As a financial planner, clients will frequently ask me the following question, “Should I apply extra money toward my mortgage and pay it off early?”. The answer depends on several factors such as:
- The status of your other financial goals
- Interest rate
- How long you plan to live in the house
- How close you are to retirement
- The rate of return for other available investment options
Status of your other financial goals
Before you start applying additional payments toward your mortgage, you should first conduct an assessment of the status of your various financial goals.
For clients that have children, we usually start with the following questions:
“What are your plans for paying for college for your kids? Are the college savings accounts appropriately funded?”
The cost of college keeps rising which requires more advanced planning on behalf of parents that have children that are college bound, but before committing more money toward the mortgage, you should have an idea as to what your financial aid package might look like, so you have a ballpark idea of what you will have to pay out of pocket each year for college.
If you have an extra $5,000 sitting in your savings account, you can either apply that toward the mortgage, which is a one-time benefit, or you can put that money into a college 529 account when your child is 5 years old, and let it accumulate for 13 the next years. Assuming you get a 6% rate of return within that 529 account, you will be able to withdrawal $10,665 all tax free when it comes time to pay for college.
Here is the list of other questions that we typically ask clients before we give them the green light to escalate the payments on their mortgage:
- Is there enough money in your retirement accounts to fulfill your plans for retirement?
- Do you have any other debt? Student loan debt, credit card debt, HELOC?
- How many months of living expense have you put aside in an emergency fund?
- Are there any big one-time expenses coming up?
- Do you have the appropriate amount of life insurance?
- Do you foresee any career changes in the near future?
If there are financial shortfalls in some of these other areas, it may be better to shore up some of the weaknesses in your overall financial plan before applying additional cash toward the mortgage.
What is the interest rate on your mortgage?
The interest rate that the bank or credit union is charging you on your mortgage has a significant weight in the decision as to whether or not you should pay off your mortgage early. We tell clients that you should look at the interest rate on debt as a “risk free rate of return”. If you have a mortgage with a 4% interest rate and you have $5,000 in cash sitting in your savings account, by applying that $5,000 toward your mortgage you are technically earning a 4% rate of return on that money because you are not paying it to the bank. The reason it is “risk free” is because you would have paid that money to the bank otherwise.
It’s important to understand the risk-free concept of paying off debt. Clients will sometimes ask me “Why would I put more money toward my mortgage with an interest rate of 4% when I can invest it in the stock market and get an 8% rate of return?”
My answer is, “It’s not an apple to apple comparison because you are comparing two different risk classes.” You have to take risk in the stock market to obtain that possible 8% rate of return, as compared to applying the money toward your mortgage which is guaranteed because you are guaranteed to not pay the bank that interest. It would be more appropriate to compare the interest rate on your mortgage to a CD rate at a bank, or the interest rate for a money market account.
After this exchange, the client will frequently comment, “Well, I can’t get 4% in a CD at a bank these days”. In those cases, if they have idle cash, it may be advantageous to apply the cash toward the mortgage instead of letting it sit in their savings account or a CD with a lower interest rate.
Interest rate below 5%
When the interest rate on your mortgage is below 5%, it makes the decision more difficult. Depending on the interest rate environment, there may be lower risk investments other than stocks that could earn a higher rate of return compared to the interest rate on your mortgage. You may also have some long term financial goal like retirement that allows you to comfortably take more risk and assume a higher long term annualized rate of return in those higher risk asset classes.
When you have a lower interest rate on your mortgage, applying additional cash toward the mortgage may still be the prudent decision, but it requires more analysis.
Interest rate above 5%
When we see the interest rates on a mortgage above 5% the decision to pay off the mortgage early gets easier. Based on the examples that we have already covered, if the interest rate on your mortgage is 6%, by applying more cash toward the mortgage you are earning a risk-free rate of return of 6%, that’s a pretty good risk-free rate of return in most market environments. For our readers that had mortgages in the early 80’s, they saw mortgage rates north of 15%. That’s a nice risk-free rate of return, but hopefully we never see the interest rate on mortgages that high ever again.
How long do you plan to live in the house?
If you plan to sell your house within the next 5 years, applying additional payments toward the mortgage has a positive financial impact, but it’s typically not as strong as when you compare it to someone that has 20 years left on mortgage and they plan to be living in the house for the next 20+ years.
It’s a lesson in compounding interest. Example, you have the following mortgage:
Outstanding balance: $200,000
Interest rate: 4%
Years left on the mortgage: 20 Years
You have $20,000 sitting in your savings account that you are considering applying toward the mortgage. If you plan to sell the house a year from now, applying $20,000 toward the mortgage would save you $800 in interest.
If you plan to stay in the house for the full 20 years, applying the $20,000 toward your mortgage today would save you $9,086 in interest over the remaining life of the mortgage.
Should I payoff my mortgage before I retire?
When we are helping clients prepare for retirement, we remind them that with all of the unknowns that the future holds, the one thing that you have 100% control over both now and in the future are your annual expenses. You don’t have control over market returns, inflation, tax rates, etc, so the goal is to give you the most flexibility in retirement and minimize your expenses. It not uncommon for the mortgage to be your largest monthly expense.
It is for this reason that retirement serves as kind of a wild card in this rate of return analysis. During the accumulation years, you may be assuming an 8% rate of return on your retirement account because you had an overweight to stocks in your portfolio. Now that you are transitioning over to the distribution phase, it’s common for investors to decrease the risk level in their retirement accounts, which is often accompanied by a lower assumed rate of return over longer time periods. It makes that gap between the interest rate on your mortgage and the assumed rate on your investment accounts smaller, thus giving more weight to escalating the payoff of the mortgage.
Additionally, no mortgage means less money coming out of your retirement accounts each year, which helps investors manage the risk of outliving their retirement savings.
While we like our clients to retire with as little debt as possible, there are scenarios that arise where it does make sense to have a mortgage in retirement. Both of these scenarios stem from the situation where 100% of the client’s assets are tied up in pre-tax retirement accounts.
If they have $50,000 left on the mortgage and they are about to retire, we typically would not advise them to distribute $50,000 from their retirement account to pay off the mortgage because they will take a big income tax hit by realizing all of that additional taxable income in a single tax year. In these cases, it may make sense to continue to make the regular monthly mortgage payments until the mortgage is paid in full.
In a similar situation when clients want to buy a second house in retirement, but most of their money is tied up in pre-tax retirement, instead of incurring a big tax hit by taking a large distribution from their retirement accounts, it may make sense for them to just take the mortgage and make regular monthly payments. This strategy spreads the distributions from the retirement accounts over multiple tax years which could more than offset the interest that you are paying to the bank over the life of the loan. In addition, the money in your retirement accounts is allowed to accumulate tax deferred for a longer period of time.
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.