Broker Check

Should I pay off my mortgage early?

| May 14, 2017
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Retirement

I occasionally come across prospective clients who say to me: I would like to have you help me with my investments someday but I’m going to work on paying off my home first before I start saving.  Their plan is to take as much extra cash as they have each month to pay down the mortgage.  Once the mortgage is paid off, they plan to invest for retirement.

 

Is it better to pay off the mortgage and then begin saving?  Is it better to save/invest now and pay down the mortgage more slowly? Who will come out better?

 

Let’s take a look at a hypothetical example:

 

Couple A, are both age 35.  They put a 20% down payment on a $350,000 home and take on a 30 year fixed mortgage at the current rate of 3.3%.  With a down payment of $70,000 this leaves the couple with a loan amount of $280,000 and monthly mortgage payment of $1,222 per month not including taxes and insurance.  Couple A pays an extra $1,000 per month towards the mortgage for a total payment of $2,222 per month not including taxes and insurance.  Couple A’s home will be paid off in 12.9 years which saves them from paying thousands in interest.  With the house fully paid off, the couple can now begin saving $2,222 per month starting at the age of 48 in a portfolio of stocks and bonds earning a hypothetical 6.5% annual return.  At age 65, the couple retires. With 17 years of savings/investing using a 6.5% growth rate*, the couple’s portfolio might have grown to $829,095 at the age of 65.  Using a 4% withdrawal rate, the couple could expect monthly income starting at age 65 of $2,763 per month before taxes.

 

To summarize couple A:

  • Buy a $350,000 home at the age of 35 with a monthly mortgage payment of $1,222
  • Put an additional $1000 per month towards the mortgage to pay it off in about 13 years
  • Begin saving $2,222 per month for retirement at age 48
  • By age 65, using a 6.5% estimated growth rate, the couple will have $829,095 saved
  • This gives them an estimated $2,763 per month in income before taxes during retirement
  • If the home averaged 3% growth over time, at age 65, the couple’s net worth would be $859,894 (home) + $829,095 (investments) = $1,688,989 total net worth

 

Couple B, are both age 35.  They put a 20% down payment on a $350,000 home and take on a 30 year fixed mortgage at the current rate of 3.3%.  With a down payment of $70,000 this leaves the couple with a loan amount of $280,000 and monthly mortgage payment of $1,222 per month not including taxes and insurance.  Couple B begins saving $1,000 per month toward retirement beginning at age 35 in a portfolio of stocks and bonds earning a hypothetical 6.5%.  Couple B’s home will be paid off in 30 years at the age of 65.  At age 65, the couple retires. With 30 years of savings/investing using a 6.5% growth rate*, the couple’s portfolio might have grown to $1,112,169 at the age of 65.  Using a 4% withdrawal rate, the couple could expect monthly income starting at age 65 of $3,707 per month before taxes.

 

To summarize couple B:

  • Buy a $350,000 home at the age of 35 with a monthly mortgage payment of $1,222
  • Invest $1,000 per month into a portfolio of stocks and bonds starting at age 35
  • By age 65, using a 6.5% estimated growth rate, the couple will have $1,112,169 saved
  • This gives them an estimated $3,707 per month in income before taxes during retirement
  • If the home averaged 3% growth over time, at age 65, the couple’s net worth would be $859,894 (home) + $1,112,169 (investments) = $1,972,063 total net worth

 

There is an additional factor that is not taken into account in the two scenarios above: taxes.  Couple A deducts the interest payments on the mortgage for 12.9 years.  Couple B deducts the interest payments on the mortgage for 30 years.

 

Couple A would have paid (and potentially deducted) a total of $64,086 in interest over the entire loan.  If couple A is in a 28% federal tax bracket, this would save roughly $17,944 in federal income taxes over the entire loan.

Couple B would have paid (and potentially deducted) at total of $161,458 in interest over the entire loan..  If couple B is in a 28% federal tax bracket, this would save roughly $45,208 in federal income taxes over the entire loan.

 

Comparing couple A and couple B, the biggest advantages in my opinion for couple A is they pay less interest and they may get peace of mind from paying off their mortgage early.  Also, couple A has no market risk on their investments during the mortgage period because they are not investing during this period of time.  However, there are numerous disadvantages for couple A.  Under this basic example, couple A’s portfolio has a lower value at age 65 which leads to a lower income stream during retirement.  Couple A has a lower estimated net worth at age 65.  And couple A loses a tax deduction when their mortgage is paid off early.

 

Couple B has market risk with their investments during the entire 30 year period, which may be a disadvantage.  Couple B pays more interest than couple A.  However, couple B has a larger estimated portfolio value, a larger estimated net worth, and larger estimated income in retirement.  Couple B also has a larger tax deduction over the entire loan period.

 

In order for couple A to come out ahead of couple B, the annual percentage growth rate on the home would have to consistently outperform the annual growth rate on the investment portfolio plus the extra taxes paid.

According to Zillow, US Home prices have risen between 3 and 5% annually.  According to MarketWatch.com the S&P 500 Index returned an average of 9.8% between 1928 and 2014.

Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.

All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. Past performance is not an indication or guarantee of future results.

*The hypothetical investment results and growth rates are for illustrative purposes only and should not be deemed a representation of past or future results. Actual investment results may be more or less than those shown. This does not represent any specific product and/or service.

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