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Should You Pay Off Your Mortgage Early?

February 09, 2021
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Should You Pay Off Your Mortgage Early?

 

In 1968, the Federal government passed the Truth in Lending Act.  The law requires lenders to provide borrowers with loan cost information for certain types of loans, including mortgages.

I’ve always been a proponent of laws that promote disclosure and transparency.  I believe we should all have the most information available to make informed decisions, and the Truth in Lending Act accomplishes that.

One unintended consequence of the Truth in Lending Act, however, sometimes gets in the way of prudent financial decisions.  That is, when borrowers see the amount of interest they will pay to the bank over the life of a mortgage the usual reaction is, ‘we need to pay this early to avoid all this interest.’

But is that the right course of action?  Under current conditions, the answer is likely no.  Let me explain.

At the time of this writing, interest rates on a 30-year mortgage are at approximately 3.0%.  If you were to borrow $300,000 at these rates, you would pay approximately $155,000 in interest over the course of the loan.  That seems like a huge sum, so the natural instinct might be to pay this off early in, say, 15 years instead of 30. 

In order to pay the loan in 15 years instead of 30, you would need to pay an extra $806.93 to the bank each month for 15 years.  This would provide a savings on the interest of $82,419.[1]  No doubt this is a significant savings, unless you consider an alternative scenario…

Over the course of the past 15 years (from January 2006 to last month) the S&P 500 Index has returned an average of 7.47% on an annual basis.  This is despite the crash of 2008/09 and the many corrections in that time frame.[2]

Let’s suppose you used your monthly $806.93 to invest in the S&P 500 Index for those same 15 years[3]  and you earned a flat 7% rather than the 7.47% the S&P 500 returned for that period.  At the end of the 15 years, your monthly investments would be worth $257,258 – far greater than the $82,419 you would have saved by paying your mortgage off early.[4]  Having $257,258 is far better than saving $82,419.  In this scenario of low mortgage interest rates, the correct strategy would be to pay the interest and invest the extra mortgage payment for yourself instead.[5]

To be sure, this won’t always be the case.  If mortgage interest rates were to climb to the 7% range, for example, you might be better off putting your money toward the mortgage instead.  This is why we tailor our financial plans for the individual.  We base our financial recommendations for what is appropriate for our client at a given time.

If you have any questions or wish to discuss this further, please don’t hesitate to contact me.

[1] https://www.nerdwallet.com/article/mortgages/early-mortgage-payoff-calculator

[2] https://dqydj.com/sp-500-return-calculator/

[3] You cannot invest directly into an index.  This is for illustration purposes only.

[4] https://www.nerdwallet.com/blog/investing/investment-calculator/

[5] Notes:  All investing involves risk including loss of principal.  No strategy assures success or protects against loss.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.