taxes on the withdrawals.
Here's the best part: By the time the 30-year mortgage is paid off, your investment account will have dropped a grand total of $2,000. (Again, we are assuming an 11% average rate of return.) Talk about having your cake and eating it, too! By saving the extra payments instead of sending them to the mortgage company for the first 15 years, you've built up an anti-mortgage account, used the earnings from it to make your mortgage payments for the next 15 years, and after 30 years, you're left with $104,000 in cash.
Don't believe us? Take a stroll over to our Personal Finance area and play around with our mortgage calculator and savings calculator. Run some scenarios and see what happens. You may also want to check out our Home Center, which has more calculators and information about mortgages. Then proceed to Part 2 where we discuss a few more reasons not to pay off your mortgage, and a few reasons why you might want to consider it.
Part 2: Money-Saving Mortgage Advice »