Should You Pay Off Your Mortgage Early? This is a popular question among homeowners. Some people believe paying off the mortgage as fast as possible is better, and some people believe investing the difference is better. In his book The Total Money Makeover, Dave Ramsey’s Baby Step #6 advocates paying off your home loan early. I think this is a good advice for his audience, and probably, the majority of people out there.
Dave says you should first invest 15% of your income for retirement before you work toward paying off your mortgage.
The Right Answer
I think there are many factors to consider to find the right answer, but for the most part, it can be summed up into three main choices.
- Pay Off Early. If you are not proficient with investing and your mortgage rate is relatively high, you’re better off prepaying your home mortgage. If your interest rate is higher than 6.5%, you should definitely pay off early or refinance your loan (see: 1.4x Investing vs. Debt Pay Down Rule for explanation). This is also a great choice if you are paying a Private Mortgage Insurance and you can get rid of it by increasing your equity.
- Invest. If you have a low mortgage rate, and you are a proficient investor, investing instead of prepaying is probably the more financially rewarding option.
- Dave Ramsey’s Approach. This is a balanced approach. Invest 15%, then use any extra money to pay off your mortgage early.
I feel mortgage debt is the lowest priority and you should prepay only if you already maxed out all of your retirement contributions and paid off your higher interest rate debts. Here is a graphic showing how we rank mortgage prepayment relative to other debts and investments (mortgage is at the very bottom):
Early Mortgage Pay Off vs. Invest
Since the right answer depends on so many factors, I cannot say that mortgage prepayment or investing is better for you. Instead, let’s examine the key factors that will help you make the final decision for yourself.
Advantages of Prepaying Your Mortgage
1. Reduce or Eliminate Private Mortgage Insurance
If you paid less than 20% down payment, then you have to pay a Private Mortgage Insurance (PMI) each month. Getting rid of your PMI is a good reason for prepaying your mortgage. If I have to pay PMI, I would definitely pay down my mortgage to get rid of PMI before I start investing in a taxable account.
2. Lower Your Lifetime Mortgage Interest Paid
I believe this to be the second most significant benefit of prepaying your mortgage. You’ll end up saving a good amount of money on interest payments. The money saved is risk-free and guaranteed. Not to mention, you’ll get out of a major debt obligation and own your home sooner.
3. No Investment Risks
Since you can’t beat prepaying with risk-free investments like certificates of deposit, money market, and savings, you’ll have to utilize investments that provide higher returns, such as investing in the stock market. With prepaying, there’s no investment risk involved.
If you are not a proficient investor, paying off your mortgage early is a good choice.
4. No Taxes on Money Saved
You have to pay the long-term capital gains tax on your investment gains, plus the dividend and interest payments are taxed at your marginal tax rate. Therefore, you do not recognize the full value of your investment gains.
For example, if your investment gained $6,000 in value and you have to pay 20% in taxes (15% for Federal and about 5% for State), that’s only equivalent to $4,800 net gain.
Disadvantages of Prepaying Your Mortgage
1. Opportunity Cost
Depending on your interest rate, investing could provide you with a superior return on your investment. So it’s possible to come out financially behind if you prepay. This is especially true if you have the opportunity to fund a retirement account like a 401(k) or an IRA due to their tax benefits.
This is why I think it’s better to max out your retirement contributions before you even think about making an extra payment toward your mortgage.
2. Lack of Diversification
Your house could be a significant portion of your assets (it is for me). By prepaying, you are not increasing your real estate investment (it’s still the same; you are just lowering the debt you owe).
By opting to invest your money elsewhere instead of prepaying, you are increasing your investment in other asset classes. This effectively reduces your real estate exposure and overall financial risk through diversification.
3. Fewer Tax Deductions
If you prepay, you are also reducing the amount you could use for tax deductions. For example, if you saved $500 on interest and your marginal tax rate is 27% (State plus Federal), you’ll lose $135 in tax deduction — therefore, your net saving is only $365.
Since long-term capital gain taxes add up to about 20% (15% for Federal and about 5% for State), you’ll need an investment gain of about $456 to match the $365 savings (i.e., $365 ÷ (1 – 0.2)).
However, this factor depends on how much you itemize because the IRS offers standard deduction — as such, your true deduction is only the difference between your itemized deductions minus the standard deduction.
4. Less Inflation Hedge
When you owe money, and you pay back over 30 years, inflation is your best friend. Assuming an average 3.0% inflation rate, your $1,000 mortgage payment is only worth about $415 thirty years from now.
5. Less Liquidity
Your mortgage is a secured loan. Prepayment doesn’t earn you any favor with the bank. The bank still has a lien on your house until you pay off that last penny.
If you hit some rough patches down the road and cannot make your payments, you could lose your home.
By investing instead of prepaying, you maintain liquidity and give yourself a little insurance against potential financial hardship. Sure, you could sell your home to avoid foreclosure…but selling under pressure is not fun.
The Swing Factors — It could go either way…
1. Mortgage Type
There are many types of mortgage. Your decision to pay off your mortgage early or not could depend mainly on the mortgage terms and the prepayment clause.
For example, you might not prepay if there is a prepayment penalty, or you might prepay if you have an Adjustable Rate Mortgage (ARM).
2. Mortgage Age
The age of your mortgage determines how much interest savings you will realize. Prepaying a newer mortgage is more beneficial than prepaying a mortgage that only has a few years left.
3. Mortgage Interest Rate
Obviously, it’s better to prepay (or refinance) a mortgage with a high interest rate. Since the long-term return on investment for the stock market is about 9%, it’s most likely better to prepay if your mortgage interest rate is higher than about 6.5%. On the other hand, if your mortgage interest is lower, it’s probably better to invest.
4. Investing Skill
The whole premise of this argument depends on your investing skill. If you can’t or won’t invest, and ended up spending the money, you’re better off prepaying.
5. Financial Stability
If your financial situation is unstable, it’s probably better to invest and stay liquid. This gives you some cushion against financial emergencies or losses.
Prepay vs. Invest Calculation
Here is an example of Prepay versus Invest calculation using my own situation as an example. I will be using two calculators that you can use to calculate your own numbers.
The variables are:
- $188,000 loan amount
- 4.25% interest rate
- 30 years fixed loan
- $116 principal prepayment per month
Using the Mortgage Payoff Calculator at Calculator.net, I found out that I saved $32,406.46 in interest and will shave off 5 years and 11 months.
The saving is not bad. If I factor in the loss in tax deduction, then my NET saving is probably about $21,000.
Now, using the Investment Calculator at Calculator.net, if I instead invest the $116 per month for 24 years at 9% average annualized gain, I would end up with $111,232….after 20% federal capital gains tax plus state tax, this is about $89,000!
For my specific situation, investing would be about 4.25 times more beneficial!
Dave Ramsey Mortgage Payoff Calculator
Dave Ramsey also has a very user-friendly Mortgage Payoff Calculator that you could check out.
The caveat here is that Dave Ramsey encourages people to pay off their mortgages early, so the calculator is only showing the benefit of making extra payments and leaving out the opportunity cost.
Is It Better to Pay a House Off Early or Not?
To sum it up, many factors affect your decision to prepay your mortgage or invest your money. To find the right answers, all of these factors must be considered carefully. Personally, my mortgages have low interest rates (3.75% and 4.25%), I am in a high tax bracket, and I have long investment horizon, so here is what I do:
- Make sure I have plenty of emergency fund,
- Make sure I fully fund my retirement savings in tax-advantaged accounts, and
- Make small prepayments along with my normal mortgage payments.
Essentially, I chose not to make any commitment to one specific area and spread my money out.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.