Paying off your home early? Let the market do it for you.

One of the most common questions I get from people is whether or not it is a good idea to pay off/down their mortgage and what is the best way to do so. This question never surprises me. After all, about 65% of U.S. citizens are homeowners and about 60% of those homeowners currently  have a mortgage on their home. That means about 40% of the total U.S. population deals with a mortgage payment each month. And, given that their mortgage is likely the largest debt payment they face, it’s no wonder people would prefer to get rid of it early.

These conversations happen regularly enough that I already wrote an article about paying down mortgages during a low interest rate environment. If you haven’t read “Don’t pay down your mortgage!”, then click the link to read about the different factors involved and how it might benefit you.

Cliffs notes: is paying down your mortgage right for you?

If you do read the previous article, you will have a much clearer understanding of the reasons behind paying down your mortgage (and perhaps why not to). However, in the interest of time, here are some of the main ideas to consider:

1.      Most people who have purchased or refinanced a home between 2005 and 2021 have an interest rate below 5%. If you currently have one of these mortgages, you should consider the idea that your money will likely earn more invested in the market over the long run than it will save you against your mortgage.

2.      Paying down your mortgage does not increase your liquidity. While yes, this will increase the equity in your home, extra money spent towards your mortgage is immediately tied up in the equity it creates. Yes, there are ways you can get this money back if you need it, but doing so will involve loans (more debt) or selling your home.

3.      What goal are you hoping to achieve by paying down your mortgage? While it’s never a BAD idea to pay down debt, you should explore what this is helping you accomplish (other than just paying off debt). Most common goals associated with paying off a mortgage revolve around cash flow. That is, by eliminating the mortgage payment on your home, the resulting increase in cash flow may allow you to pay for college or finally retire.

Meet Morty, our Mortgagee

Meet our friend Morty. Morty is 45 years old, has 25 years left on his 30-year mortgage and is suddenly realizing that retirement isn’t so far off in the future as it once was. Morty visits his planner and is pleased to learn that he might have some options. He learns that even though his mortgage payment isn’t a huge burden currently, paying off his home and removing the monthly payment could go a long way in making an earlier retirement possible. His planner explains that pairing a decreased (or eliminated) mortgage payment with decreased income in retirement could ultimately make a difference in his decision.

Morty doesn’t have a firm retirement year in mind but he knows he doesn’t want to work until his mortgage is paid off at age 70. He’s intrigued by the idea of an early payoff and eager to find out how it could work. His planner has an idea for him but first explains the most traditional method of paying off a mortgage.

Common wisdom from the 80s

During the 80s, the mortgage environment was much different than it is currently. It’s impossible to believe compared to today, but over the 10-year period from 1980-90, mortgage interest rates averaged between 10 and 16%. Needless to say, it was a much different time.

During this decade, it became common wisdom to pay extra on top of regular mortgage payments. After all, through some inverted thinking, for any extra payment made towards a mortgage, the payer would be earning a guaranteed 10-16% return! It was a wise investment indeed.

The most common form of this strategy was dividing a single mortgage payment by twelve and adding the result to each monthly mortgage payment. This would result in paying an extra mortgage payment towards the principal every year. So, instead of 12 payments towards your mortgage each year, you would end up paying a total of 13.

For example, let’s say you bought a home with a 30-year, $250,000 mortgage at 10%. Your principal and interest payment on this mortgage would have been $2,193.93 a month (ignoring insurance and property tax).

Using the strategy outlined above, you would divide your payment by twelve, resulting in $182.83. You would then add this result back to your mortgage payment, bringing your new total to $2,376.76 a month.

The magic in this strategy is that the additional $182/mo would all go to principal. With each payment, the interest portion shrinks along with the principal, exponentially increasing the effect and exponentially paying down your mortgage over time.

The final result: With the accelerated plan, you would be mortgage free in 21 years and save over $190,000 in payments. Not a bad deal at all.

Does it apply today?

Morty loves the idea, but his planner continues to explain how this works with lower rates:

In the example above, you can see the wisdom in this approach. Increasing your mortgage payment by a relatively small amount can have a huge impact over time. However, does it work with smaller interest rates? Short answer: yes, but the impact is less.

If we used the same example above, but instead of a 10% mortgage, let’s assume a more common current mortgage rate of 3%.  In this scenario, we would have a normal mortgage payment of $1,054.01 (wow, interest rates make a difference!) and an accelerated payment of $1,141.84.

This is scenario, the effects of paying down the mortgage still works, but the details are different. Instead of being mortgage free in 21 years, this would take you over 26 years. Also, instead of saving over $190,000 over the life of the loan, now you would only be saving about $17,000.

Back to Morty

Since Morty has a 3% mortgage, he sees the writing on the wall. This method will certainly help, but obviously is not as effective as he hoped. His planner confirms that, if he adds an extra payment a year, he will be 67 when his mortgage is paid off.

He asks his planner if he could do it sooner than that, say within 15 years? After some crunching, the planner reveals that Morty would have to increase his mortgage payment by 45% to accomplish this goal. The planner explains the problem with using this conventional method with a low interest mortgage. The reason: the effect of this strategy is directly related to the interest rate. In simple terms, higher interest rate = better effect; lower rate = lower effect.

Discouraged, Morty asks if there is another option.

Let the market pay off your home

The planner explains that since Morty’s results are limited by his 3% interest rate, he should look for something with a higher return. Since Morty’s goal timeline is somewhat flexible, his planner tells him about another, faster way to pay off his mortgage.

His planner explains that, instead of putting his extra payments towards a mortgage, Morty could open a brokerage account and begin investing the extra payments each month in a broad stock market index fund instead of paying towards his mortgage. He explains the benefits:

First, the average historic rate of return of the stock market is ~10%, far outpacing his 3% mortgage over the long run.

Second, and most importantly, money invested in a brokerage account remains liquid. Should Morty’s goals or situation change over time, he can access this money at any time. This isn’t the case with money paid towards a mortgage. Never ignore the value of liquid funds!

The beauty of this idea is that the higher return of the stock market creates potentially faster effects (and a faster payoff) over time. Once the brokerage account matches the mortgage balance, you guessed it, time to sell the investments and finally pay off the mortgage. It’s that simple. Let the market decide for you.

Here’s the rub

Morty is sold, but there are a few downsides to this idea he should consider. His planner continues:

Morty should remain flexible in his plans. If the market does well, he will end up paying off his mortgage quicker. If it doesn’t do well, he will need to wait longer or invest more per month. It’s impossible to predict for sure.

Also, don’t forget about taxes. While this method typically works faster over the long run, Uncle Sam wants his cut. Morty should expect to pay 15% long-term capital gain taxes on any earnings he realizes when he sells his brokerage account balance. This means that he should ideally wait until his brokerage balance is around 110% of his mortgage balance to account for the taxes.

The bottom line

Using the market method, Morty stands a good chance of paying off his mortgage by age 64. Not the age 60 he was thinking about, but certainly better than 67 with the normal accelerated method or 70 if he paid it in full.

Since Morty doesn’t hate his job and isn’t afraid of risk, he likes the idea of using the market to pay off his mortgage. He likes the possibility of an early payoff, keeping his money liquid, and putting more or less into the brokerage account whenever he is able to do so.

Key takeaways

When it comes to tackling your financial goals, there are a lot of “common wisdom” ideas floating around out there. It’s important to look closely at these ideas, think about where (or when) they were born from, consider them carefully, and finally take a close look at the math involved. Your planner can help with that part.

For instance, if you were young during the great depression, you might have thought stuffing cash in a mattress was a great idea. Similarly, if you were around during the 80’s you might prescribe to the idea explained earlier, or over-value CD’s or treasury bonds (who were paying higher rates at the time as well). Finally, since we all lived through the recent unprecedented stretch of low interest rates, we probably think differently about how debt is used and treated.

The point is, accept common wisdom, but understand how it will impact your current situation and goals. Be creative, think outside the box, be critical, seek help, and find the right path forward for you. After all, there might be a different way of looking at the facts involved; a new common wisdom born from the situation we live in today.