Mortgage rates have dropped drastically in recent years and here at Ironstream we’ve been fielding questions from clients regarding the pros and cons associated with paying off their mortgage early.
This is a really great question because it deals with the difference between a “sure return” (paying off the mortgage early) and an unknown, but likely higher, variable return (investing in a diversified portfolio). In this investor letter we’ll share an overview of current mortgage rates and the pros and cons of paying off your mortgage early.
As bond interest rates have fallen this year, mortgage rates have followed suit. Recently, 30-year fixed rate mortgage rates have fallen below 4%, with 3.75% being the most recent nationwide average (Exhibit A). Relative to history, this is extremely low. Over the past 48 years, the average 30-year mortgage was in excess of 8%.
To put this in perspective, for a $500k mortgage loan, this means the difference between a $3,669 payment per month for an 8% loan and a $2,316 payment per month for a 3.75% loan. Furthermore, and even more impressive, this difference in mortgage rates results in 59% less interest being paid over the life of the loan, $821k vs. $334k.
Exhibit A: 30-Year Fixed Rate Mortgage Average in the United States
Should you pay off your mortgage early? Well, it depends. As with every financial decision, there are pros and cons:
Pros
Peace of mind: Paying off a mortgage early provides an emotional benefit through peace of mind. Retiring a mortgage early reduces monthly cash outflows and can help many sleep better at night knowing they own their home free and clear.
Interest savings: With every mortgage, comes the interest cost of the loan. Every monthly payment contains a portion allocated to the interest cost. By paying down a mortgage early, you can reduce the overall interest cost of the loan and a dollar saved in interest is a dollar earned.
Cons
Uses up liquidity: By paying off a mortgage early, especially in a large single payment, you are using up cash that could be allocated to other purposes, such as paying down higher-interest debt such as credit cards, student loans, and auto loans. Additionally, you always need to make sure you are “paying yourself first”, i.e. saving for retirement. The unfortunate truth is while banks will line up to loan you money for a home purchase, they won’t do the same to loan you money for retirement!
Opportunity cost: Paying off a mortgage early is a great example of the opportunity cost of a major financial decision. While paying off a mortgage provides a predictable “return” through interest savings, the opportunity cost is that you may miss out on better returns achieved in a diversified investment portfolio. For example, if your mortgage rate is 4% and you can earn 5% after taxes and fees in a diversified investment portfolio over the life of your mortgage, the opportunity cost of paying off your mortgage early is 1% per year. Said a different way, by investing in a diversified investment portfolio, you could earn a higher return on your extra cash than by paying down your mortgage, providing a better financial outcome.
In the end, there is no right decision when it comes to the question of paying off your mortgage early. One must evaluate the different options, their unique financial situation, and their personal feelings towards debt. While mortgages in previous decades carried higher interest rates, today’s extremely low rates make this decision more difficult. As the return from a diversified investment portfolio may exceed the low interest rate of a 30-year mortgage, the opportunity cost of paying down a mortgage early has grown.
Ironstream Capital works with clients to quantify and weigh the pros and cons of this decision and other important financial decisions. Please let us know if we can help you answer this question based on your personal financial situation.
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