Debt is a double-edged sword. It allows you access—or earlier access—to resources that might otherwise have been unavailable.
But… (of course) you have to pay it back.
And, when you pay off debt, you almost always end up paying more than the original amount you borrowed due to a little thing called interest.
But, after all, if lenders aren’t earning a profit over the long-run, they have no incentive to lend.
And by far the largest debt most Americans take on throughout their lives is a home mortgage (although student loan debt is on the rise).
Which makes sense since mortgage debt is often a sensible debt. For one, real estate is usually an appreciable asset. Plus, your family needs a place to live, and paying cash for a home is not an option for most people.
Even so, all things being equal, it’s often better to not be in debt than to be in debt. And so many homeowners strive to pay down their mortgages ahead of schedule—whether by making additional principal payments each month or via a lump sum, perhaps acquired from some windfall or inheritance.
Here’s the thing, though: you don’t always come out ahead when you pay down your mortgage early.
There are a host of factors to consider, but, in many situations, you may be better off applying the extra mortgage payments toward another investment or more liquid savings vehicle.
That’s not to say there aren’t advantages to paying off your mortgage (because there are), but there are costs as well.
Advantages of Paying Off Your Mortgage Early
There’s something to be said for not being in debt. Eliminating a mortgage can be an emotional relief, lifting a metaphorical burden off of your shoulders.
And getting rid of a major fixed expense allows you more budgeting flexibility to do other things. That can be a serious boon if you’re getting ready to retire, start a new business, or put your kids through college, (although the cash you just used to pay off your mortgage early might have been handy to have when pursuing any of these).
Cut Out The Bank
Just as significantly, when you pay your mortgage early, you’re reducing the total amount you’ll have to repay to the bank.
Every supplemental payment reduces the principal balance of the loan, and every dollar applied toward principal is not accruing any future interest.
And over the course of a twenty or thirty-year mortgage, the interest savings can end up being considerable, amounting to hundreds thousand dollars in savings.
When you think of it this way, supplemental mortgage payments are like an interest-earning investment. The extra principal is the investment, and the return is the interest you don’t pay in the future.
Like Benjamin Franklin said, “a penny saved is a penny earned,” right? And every financially guru, from Dave Ramsey to Suze Orman, will tell you to get out of debt as soon as possible.
By reducing or eliminating your mortgage, it can free up the real estate to serve as security for future credit access, although having an equal amount of liquid cash available might be superior.
Another potential benefit to paying your mortgage vs investing is that when you own your home outright or have significant equity, selling the home and moving, or refinancing, is a lot easier.
Additionally, you’re also removing or decreasing the risk of foreclosure, which puts your family in a better position to weather a future financial setback. But if you have a lot of equity in your home vs another home owner who has little to no equity, who do you think the bank is going after first in a foreclosure, all things being equal?
If a major setback does occur, a home owned free and clear (or close to it) can provide a bedrock asset capable of surviving a personal bankruptcy, although, once again, having your cash liquid and accessible might also protect you from bankruptcy.
State homestead exemption laws, which provide protection in bankruptcy and from creditors, exempt certain residential real estate value.
For example, under Florida’s Homestead Act, a primary residence is 100% exempt. A secured creditor may still be able to foreclose, but a mortgage-free home is safe from trustee attachment, and the home’s value can come out of a bankruptcy fully intact.
Similarly, personal residences are exempt from the eligibility tests for most means-tested government benefits. So, a homeowner trying to qualify for nursing-home coverage through Medicaid could benefit from shifting wealth into his or her primary residence, if structured correctly.
Ben Franklin’s old quote about pennies is certainly applicable when thinking about paying down a mortgage early. But there’s another old adage you also need to consider: “there’s no such thing as a free lunch.”
Advantages of Investing the Extra Money
When economists view a purported “free lunch” with suspicion, they’re thinking about a concept known as “opportunity cost.”
Every dollar you put into paying down your mortgage early is a dollar you can’t use for something else.
Now, if you would just use that money for luxuries anyway, paying down your mortgage is probably a wise decision.
But if there are more productive investment or savings options available, you’ll want to review the decision carefully. After all, the rate of return of home equity is zero. So, if you can get any return on your money outside of home equity, you are probably better served elsewhere than keeping all your money trapped in your home.
And because first mortgages are typically fully secured, they tend to have fairly low interest rates.
If paying extra on your mortgage will save you 4% annual interest on the additional principal, but you could just as easily put that money in a secure investment that earns 6% returns, you’ll come out ahead over time by making the minimum mortgage payments and investing the surplus.
If an investment can be made with pre-tax money—like with an IRA or qualified annuity—the benefit is even greater because you’re both earning bigger returns and saving on taxes.
Of course, mortgage interest is also deductible, but only if you itemize your deductions, which, under the current tax code, fewer filers are doing.
Even assuming the savings on future mortgage interest and available investment returns are comparable, the financial advantages of an early pay-down are less tangible.
The increased equity undoubtedly has value, but it’s more difficult to access than more liquid savings or investment vehicles.
And, with many older mortgages, there may be a contractual pre-payment penalty that will eat away some of the interest savings.
Difficult to Tap Into Equity
For the most part, accessing home equity in the form of cash requires either a sale of the property or another loan like a HELOC (“home equity line of credit”).
Either option involves significant transaction costs (reducing the real value of the interest savings), and, with a HELOC, you’ll lose some or all of the saved interest when you pay back the interest on the new loan.
So, if you’re goal in paying down the mortgage is to build up equity to facilitate future credit access, you’re probably better off applying the money toward another asset that can serve as security but is more liquid and easier to tap.
As an example, say you applied money otherwise slated for a mortgage overpayment toward a secure, long-term, interest-accruing asset like cash value life insurance.
Take whole life insurance, for instance. The growth on the life insurance policy’s cash value is guaranteed and you get the benefit of insurance coverage in the event of an untimely death.
Other Considerations to Consider When Deciding Between Paying Off Your Mortgage Early or Investing
The above analysis relies on the assumption that investments will pan out, which we all know is not always the case.
Historically, stock market returns almost always beat prevailing mortgage rates, but you also run the risk of poor investment performance and loss of principal. After all, the stock market is a zero sum game.
On the flipside, future interest saved by prepaying a mortgage is more or less definite, but an increase in equity is not a sure thing because there’s always the chance of the real estate market dropping.
Thus, the most reliable approach may be to invest the surplus in an asset with guaranteed returns. And whole life insurance is an asset that offers such guarantees as a fixed premium, interest rate growth and death benefit protection.
Inflation is another factor that can potentially change the calculation.
If you make sufficient extra principal payments over time to knock off a full year’s worth of mortgage payments at the end of the loan, the money you save on the back end probably won’t be worth the same, dollar-for-dollar, as it is now.
Mortgages are usually long-term, and inflation can change the value of a dollar a lot over twenty or thirty years.
Also, interest rates are low now, but that might not always be the case. If rates increase, the real value of an early payment on a low-interest mortgage will decrease.
As financial advisers have long said, there are advantages to having diversified assets. Unforeseen contingencies can arise that affect the value of just about any asset—whether it’s inflation, a bear market, a drop in real estate values, or a natural disaster.
Don’t Put All Your Eggs in One Basket, i.e. Your Home
So, it’s a good idea not to have all your eggs in one basket. Having too much of your wealth tied up in your home creates the potential for financial disaster if, for some reason, the property sustains a significant drop in value due to a depressed housing market or natural disaster.
By contrast, putting extra cash into an asset with guaranteed growth and little or no risk of loss—whether it’s CD’s, cash-value life insurance, or annuities—provides protection against losses in other areas.
The odds are that, even if you only make minimum mortgage payments, your home’s value will increase over time (the national average is between 3-5%).
Your house is not a bank. And if you have a mortgage, the bank actually owns the property, not you. Therefore, holding your wealth in multiple places is almost always the safest and most reliable way to grow net worth while mitigating risk and guaranteeing liquidity.
And you can always consider using life insurance as your own bank.
One final point worth noting is that, to successfully implement any financial strategy, you need to have the discipline to carry it out.
If you’re not diligent about investing the money you’d otherwise apply to your mortgage, the strategy won’t lead to a long-term increase in wealth.
But if you’re confident you’ll invest the surplus religiously, it’s worth exploring whether you’d be better off with a secure investment than a reduced mortgage.
Finally, check out our book review of 7 Money Myths That Are Killing Your Wealth, by Keith Weinhold as well as the below video from Keith as part of his Get Rich Education podcast.
Keep your debt. Get financially-free instead. We’re talking about good debt. Retiring your debt often means you can’t retire yourself.