FI Step by Step: Step 10, Paying Off Your Home Mortgage

FI Step by Step: Step 10, Paying Off Your Home Mortgage

Today I’d like to discuss Step 10 of my FI Step by Step series of posts: paying off your home mortgage.  If you’ve reached this step in your journey towards financial independence, congratulations, you are well on your way.  If you haven’t yet, keep moving forward and you’ll be there before you know it.  

Before moving onto this next step, you should have completed the following:

• You have defined the specific reasons why you want to pursue financial independence
• You have calculated and track your net worth
• You are actively tracking your income and expenses
• You have a written financial plan that you review and update regularly
• You are adequately insured against disaster
• You have a liquid cash emergency fund
• You are maximizing your employer benefits
• You have paid off all of your consumer debts including credit cards, auto loans, and student loans
• You are maximizing your contributions to your available tax advantaged accounts

If you have done or are doing all of these things, it’s time to consider the next steps toward financial independence.  But before we discuss paying off your home mortgage, make sure that you are also adequately saving for all of your intermediate financial goals as well.  A big one that comes to mind is saving for your kids’ college expenses.  I didn’t include that as part of my FI Step by Step series because I don’t consider it something you HAVE to do to become financially independent.  However, I recognize that it is a very important financial goal for many people (including myself).  And if that, or any other financial goal like traveling to a certain part of the world or buying a car you’ve always dreamed of is a priority for you, I would advise having a plan for that before aggressively paying down your home mortgage.  

With that said, at this point I will assume you have completed the above steps and are ready to consider paying off your home mortgage early.  

Paying Off Your Mortgage Early vs. Investing

One of the most common debates in personal finance is whether to pay off your home mortgage early or invest.  You will find proponents strongly arguing both sides of this debate in books, podcasts, and all over the internet.  Which is the right answer?  Well, I think the fact that there are so many arguments for both sides suggests that there is no one right answer for everyone.  It really depends on what’s right for you.  And to make the right decision, you need to understand the pros and cons of each choice.  

Mathematically, with interest rates where they currently are, it almost always makes more sense to invest your money than to pay down your mortgage faster.  I could lay out a lengthy numerical example to demonstrate this, but let’s keep it really simple.  Let’s say the average mortgage interest rate is 4% (and now it is likely even lower with falling interest rates).  If you invest your money and earn a net return that is anything greater than 4%, then mathematically that is the better move.  Plain and simple.  

But this is just the math.  In reality, I believe the decision is a little more complex than this.  When you consider other factors like the risk that comes with carrying a mortgage, the risks associated with investing, and the huge psychological benefit of owning your home outright, I think it is a closer race than the math alone would suggest.  If math were the only consideration, then everyone would go out and get a $100,000 loan at 4% interest and invest it with plans to earn 8% (the market average).  Why don’t we do this?  The answer: risk!

Why I Recommend You Maximize Your Tax Advantaged Accounts First

With that being said, the math is hard to ignore.  We all want to maximize our returns, right?

This is why I recommend maximizing investments in your available tax advantaged accounts first.  When you invest in tax advantaged accounts first you not only get the higher return compared to paying down your mortgage, you also get a significant tax benefit.   From where I sit, this gives you a triple mathematical win.  

First, you likely save between 20-40% of your money up front with the tax advantage in a pre-tax account.  Plus you don’t pay taxes while your money grows.  

Second, you will likely earn at least 5-8% annually on your invested dollars, compared to the 3-4% average mortgage interest rate.

Third, when you invest early, your money can grow for the maximum period of time, tapping into the power of compound interest. 

Pros and Cons of Paying Off Your Home Mortgage Early

But as I alluded to above, once you fill those tax advantaged buckets, the answer becomes less clear about which choice is best.  Is it better to pay off your home mortgage early or invest?  Here are some of the pros and cons of paying off your home mortgage early:

Pros of paying off mortgage early

• Guaranteed return:  When you pay off your mortgage early, you essentially earn a guaranteed return on your money, which is your mortgage interest rate.  It may only be 3-4%, but it will always be positive and won’t fluctuate like returns in the stock market or with real estate. In today’s volatile market that could be a pretty big plus.  

• Lose less money in paying interest:  Most people don’t realize how much money they pay in interest over the course of paying off their mortgage.  On a 30-year, $350,000 home mortgage with a fixed interest rate of 4%, you’ll pay a total of $601,543.  This means you will pay $251,543 in interest over 30 years.  If you pay off your home mortgage early, you can save thousands of dollars in interest.  We’ll discuss this further below. 

• Eliminate your largest monthly payment:  For most people, their monthly mortgage payment is their largest bill.  How much more financial freedom would you have if you didn’t have to make this payment anymore, month after month?  You could then use this money every month to invest or for other financial goals.  It also makes your expenses in retirement much more manageable.  

• Peace of mind:  It’s hard to argue with the peace of mind that comes from having a paid off home.  For many, the psychological benefit of having your home completely paid off outweighs anything that can be quantified on a spreadsheet.  This could be especially true during these uncertain times.

Cons of paying off mortgage early

• Opportunity cost:  Perhaps the biggest con of paying off your mortgage early is the opportunity cost.  You could potentially be earning more interest on invested dollars than your mortgage interest rate.  However, keep in mind that this is not a guarantee and there is always risk associated with investing.  

• Loss of liquidity:  Another negative of paying off your mortgage early is that a large chunk of your money is tied up in home equity.  This money is highly illiquid, meaning it would likely take months or longer to access it.  So, before you decide to pay off your home mortgage early, make sure you have liquid cash for emergencies and other short term financial goals.  

• Lose the benefit of inflation:  What? How can inflation be a benefit? Well, over the average 30 year mortgage period there will typically be a significant amount of inflation that occurs.  Yet, despite this, the amount of your monthly mortgage payment won’t change. This works in your favor because it will be much easier in the future to make your payments, plus your income is also likely to increase over that period of time.  This leaves more of your money to invest or spend on other things. If you pay off your mortgage early, you lose this advantage.  However, I would argue that the amount you lose in interest by drawing your mortgage out over the full duration of the loan negates this potential upside.  Also, beware of deflation, which would have the opposite effect.  While deflation is uncommon, there is a real possibility we could see a deflationary economy as a result of the COVID-19 financial crisis.  

• Lose the tax deduction:  Many people cite this as a major reason not to pay off your home mortgage.  While it is true that you can no longer claim the tax deduction on mortgage interest if your home is paid off, this is really NOT a good reason to keep your home mortgage.  I recently wrote an entire post about this, which you can find here.

These are just some of the factors to consider.  Before making the decision to pay off your home mortgage early or invest, you should review your own personal situation and play with the numbers a bit to see how things would pan out over time.  I recommend using both a mortgage payoff calculator AND a compound interest investment calculator to better understand your own numbers.  I like the free online calculators at calculator.net.

Remember, there isn’t necessarily a wrong choice here.  This is why Step 10, Paying Off Your Home Mortgage and Step 11, Investing in a Taxable Account and Alternative Assets in my FI Step by Step series are consecutive and transposable.  You could do Step 11 before Step 10, 10 before 11, or do them simultaneously.  You need to choose what makes the most sense for you taking into account your age, mortgage balance, mortgage interest rate, expected returns on investments, risk tolerance, time horizon, and other financial goals.  

Another factor to consider would be any pre-payment penalties on your mortgage agreement.  Make sure this doesn’t apply to you.  But if it does, try negotiating with your lender to see if you can get these removed. 

Still can’t decide?  Consulting with a financial advisor or financial planner (for a flat fee) could help you out.  Generally, the following are good rules of thumb:

Paying your mortgage down early makes more sense if you have a higher mortgage interest rate, you are older and closer to retirement, or you are a more conservative investor.

Investing makes more sense if you have a very low mortgage interest rate, you are young with a longer time horizon, you are in a high income tax bracket, and you are an aggressive investor with a higher risk tolerance.  If this makes more sense to you, go onto Step 11 before paying off your mortgage.  

Ways to Pay Off Your Mortgage Early

Ok, so let’s say you decide that paying off your home mortgage early is right for you.  What is the best way to do it?  There are many different strategies you could choose from.  Here are some ideas to get you started.  

Biweekly payments

Most people make a mortgage payment once per month.  This works out to 12 payments per year.  However, most people earn a paycheck biweekly (every 2 weeks).  If you work it out with your lender so you pay half your mortgage payment every 2 weeks, budgeting a fixed amount from each paycheck, you would make 26 payments in a year, which works out to 13 full payments, or one extra payment per year.  While this doesn’t sound like much, it can save you thousands of dollars and take years off your mortgage.

Let’s return to our above example to see how this would make a difference.  We looked at a 30-year mortgage of $350,000 at a 4% fixed interest rate.  This would be a $1,670 monthly payment for 30 years, after which you would have paid a total of $601,543, of which $251,543 would have been paid in interest to your lender.  

If you were to instead pay $835 every 2 weeks, the mortgage would be paid off in only 26 years and you would have paid a total of $563,210.  This means by just switching to biweekly payments, you pay off your mortgage 4 years earlier and save $38,332 in interest.  Not too bad for a simple change you are unlikely to feel much in your budget.

This is the simplest way to pay extra on your mortgage.  Even if you decide to invest more aggressively before paying off your mortgage early, you could still make this simple change and be way ahead of the game.

Months with 3 Paychecks

If you don’t like the idea of biweekly payments, but are still paid on a biweekly schedule, this could be a good option for you.  

On a biweekly pay schedule, each year there are a couple of months where you will earn 3 paychecks.  If you keep the same budget during those 2 months as you do during the other 10 months of the year with only 2 paychecks, you essentially have an entire extra paycheck twice a year.  

If you used those “extra paychecks” to make one extra mortgage payment per year, it would have a similar effect as the biweekly payment method above, taking 4 years off your repayment term and saving you almost $38,000.  If you used those extra paychecks to make two extra mortgage payments per year in the above example, it would reduce your repayment term by 7 years and save you almost $65,000 in interest.  

Principal Only Payments 

These first two methods above don’t require a lot of extra money, it’s really just rearranging your payments and budget slightly.  And while these strategies can save you tens of thousands of dollars and 4-7 years of payments, if you want to dramatically reduce the amount you will pay in interest and pay off your mortgage even earlier, you will need to make extra principal only payments.

Before we discuss this further, let’s break down what goes into a typical mortgage payment each month.  A portion of every mortgage payment you make is used to pay the interest on the loan.  This is determined by taking the total amount due (the principal), multiplying it by the interest rate, and dividing by 12 (since it’s a monthly payment).  The rest of the money left over is applied to the principal loan amount, paying it down over time.  Early in the mortgage repayment term, most of what you pay each month goes to interest and very little is applied to the principal.  However, late in the repayment term most of the payment is applied to principal and little to interest.  

Let’s look at our above example to see how this works out.  Remember, this is a 30-year $350,000 mortgage with a fixed interest rate of 4%, and a monthly payment of $1,670.  Let’s look at how the first payments in year 1, year 10, year 20, and year 30 break down.  Remember, the payment remains constant at $1,670; we are just trying to determine how much is paid in interest and how much is applied to the principal based on a standard amortization schedule.

• Year 1 payment: $1,166 paid in interest, $504 applied to the principal
• Year 10 payment: $948 paid in interest, $722 applied to the principal
• Year 20 payment: $594 paid in interest, $1,076 applied to the principal
• Year 30 payment: $65 paid in interest, $1,605 applied to the principal

I’m not sure about you, but to me these are sobering numbers every time I see them.  Almost all the money you are paying early on is going towards interest.  It isn’t until payment 153 (which is month 9 of year 13) that more of your monthly payment starts going towards the principal than interest.  This is why, in this example, you end up paying more than $600,000 for a $350,000 mortgage.  Most of America is in this boat.

The best way to get ahead is to start chipping away at that principal.  In addition to your standard monthly payments, you can make additional principal only payments.  As the name implies, all of the money you pay in a principal only payment goes towards the principal.  None of it is paid in interest to your lender.  

Making principal only payments can have a synergistic effect in paying off your home mortgage early.  Not only is the principal of the loan being reduced, but more of your regular monthly payments will be applied to the principal since you will owe less in interest.  

You can make these payments as infrequently or as often as you like.  It could be a natural next step after the debt snowball for paying down other higher interest debts.  You could make it a part of your biweekly or monthly budget.  Or you could only make extra payments when you have an inflow of cash, such as when you get your tax return or a bonus at work.  Just remember, the more you pay towards the principal, the more you will save in interest over time and the quicker you will pay off your mortgage.  

Refinance Your Home Mortgage

Another strategy to help you to pay off your home mortgage early is refinancing.  How does refinancing help?  Well, first let’s briefly discuss what refinancing means.  

I’ll admit, several years ago, when someone would mention refinancing their home mortgage, I really didn’t understand what that meant.  Like many, I just nodded my head and acted like I understood, but my financial literacy was pretty limited at the time.

Basically, refinancing your home mortgage is like getting a brand new home mortgage.  The bank or lender that you refinance with pays off the first mortgage, and then issues you a new mortgage with new terms.  The new mortgage can be a completely different type of mortgage with a different duration and a new interest rate.  I plan to write an entire post about refinancing your home mortgage in the future since this is something we are considering doing ourselves.

How does refinancing help you pay off your home mortgage early?  I liken it to running a marathon with ankle weights.  The 26.2 mile marathon distance represents the term of the loan and the ankle weights represent the interest rate.  Wouldn’t it be nicer to run a half marathon without ankle weights?  When you refinance, you can typically decrease the term of loan and lower the interest rate.  For example, going from a 30-year loan at 4.5% interest to a 15-year loan at 3.125% interest.  This could potentially save you six figures in interest payments, depending on the amount of the loan.  While this may increase your monthly payment, if you are already considering paying off your home mortgage early by paying more each month, this could potentially be a very smart move for you.  

As with anything, however, you need to run the numbers to see if refinancing makes sense for you and your situation.  Refinancing isn’t free (this is how banks and lenders make their money).  So you need to determine if the cost would be worth it for you.

What We’re Doing

Personally, I have been back and forth between paying off our mortgage early and investing more times than I can count.  I understand that the math supports investing as the right move.  But I love the security of knowing that our home is paid off, so that no matter what happens to us financially or in the economy, we won’t lose our home.  

The decision my wife and I have arrived at is to do both simultaneously. 

As I have written about in recent posts, we finally paid off my student loans in February 2020.  We were already maximizing contributions to our available tax advantaged accounts, so we’re good there.  Our plan moving forward is to use the money each month that was going towards student loans to now pay off our mortgage early AND invest. A modified debt snowball approach, so to speak.   

We plan to use a variation of the biweekly payment method.  Instead of splitting our regular mortgage payment in half and making a half payment every 2 weeks, we are going to make a full mortgage payment every 2 weeks.  This is possible because we built a house that was well within our means, and our total housing costs are <10% of our gross income.  If we stick to this plan, our home will be paid off in 7 years.  

While we could potentially be even more aggressive and put more money towards our mortgage, we are going to try and balance this with further investing, which I will talk more about in Step 11.  This gives us more diversification, liquidity, and higher returns in our portfolio.  

I am also actively looking into refinancing our home mortgage since interest rates are at historic lows.  I will likely pull the trigger on this later in the year and write a post about what I have learned in the process. 

Conclusion

In the words of Dave Ramsey, “The paid-off home mortgage has taken the place of the BMW as the status symbol of choice.”  While I don’t look to pay off my home mortgage early as a status symbol, I do think it is a responsible financial choice if done at the right time on your journey towards financial independence.  

As you try to decide if paying off your home mortgage early is the right next step for you, here are some take home points to consider:

• Before considering whether or not to pay off your home mortgage early, make sure that the rest of your financial house is in order.  I recommend making sure you have an appropriate emergency fund for your situation, all of your other debts are paid off, you are maximizing your tax advantaged investing accounts, and you are saving adequately for any intermediate financial goals before moving to this step.

• I recommend considering your overall situation, including age, financial goals, risk tolerance, time horizon, etc. in determining whether it makes more sense for you to pay off your mortgage early or invest.  Online calculators can help you play with the numbers to help with this decision.  You may decide to do both simultaneously.

• If you do decide it’s right for you to pay off your mortgage early, first make sure there are no prepayment penalties in your mortgage agreement.  Then, develop a plan of attack that my include biweekly payments, principal only payments, and possibly refinancing.  

Thanks for reading.  I hope you are doing well in your progress towards reaching FI.  If you have any questions or comments that might help other readers, please list them below.  In the meantime, keeping working towards Freedom Through FI!

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