Just came across Penelope Wang’s blog on CNN Money – absolutely a must-read. Read her post from July, 2010, on education costs it’s thought-provoking stuff.
First of all congratulations if you are fortunate enough to have a low interest rate mortgage AND have the means to pay it off early. This is an excellent financial situation to be in. Now there are very instances in which this blog will recommend NOT paying off a debt ahead of schedule but you are in an unusual situation. Generally the interest rate charged on a debt is high enough that is advantageous to repay it as soon as possible. However, recently mortgage rates have been at historic lows and the interest paid on a mortgage remains an itemized deduction for tax purposes. This combination makes mortgages a very inexpensive form of debt. The two factors that must be considered when deciding whether it is advantageous to pay off your mortgage ahead of schedule are whether you can get a better overall rate of return by investing the money and whether it is too hard psychologically to keep the debt.
While historically it was assumed that 10% annualized investment returns could be counted on, the financial storm of 2008 taught many that this is unrealistic. However, a well-diversified portfolio can still be expected to return at least 6%-7% annually over a long period of time. If you have a mortgage with an APR of 4.5% your effective rate is actually lower once you factor in the tax deduction for the interest paid. If you were to pay off the balance of your mortgage the “return” you would realize would be the interest that you no longer have to pay (in this example it is less than 4.5%). If instead you had invested the money you would have realized a gain of 6%-7%. While in this example investing the money is the superior strategy, if the interest rate on the mortgage was 7% or greater then paying it off would yield a higher return. This example does not take into account the added calculations of taxes on investment income and itemized mortgage interest deductions – to get a true picture of actual costs/savings you would have to include said taxes.
It is much easier to prove on paper the dominant strategy than it is to implement it in real life. The simple mathematical calculation does not factor in the psychological impact of a debt weighing you down. Different people have different risk tolerances and for some it may be better to pay off their mortgage and realize the lower but guaranteed return. Also if you are only a year or two from retirement it may make more sense to take the guaranteed return of paying off your mortgage and also not have to worry about a debt payment during your retirement years.
This post demonstrates the quantitative method for determining if paying off your mortgage ahead of schedule is financially advantageous while also attempting to show the other “real life” factors involved in the decision. Many people with the means to pay off their mortgage ahead of schedule also have other complicating factors that need to be considered and would benefit from the advice of a financial planner. Finally, as always, this post should not be taken as investment or tax advice.