Some Reasons Pre-Paying Your Mortgage Isn’t Worth It

by Darwin on June 30, 2012

There’s a perennial debate in the financial blogosphere about whether it’s worth paying down a mortgage early or using the funds elsewhere.  Often times, financial calculations are trumped by “emotion” whereby people justify paying down a mortgage early for “peace of mind” or because it feels better not having any debt.  I suppose if you make decisions primarily on an emotional basis, then objective analysis is of no value regardless of the alternatives.  However, if looking to compare apples to apples options financially to see where your excess funds are best spent, here are some different considerations.

Assumptions:

  • 30 Year Mortgage Term
  • 3.75% Rate
  • 2.x% Effective Rate given mortgage interest deduction offset by standard deduction
  • Ability to put more funds toward paying down mortgage or other options

Now, I used the 30 year term to contrast with other options available (since using a 15 year term or lower is in effect paying down the mortgage early).  I used a sub-4% rate with the assumption that you are either a recent homebuyer or have recently refinanced at today’s low rates.  Finally, since mortgage interest is deductible, when you consider that into your actual annual payments, chances are your “true” interest rate is something south of 3%, but this depends of course on the size of your mortgage and tax bracket, so to keep it simple, let’s just call it 2.x or something less than 3%, meaning that any guaranteed return of 3% or greater would yield a better return. With these assumptions in mind, here are some alternatives that may or may not make more sense than paying down your mortgage earlier than necessary:

  • Stocks – The stock versus mortgage argument is always a tricky one.  History has shown that over very long periods of time, in this case, decades, stocks always outperform all other conventional asset classes and notably, don’t end up in the red.  So, over a 30 year period, regardless of how scary the Euro situation, Healthcare reform and the impending election may be, chances are that stocks will return greater than 3% (probably double that or more), especially given dividend distributions in the 2-3% range depending on the index you use.  The argument against is that in the near-term, there is a very high chance of loss of capital, so you have to be sure that this is a 30 year gambit.  Then again, when you’re pre-paying a mortgage, you don’t see that ‘return’ immediately either, only when your mortgage is finally paid off.
  • 529 Plan – Here’s a special situation I’d like to draw your attention to.  Depending on the state you live in and plans you have access to, you can well exceed the returns on paying down a mortgage if you planned on funding your kids’ college expenses anyway.  See, in my state, 529 contributions are state tax deductible, so it’s an automatic +3% return on any funds I invested regardless of underlying assets.  Next, with college tuition rising at 5-6% a year, if you put it into the tuition plans (as opposed to stock/bond mix), you’re basically getting an 8-9% return annually without the risk and volatility of stocks and bonds.  Of course, if you don’t plan on funding college for the kids then you’ll say it’s not an appropriate comparison, but if you are, it’s money you have to spend one way or the other, so why not let it grow tax free at an effective 8-9% over paying down a mortgage at an effective rate of less than half that?
  • Bonds – Most corporate bonds can be had for a yield in excess of 3% for long maturities but you’re taking on the solvency risk of the corporation.  Needless to say, a bond ETF is probably the best bet.  US Treasury bonds have very low yields (which are driving down mortgage rates), so aside from the potential for loss in bond price when the bond bubble eventually bursts, yields are 3% or less for even longer dated maturities.
  • CDs – Most CDs, even the longest durations available will not make sense.  You’re tying up money with withdrawal penalties for sub-3% returns for the most part anyway. And they’re taxable.  So, CDs probably aren’t a great bet.

What Are Your Thoughts on Mortgage Pre-Payment?

Share

You're Not Following Darwin's RSS? Check out Why You Have to Subscribe to Darwin's Finance!

If you enjoyed this post, you can get free updates through RSS Feed or via Email whenever a new post is published. Rest assured that you can unsubscribe at any time via the automated system and your information will not be sold, archived or utilized for any other "nefarious" purposes.

{ 23 comments… read them below or add one }

1 Brian @ EverywhereOnce July 1, 2012 at 5:18 pm

I think you approach this from the right perspective by asking “what are the expected returns on my alternative uses for this money?” I also think you come to the right conclusion that choosing not to pay down the mortgage may be a good idea, but isn’t a slam dunk decision, even with rates as low as 3.75% That is because low benchmark rates push down yields on all competing investments (even stocks).

I’d go a little further thought. If you have a diversified investment portfolio you likely own bonds paying less than 3.75% in interest. If you own a 3.75% mortgage and also own bonds (even in funds) that pay less than 3.75% you are effectively engaging in a negative arbitrage . . . borrowing money at a higher rate than your expected investment return.

Instead of perpetuating that negative arb, it makes more sense to use some of your lower yielding bonds to pay down that mortgage. That will tilt your asset allocation slightly more aggressive, but then your balance sheet will have less leverage and therefore less risk.

[Reply]

2 uclalien July 1, 2012 at 7:13 pm

I don’t necessarily disagree with your analysis, only your assumptions.

First, I think you minimize the peace of mind that comes with being debt free by referring to it as an “emotional” choice and how this peace of mind has positive carry-over into other aspects of a person’s life. But I’ll stick to a pure numbers analysis here.

Second, a 3.75% interest rate on a 30-year mortgage is a pretty aggressive assumption. Yes, there are lower rates out there. But in order to obtain these lower rates, borrowers are required to pay hefty fees. Once these fees are accounted for, the lowest APR I can find is 3.761%. And not everyone has or can refinance their mortgage at these lower rates. So I have a hunch that the median mortgage interest rate is at least 4.25%.

Third (and most importantly), the mortgage interest deduction means little or nothing to the vast majority of homeowners. According to the NAR, the median home price in the US is $182,600. Of those with mortgages, 64% are married couples. So the median homeowner is married with a mortgage less than $182,600.

Even if we assume that a homeowner did not make a down payment and has yet to make a principal payment, total interest paid in year 1 is $7,701 (assuming a 4.25% interest rate). This is well below the standard deduction for a married couple ($11,900). In other words, the median homeowner must have a fairly large amount of other deductions to see any benefit from the mortgage interest deduction.

And that’s year 1! As interest payments become a smaller and smaller portion of a borrower’s monthly mortgage, the mortgage interest deduction becomes even less relevant. In the end, the mortgage interest deduction only pertains to those people with large mortgages, not the average home buyer.

[Reply]

3 Dana Mills July 3, 2012 at 8:53 am

We made payments for about 23 years. I’m not rich, but I have a paid for house and 3 paid for viehicles. Maybe I need to borrow money on my house and buy stocks. NOT! As Dennis Millser used to say, “however that’s just my opinion. I could be wrong.”

[Reply]

4 Habib Darish July 5, 2012 at 5:35 pm

Paying down a mortgage is akin to investing in a truly risk-free asset. You should only compare that to a similar asset class ie CDs, 30-yr treasuries, checking acc, MMA etc. Therefore, as Brian suggests, paying down a mortgage in lieu of a cash or treasury position as part of a diversified portfolio makes sense.

[Reply]

Phillip Reply:

@Habib Darish,

What about the possibility that the value of your house will drop by a large amount? Some people will say no big deal because they would still own the house, but those with a broader view of net worth would consider this a loss.

[Reply]

Habib Darish Reply:

@Phillip, When you own a home you have equity risk regardless of your loan amount. In otherwords, a large loss on home value is still a large loss whether you paid cash or you’re 6 months in on a 30-year mortgage (unless you’re planning to short-sale or default) In that case, the banks may be able to come after your collateral.

[Reply]

5 Marie July 7, 2012 at 1:37 pm

A good read no doubt. It’s very rare these days when someone is totally debt free. there is definitely a giant psychological benefit of paying off
your mortgage. To own it free and clear except your taxes and
insurance is very liberating. Less stress, less worry,
less wondering, and more peace. But, at the same time,
if you took a loan out, say for 50% of it’s value so your
payments are low and you get $100,000, you can take that
money and get a nice rental that can give you about a 15%
rate of return. More risk, more responsibility, but it
can be more rewarding if you can adequately manage the
overstress that may come.
Marie

[Reply]

6 Tim Richmond July 25, 2012 at 11:48 am

This is an important debate to have, but maybe it needs to be widened beyond the financial blogosphere. I imagine many the average home buyers would not even consider other options beyond paying down their mortgage as quickly as possible.

[Reply]

7 شات مصرى September 5, 2012 at 10:55 am

Received hands Thanks

[Reply]

8 دردشة مصرية September 6, 2012 at 3:48 pm

شكرررررررررا لك علي مجهودك

[Reply]

9 منتدى اساحبى September 6, 2012 at 3:49 pm

شكررررررررررررررررررررررررررررا

[Reply]

10 منتدي اساحبي September 6, 2012 at 3:50 pm

ميرررررررررررررررررررسي

[Reply]

11 اساحبي September 6, 2012 at 3:51 pm

مششششششششششششششششششكور

[Reply]

12 شات مصري September 6, 2012 at 3:52 pm

براااااااااااااااااااااااافو

[Reply]

13 شبكه اساحبي September 6, 2012 at 3:53 pm

ميرسى شكرا لك علي مجهودك

[Reply]

14 asa7py September 6, 2012 at 3:54 pm

براااااااافووووووووووووو

[Reply]

15 شات October 5, 2012 at 9:55 am

Gooooooooooooood ….

[Reply]

16 شات بحبو October 5, 2012 at 9:57 am

بحبوووووووووووووووووووووووووووو

[Reply]

17 شات October 5, 2012 at 9:58 am

شات بحبوووووووووووووووووووو

[Reply]

18 شات مصري October 5, 2012 at 9:58 am

شات بناااااااااااتى

[Reply]

19 دردشة October 5, 2012 at 9:58 am

دردشة بحبووووووووووووووووووووو

[Reply]

20 دردشة بحبو October 5, 2012 at 10:00 am

جووووووووووووووووود دردششششششششة

[Reply]

21 دردشة مصرية October 5, 2012 at 10:00 am

جوووووووووووووووووووووود

[Reply]

22 منتديات October 5, 2012 at 10:01 am

منتديات بحبووووووووووووووووو

[Reply]

23 منتديات بحبو October 5, 2012 at 10:02 am

بحبووووووووووووووووووووووووووووووووووووو

[Reply]

Leave a Comment

You can use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>