Should You Pay Off Your Mortgage Early? With Rates Rising, the Answer Gets More Complicated
Author: Nick Prigitano
A common question we get asked as financial planners is whether homeowners should put extra money toward their mortgage to pay it off early. Of course, the exact answer will depend on your goals, but with previous mortgage interest rates being near historic lows, it often didn’t mathematically make sense to pay down the mortgage. While past performance does not guarantee future results, over the long term, the return from the stock market has been higher than the interest rate paid on these mortgages.
However, with interest rates on mortgages rising, the math part of the equation gets a little more fuzzy if you’ve taken out a mortgage recently, or may in the near future. Here are some things you should consider before deciding whether to allocate extra money toward paying off your mortgage.
Check These Boxes First
Homeowners should consider allocating extra money toward paying off a mortgage only if certain items have already been handled. This includes ensuring that you have an emergency fund in place, which is generally recommended to be three to six months’ worth of living expenses. Also, it’s important that you contribute to, and probably max out, your retirement accounts at work because of the tax benefits and the need for savings for retirement. Last, considering your goals holistically is critical when deciding how to allocate your limited resources. This includes considering whether money would best be allocated elsewhere, such as for vacations, college funding, a new car, or additional retirement savings, among other goals. Once these boxes are checked, then you can decide whether it makes more sense to put additional money toward the mortgage or invest it.
You’ve Had Your Mortgage for a While
As mentioned before, much of the reason the recommendation to invest rather than put extra money toward a mortgage has been pretty straightforward is because historically, over the long term, the stock market has outperformed the interest rates on many mortgages. While past performance does not guarantee future results, many advisors and consumers are comfortable accepting the risk of the stock market outperforming a 3% mortgage interest rate over the long term. Therefore, common wisdom is generally to invest extra cash flow rather than paying down the mortgage based on that interest rate environment.
This remains true even as interest rates have begun to rise. If you’re locked into a fixed-rate mortgage, changes in interest rates don’t affect you. You continue to make the same payment regardless of what the new rates are. These interest rate changes only impact those with an adjustable-rate mortgage (ARM), new fixed-rate borrowers, and those who decide to move or refinance.
Another reason to consider investing extra cash flow instead of paying extra toward a mortgage is because of the way amortization tables work. An amortization table is just a fancy way of saying how much of each payment is made up of interest versus payments against the outstanding loan balance.
The way that mortgage payments work is that at the beginning of the loan the vast majority of the payment is made up of interest. On those first payments, very little of the monthly amount goes toward reducing the outstanding loan balance. As time goes on, more and more of the payment is made up of principal and less of interest. The math of these calculations ensures that interest is front-loaded so the bank gets paid first. If you’ve had your mortgage for a while, there is a good chance that much of the payment is already going toward the principal anyway, and there isn’t much “interest” savings on extra payments. This is why making extra payments early on in the mortgage has an outsized effect on the total amount of interest paid.
While the cold hard math may suggest that investing instead of paying additional money toward a mortgage is the more prudent path, not enough can be said about the psychological and emotional benefits of not having a mortgage. We’ve all heard of mortgage payoff parties where homeowners celebrate being completely debt free. On the other hand, I’ve never been invited to a party for “our investment account has increased X percent over the past year.” That’s just not as exciting or meaningful. So, depending on your goals and values, it may be perfectly reasonable to pay off your mortgage faster even if the math would argue otherwise.
Your Mortgage Is at a Higher Rate
As of May 4, the average interest rate on a 30-year mortgage was at 5.58%. That’s a far cry from the mid-to-low 3% rates we’ve seen over the past few years. What may be even more troubling to future borrowers is that, at least in the near term, it appears that rates may continue to rise further as the Federal Reserve takes additional actions to attempt to combat inflation.
Although the math doesn’t work perfectly, a quick back-of-the-envelope way to consider the “return” on paying extra toward a mortgage is the interest rate of your loan. As interest rates have continued to rise, the return someone would get for paying extra toward their mortgage has increased. While the math is more clear cut when the rate is 3%, the decision to invest or pay extra toward a mortgage gets a bit more murky when the rate is 5%, 6%, or even higher.
In the current interest rate environment, the decision to invest or pay additional money toward the mortgage requires a bit more thought. Everyone’s goals and risk tolerance are different, so the ideas proposed below are hypothetical and should be discussed thoroughly with a financial advisor to determine what may be right for you.
A cornerstone document that nearly every investor should implement is an investment policy statement (IPS). Every client at Milestone has one of these because it is so critical to prudent investment management. This document can be as broad or specific as you like, but at a high level, it will define your target allocation between stocks and bonds. This document is important because when the stock market gets volatile, you have a written statement that defines what your investment breakdown should be. It’s intended to keep your investments on track and to help you avoid making emotional investment decisions when stress is high. This oftentimes means selling bonds to buy stocks to rebalance your portfolio when the stock market has dropped. It can be incredibly difficult to implement a rebalance when fears and emotions are high. The purpose of the IPS is to help you take a step back to review things more rationally.
As we keep mentioning, past performance does not guarantee future results but historically speaking, the stock market has always recovered from temporary drops. Rebalancing can improve returns by selling what has performed better and buying what has performed worse because of the historical potential for outsized future returns. When a diversified asset class, like large US companies, drops in price, the overall valuation of that asset class improves. This is because when prices are lower, all things being equal, the valuation of expected future returns is higher. When the stock market drops, it is said to be like buying “at a discount” (or “on sale”) because future expected returns have increased.
Having an IPS can help take the emotions out of rebalancing and encourage investors to sell high and buy low when rebalancing is warranted. However, these predetermined “rules” for investing can be expanded beyond just determining what percentage of stocks and bonds to target. It can include other topics such as when it may make sense to invest additional money instead of paying extra toward a mortgage. With new mortgages being at higher interest rates, the go-to recommendation may not be to invest extra cash flow. Instead, the determination of whether to invest or pay down the mortgage may depend on what the market is doing. As discussed before, when the market drops, future expected returns are higher. This may be a better time to invest than to pay down the mortgage. Below is an example of what an additional investing rule may look like. Example: Mary and Mike have an established emergency fund of six months’ worth of expenses and are both maxing out their 401(k)s at work. They just bought a new home, and their current mortgage interest rate is 6%. They have an extra $1,000 of cash flow a month and have decided to “invest” that extra cash as follows: Under normal circumstances, pay an extra $1,000 a month toward the mortgage. If the S&P 500 drops between 10% and 20%, split excess cash flow 50/50 ($500 each) between paying down the mortgage and investing.
If the S&P 500 drops more than 20%, begin allocating 100% of excess cash flow ($1,000) to investments. In the example above, Mary and Mike have a predetermined plan of what to do with excess cash flow depending on what the market is doing. Based on future expected returns, investing when the market has dropped can be a good time to buy, but it is often the most psychologically difficult time to buy because of concern about the market dropping further. Forming a plan when emotions are calm can help ensure that the plan is created thoughtfully. In the above example, based on the higher interest rate of the mortgage, Mary and Mike opted to take a “guaranteed” return of paying down the mortgage when the market was doing well. However, they decided that if the market dropped and future expected returns were higher, they would take more risk by investing in the stock market. Of course, the example above is just that — an example. Depending on your personal mortgage situation, risk tolerance, and goals, your investment plan may look significantly different. It is best to work with a qualified financial professional to help evaluate your financial situation and collaborate to create a plan that works for you and your goals.
The mortgage interest rate environment is changing rapidly. Although rates are increasing, these changes will not affect many who already have mortgages. However, for those who are entering new mortgages, the math evaluating whether it makes sense to allocate extra income toward investing or paying down the mortgage is becoming less clear-cut.
It is crucial to have an investment plan in place. One of the foundational documents to implement is an IPS that establishes the breakdown of stocks and bonds you wish to target. In addition to that, you can include other “rules” to help determine in advance when you would want to invest extra dollars rather than paying down the mortgage faster.
Everyone’s situation and risk tolerance are different, though. What may make sense for someone else may not work for you. It is best to work with a qualified financial advisor to help determine what your goals and financial situation are and point you in the right direction. If you need assistance with your overall financial plan, please reach out to our team.
Nick Prigitano, CFP® is an advisor at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisor.