When Does It Make Sense to Pay Off Your Mortgage Early?

Can you save money by sending in extra principal payments to pay off your mortgage early?

It all depends on the rate you’re paying, your tax bracket and how you’ll invest the money. The downside of paying off your mortgage ahead of time is that you’ll have less money to put into investments.  Plus the money or Equity in your home is less liquid.  If you needed quick access to it you probably couldn’t get it.

To determine what’s best, calculate the after-tax cost of the interest on the mortgage and compare it to your projected after-tax rate of return on your investments for at least the next five years. If the after-tax cost of the interest is higher than your current rate of return on your investments, then you should consider paying the mortgage down or paying it off in full. If it’s lower, don’t.

For Example:

Let’s say you have a five percent mortgage, can deduct mortgage interest on your tax return, and are in the 25 percent tax bracket. Since your payments are saving you taxes, you’d multiply .05 percent by .75 = 3.75 percent – the after-tax cost of your loan.

If you believe that you’ll make more on your investments (more than 3.75% per year) over the next five years, you should not accelerate your mortgage payments.  If you invest in taxable investments, you’ll have to earn roughly Five percent to get to a 3.75 percent net of tax. Because of state taxes and favorable tax treatment of long-term capital gains, it’s a little more complicated than that, but it’s close enough to use as a guideline for now. However, if you can invest in a tax-free Roth Individual Retirement Account (Roth IRA), you just need to earn more than 3.75 percent to come out ahead.

How much is realistic?  This depends on your appetite for risk.   The stock market for the last 75 years, despite the 2008-09 meltdown, has produced an average return of about eight percent.  Bonds have been about 3.66% and Certificate of deposits are even lower.  So in order to stay ahead you will need to take some risk in the stock market.

Generally, if you have a fixed-rate mortgage with a low rate, roughly four to six percent or less, paying it down rarely makes sense. It’s usually better to keep paying the mortgage and invest the extra cash. Investing in a well-diversified investment portfolio has historically returned greater than five percent.  So chances are good that you will come out ahead.

But if you have no appetite for risk and you were going to invest in a money market account or CD then you are better off probably paying down the mortgage.  Paying down the mortgage provides a guaranteed rate of return since you are eliminate the interest cost.

If you mortgage carries a high rate or is variable and you can’t refinance at a lower rate because of a poor credit rating or a home that has lost its value, it usually makes sense to pay down the mortgage faster.

If you don’t itemize when you file your taxes, you have another issue.  Your interested cost is not being reduced by the tax savings so you would need to earn a higher return on your investment to beat the actual interest cost.

Your accountant should be able to help you with some of these numbers.