Paying Off Your Mortgage Early – Finding Middle Ground In This Popular Debate

If there is a topic that comes up time and again on FI blogs it is whether or not paying off your mortgage early is the right move. A quick internet search returned a mere 26 MILLION results with the first page unfortunately populated by business posts instead of personal blog posts. I tend to believe that many people in the FI space have spent considerably more time pondering and analyzing this topic than the articles churned out by paid agencies on corporate sites. Now it’s my time to contribute the 26 million and first page dedicated to the topic.

Head vs Heart

The debate over paying off your mortgage early is distinctly left brain vs. right brain. On the left brain (analytical) side, math wins. Let’s say you have $1,000/month that you are considering putting toward your mortgage principal on top of your regular monthly payment. If you don’t put it toward the mortgage you are planning on putting into a broad-based, ultra-low expense ratio, equity index fund, such as Vanguard’s VTSAX or Fidelity’s FZROX. Math would tell you that if the average market return between today and the day you are scheduled to payoff your mortgage is greater than your mortgage rate (assuming a fixed rate mortgage) then the wiser financial decision would be to put the $1,000 into the index fund, payoff your mortgage as scheduled, and in the end you’ll come out wealthier than if you paid it off early.

Left Brain Right Brain
Paying off your mortgage is a left brain-right brain debate

However, the right brain (emotional) side says “Hold on a minute. Wouldn’t you feel like a huge weight has been lifted if you paid off your mortgage years earlier than scheduled?” And it’s true. If you are reading this and you have a mortgage that is not scheduled to be paid off in 10, 20, 30, or even 40 years, stop for a second. Envision the feeling you’ll have the day you make your last payment. Doesn’t just thinking about that day bring a smile to your face? Of course we all want to be free of our mortgage. The right brain argument says screw the math and do what makes you feel best. It’s hard to argue trading a few extra dollars in your bank account for years of no longer having to stress about being able to make your next mortgage payment.

Our Own Struggle

We know about this struggle as it is one we have been battling since purchasing our most recent house in 2012. For the first six years our collective left brain won. We paid our minimum monthly payment via automatic withdrawals. No more, no less. We cheered whenever the digit in the thousands column of our mortgage balance dropped by 1. It was a slow go. A couple years in you really start to understand just how long 30 years is. Nevertheless, math is math, and math told us to pay off our mortgage over the full 30 year term while investing any additional capital into index funds that should yield a higher return than the 3.75% mortgage rate we had.

Six months ago when my FI education was really taking shape my mindset changed. I was reading blog posts and listening to podcasts on the topic and heard people exclaiming how much of a stress reliever it was to have no more mortgage payment. It sounded way more exhilarating than watching the amount going toward my principal increase by $2 every month as the interest slowly dropped. By that time I had also convinced myself (or been convinced by others online) that the bull market we had been enjoying was coming to an end. If the market goes down then that 3.75% guaranteed return by paying extra toward my principal would be the better path. Using those extremely scientific arguments I convinced my wife that is was time for us to go full steam ahead with Operation Mortgage Paydown!

We started directing a portion of our monthly funds marked for savings toward an additional principal payment and away from index funds. The mortgage principal responded and really started to drop. No longer was it dropping by a few hundred dollars a month. We were watching it drop by almost $2,000 a month. Goodbye payoff date of 2042 and hello 2029! Talk about an endorphin rush!

Then a couple weeks ago on a Friday night while my wife had taken the kids to a play I was enjoying a quiet night at home. As people pursuing FI are prone to do how did I spend my evening? By opening up a spreadsheet and running the numbers on this extra mortgage payment endeavor of course. And what I saw in the numbers changed my thinking about paying off your mortgage early and formed the impetus behind this post.

What The Numbers Told Me

I created two mortgage amortization tables in the spreadsheet. The first table modeled putting an additional $1,500 toward the mortgage principal each month in addition to the minimum payment. The second table modeled paying our minimum mortgage payment each month and investing the extra amount ($1,500 per month in this case) into an index fund. The first table had a fixed 3.75% annual return on the additional $1,500 put toward the mortgage principal equal to my mortgage rate. In the second table I tested different annual returns for the $1,500 monthly index fund investment.

Mortgage Payoff Chart
Number of months to payoff mortgage based on average annual return of monthly $1,500 index fund investment

Using average annual return rates from 0%-10% I created the chart above, which shows how many months it would take for the total amount in the index fund to equal the remaining mortgage balance after paying only the regular mortgage payment each month. At that point we could take the balance out of the index fund and use it to payoff the mortgage. The star in the chart is plotted at our mortgage rate of 3.75%.

What did this simple chart reveal when compared to paying our minimum mortgage payment that has us paying off our mortgage in August 2041 (273 months away at the time of the analysis)?

1)  If we want to avoid market risk and take our fixed 3.75% return by paying an additional $1,500 toward the principal each month the mortgage will be paid off over 12 years earlier

2) If we trust long-term market returns and invest that $1,500 each month into an index fund that returns an average of 7% annually over the next 9 years we would cut an additional year off of our mortgage

3) With either approach we would pay off our mortgage in 8-12 years by taking $1,500 a month and paying it toward the principal or investing it. Either way that’s pretty awesome compared to the 23 years that the bank is expecting

Our New Approach To Paying Off Our Mortgage

After running the numbers and reviewing the chart above we arrived at a new approach to paying off our mortgage. The basis for this approach is the belief that over the next decade the returns from an index fund like VTSAX and FZROX will be greater than our mortgage rate of 3.75%. Is there risk with that? Of course, there is always risk when putting your money into the market. However, looking at long-term returns of the market tells us that over a time span of 8-10 years there is a good chance that we end up on the positive side of that bet.

Our plan blends the psychological appeal of paying off our mortgage early with the math that says investing extra money in the market vs. paying it each month toward the principal is the better approach.

The plan is…

  1. Pay the minimum mortgage payment to the bank
  2. Taking the additional $1,500 each month and invest it into VTSAX or a similar low cost index fund
  3. Repeat for the next 8-12 years (depending on average annual return of our investment
  4. Take the money out of VTSAX
  5. Use that money to pay off our mortgage
  6. Throw a party!

If the average annual return of our investment between now and when we pay off our mortgage is <3.75% we’ll consider ourselves a bit unlucky. However, it’s unlikely we’ll care about that for too long since we will no longer have a mortgage payment to pay each month.

If the annual return exceeds 3.75% we’ll have a two reasons to pop a bottle of bubbly. First, exceeding the fixed return we would have received paying off our mortgage directly through principal payments. And, second, still writing that check to the bank and saying, Adios, mortgage! As far as I see it either way is a win-win!

Applying This Plan To Your Own Situation

Some of you who are in a similar situation as us may be thinking…

I have an interest rate >5% on my mortgage. Does this approach make sense for me? As your interest rate increases it may make more sense to apply the payments directly to the principal vs. trusting that the long term returns of the market will exceed your mortgage rate.

I only have 5 years left on my mortgage and I have extra money I could pay toward the principal. Should I pay off the principal or invest it? Since your time horizon is relatively short (<10 years) you run a greater risk of investing your money right as a correction in the market occurs and the market may not recover in time for the annual returns to exceed your interest rate. That’s why this approach is ideal for people with a longer time horizon who can absorb a dip or two in the market.

What about capital gains? If I invest all of that money over a decade or more and then withdraw it to pay off my mortgage I’ll have a huge capital gains tax hit. If only we could all be so lucky to have made too much money in a rising stock market :). Honestly, though, it is something you should keep in mind. If the tax hit is too much for you to absorb in one year you could withdraw the amount over 2-3 years and spread out the capital gains. For example, withdraw half in December of one year and half in January of the next year to spread the taxes over two filings. Or, you could keep investing to the point where the total investment balance covers both the mortgage balance and the amount you will owe in capital gains tax.

Looking Ahead

We are excited to start on this new journey toward mortgage freedom. 8-12 years is still a long time but way better than looking at a date in the 2040s. Our new approach allows us to complete paying off our mortgage in a shorter time frame than our 30 year term while still trying to capitalize on higher market returns than what we would get from applying our funds directly to the mortgage principal. I look forward to providing updates along the way during our march to our Mortgage Independence Day!

What do you think of our new approach? Have you tried any alternate approaches to paying off your mortgage? Let me know in the comments below.

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