If you’re a homeowner, at some point, someone has undoubtedly advised you to pay off your mortgage early. They’ve probably suggested early payoff techniques like paying bi-weekly instead of monthly, allocating extra funds directly to the principle, or increasing your payments by some amount each month. Some may have even suggested emptying out your savings and applying it all toward paying down your home loan. The ultimate intent of these types of suggestions is usually to help you save money.
The logic goes that by paying off your mortgage early, you save yourself thousands, if not hundreds of thousands of dollars in interest payments. On the surface, this seems like sound reasoning and it's easy to demonstrate the perceived savings.
Early Payoff Savings
Both Robert and Phil have just become homeowners! They each purchased their new home for $250,000 with a 30-year 4.60% fixed rate mortgage. Although their minimum monthly payment is the same, they plan to tackle their mortgages in very different ways. Robert plans to stick to the normal payment schedule over the 30-year life of the loan, while Phil plans to pay his loan off early by contributing an extra $500 each month. Let’s see how things turn out.
Mortgage = $250,000
Loan Term = 30-Years
Interest Rate = 4.60%
Minimum Monthly Payment = $1,282
Monthly Payment = $1,282
Time To Payoff Loan = 30 years
Total Amount Paid = $461,380
Total Interest Paid = $461,380 - $250,000 = $211,380
After 30 years, Robert has paid over $200,000 in interest! His home is now paid off but it cost him nearly double the original purchase price.
Monthly Payment = $1,282 + $500 = $1,782
Time To Payoff Loan = 16 years
Total Amount Paid = $359,480
Total Interest Paid = $359,480 - $250,000 = $109,480
Money Saved = $461,380 - $359,480 = $101,900
Time Saved = 14 years
By contributing an extra $500 each month, Phil was able to pay his mortgage off in only 16 years instead of 30. In addition, Phil saved over $100,00 in interest he would have had to pay had he only made the minimum payments!
Following this example, the correct approach seems simple: Put as much as you can afford toward your mortgage, paying it off as soon as possible, and you’ll save yourself massive amounts of both time and money. At first glance, this seems like a perfectly reasonable plan. Unfortunately, it could potentially cost you hundreds of thousands of dollars.
The key component that is missing from this analysis is, you guessed it, investing. In the example above, the extra $500 Phil applied to his mortgage each month could have just as easily been used as investment capital. I wonder how things would have turned out in that case…
A Better Option?
First, we’ll calculate what Phil’s net worth would be after 30 years. Using the parameters from the original example, we assume he contributes an extra $500 each month to his mortgage and is finished paying off his house in 16 years. At this point, without a mortgage to pay, Phil begins making monthly contributions to his stock investment account, something he continues to do for the next 14 years (i.e. 16 years + 14 years = 30 years).
Stock Investment Rate Of Return = 8.5%
Monthly Contribution = $1,782
Years Of Investing = 14 years
Investment Account Final Value = $571,914
Net Worth After 30 Years = $571,914 + Fully Paid Off Home
After 30 years, not only does Phil fully own his home, he also has $571,914 in his investment account! Not a bad result at all, but could he have done better?
Let’s assume Robert also had an extra $500 to spend each month, but instead of applying it to his mortgage, he decided to contribute it to his stock investment account.
Monthly Contribution = $500
Years Of Investing = 30 years
Investment Account Final Value = $825,353
Net Worth After 30 Years = $825,353 + Fully Paid Off Home
Wow. Even though Robert only contributed $500 each month to his investment account, he ended up with over $250,000 more than Phil (i.e. $825,353 - $571,914 = $253,439)! By allocating extra money to his investments instead of his mortgage, Robert was able to out-save Phil by HUNDREDS OF THOUSANDS OF DOLLARS, all while still paying off his home! How is this possible? The answer is simple: Time + Compound Growth.
Because of the large amount of interest you end up paying, it seems logical that paying off a mortgage early will save money. However, things aren’t as black and white as they seem. By paying off your mortgage early you may ultimately be costing yourself a boatload of future wealth.
But, before making any big changes in how you handle your mortgage payments, run your own numbers and be sure that you’re doing what makes the most financial sense for your particular situation. For example, if your mortgage has a high interest rate, the benefits of investing extra money may not be as attractive. Additionally, if you don’t have the discipline to actually invest the extra money, it would probably be better to just contribute it to the mortgage.
Are there any other circumstances where it would be better to prioritize paying off your mortgage over investing? Leave a comment so we can discuss it!
Tools To Get You Started
Get a head start on your journey toward achieving financial independence by analyzing and tracking your income, expenses, investment performance, and overall net worth with the free online wealth management tool Personal Capital.
We use Personal Capital regularly to analyze our investment fees, track our investments, and project our net worth. We also periodically review our progress toward retirement with their retirement planning calculator.
If you’d rather do things on your own, become a subscriber today and you’ll receive our Free Financial Planning Dashboard. This tool allows you to enter your income and expenses to create a detailed budget. You can use it to track your spending habits over time or just to get an idea of where your money is going each month. Take a look at the automatically generated charts and you may discover you have a little more cash to invest than you thought.
If you’re interested in detailed instructions on how to budget, save, pay off debt, and invest, check out The 6 Phases of Building Wealth. This book provides step-by-step instructions for working through each “Phase” in the process of achieving Financial Freedom. If you're just starting out, the information in this book will provide you with an invaluable resource. You can pick up the digital version for only $2.99 on Amazon.
Disclosure: Some of the links found on this website may be affiliate links. Affiliate links pay GGD a small commission when you click through and/or make a purchase. This is at zero additional cost to you.