Why you shouldn’t pay off your mortgage sooner: a loan officer’s perspective.

Whenever I’m taking any type of loan application, most people have two primary concerns: either they want to lower their payments, or they want to pay their house off faster.

For most people, a mortgage is their largest monthly expense, and because of that there’s no question why they’d like to see it eliminated; it’s where all of their money goes and without it they’d have a lot more leftover to save. Under the right circumstances it can be a great financial step forward, but I don’t think it’s the right move for most people. Here’s why:

  1. The opportunity cost is too high.

One dollar spent paying down your mortgage is another dollar not being spent investing in better opportunities. What you gain in paying down your mortgage you lose in everything else. If you’re between the age of 21 and 40 (and especially if you’re on the younger end of that spectrum), you have a lot of time for the power of compound interest to work for you.

Take for example one of the loans I put together for one of my clients (we’ll call him Russell): Russell seems to have it made. He is the head of a research division at a very large government agency. Between himself and his wife they make over $250,000/year, and their house is worth a little under $2 million dollars. They only owe $900k on their primary residence, and they have an investment property which they still owe $100k on.

You would think they have a great situation: a tremendous amount of equity, a rental unit which is going to provide them long-term passive cash-flow, and excellent income.

What is the one thing Russell and his family don’t have?

Savings.

In fact, hardly anyone in America has savings anymore. (This is such an evident problem that I’m going to be writing an article on this fact alone in the coming year.)

So what did I do to help Russell? I didn’t tell him to use all of his income to pay down his house faster and get rid of his high mortgage payment. Instead, I told him to leverage it.

I refinanced his house into a 40 year interest-only loan. The first 10 years of the loan he’s only obligated to pay interest, and the remaining 30 years the loan turns into a traditional 30 year fixed at a rate of 4.125%. We also consolidated his HELOC (something I highly recommend doing if you have one open), and paid off his other mortgage and included it in the balance.

In total, Russell was able to save $1,500/month with this new loan from how much lower his payments are. With no other debt but his mortgage, I told him to take $500 and put that money in his pocket, but the remaining $1,000 he was to invest in a mutual fund, expecting a return of between 8% and 10% if the market follows historical trends.

At the end of this 10 year interest-only period, he’d still owe the same amount on his mortgage, roughly $1 million dollars, but he’d have an investment worth around $236,311.

At this point I told Russell even if he didn’t invest a single penny more into the mutual fund and let it simply sit there, 20 years afterwards (when his house would normally be paid off on a 30 year traditional loan), he’d have a total investment worth around $1,589,785.13 and only owe a remainder of $500k on his mortgage.

Ten years after that (once his mortgage is paid off), he’d have an investment worth $4,123,493.19 and fully own a $2 million dollar house.

The only reason he’s able to do this is because he was able to leverage a) money he would otherwise be spending paying down his mortgage, and b) time that he’s using to allow his investment to grow.

Remember, he only invested $120,000 into this investment. The rest of the gains are purely from compound interest.

On the contrary, if someone decided to pay this same loan off in 15 years instead, they would have to pay an additional $2,800/month to make it happen, on top of the $5,100 regular payment. That’s a total of almost $7,900/month (outrageous, and for most people, unaffordable). They could start investing after that, but they’ve lost time for compound interest to work for them, so they need to invest more money to achieve the same result.

When Russell goes to retire, who is going to be in a better spot? The person who got their mortgage paid off in 15 years and then started investing, or the person who paid it off in 40 years and invested at the very beginning?

That’s not to mention the tax incentives for keeping a mortgage loan and deducting the interest.

2. The tax deductions go a long way.

If itemizing your taxes makes financial sense for you, you’ll lose the tax break of writing off the interest on your mortgage every year after it’s paid off.

In addition, if you were to put your money into a retirement account instead of paying your mortgage, you’d also lose out on the tax break you get for investing the money into retirement savings. The great thing about retirement savings is that you don’t need to itemize in order to claim the deductions.

3. Your mortgage becomes less expensive over time from inflation.

Inflation is generally looked upon with a negative connotation. After all, if you’ve spent time diligently saving money, you never want the value of that money to depreciate.

However, what’s bad for your savings account is excellent for your mortgage. Essentially, if you have a fixed-rate mortgage loan, your mortgage payment is going to always remain the same (aside from any tax increases if you escrow), but the actual value of the money you are spending will be less.

For example, if your mortgage today is a payment of $2,500 / month, in 2039 (20 years from now), you’ll still have to make the same payment of $2,500, but due to inflation (assuming 2% per year), that will be the equivalent of paying $1,682 /month today.

Therefore, if your mortgage payment will become easier to pay over time, you’re able to secure immediate and continual tax savings, and larger returns can be gained from investing sooner, pre-paying your mortgage may not be as beneficial as you’d immediately think.

A much better alternative is to start saving and investing your money so that you have something to fall back on in the future. The goal shouldn’t be to shrink your expenses to expand your life; it should be to grow your income.

After all, you can only shrink your expenses so much, but there’s no limit to how much you can invest, and no better time to start than now.