Paying Off Your Mortgage Early

Originally posted 2007-07-16:

I was at a meeting tonight (not a high-pressure affair, fortunately) where I saw a DVD presenting UFirst Financial’s miraculous (and $3500) software and system for paying off your mortgage in the shortest amount of time possible. From what I understand, it actually seems like a fairly reasonable approach, if you ignore the cost of the software. Basically, they have you take out a HELOC (they call it an ALOC, “advanced line of credit”) and then direct-deposit your paycheck into the HELOC–basically using it as a checking account, and writing out a check to your primary mortgageholder every once in a while. Although there may be more to it, I think the “secret sauce” is the direct deposit: by having your paycheck applied to a HELOC immediately, the average balance on which you’re paying interest should–all other things equal–go down by about half the amount of your paycheck (assuming that you spend/invest the entire check each month). More questions, of course, would include fees and interest rates on a HELOC, convenience, increased propensity to spend if you have all of the HELOC sitting available to you, etc. That, however, isn’t why I’m writing.

I was irritated this evening by something that’s annoyed me, almost without exception, by all of the personal-finance “gurus” I’ve heard of. It’s something that seems to be received wisdom by many at least somewhat concerned about their finances. On the face of it, it sounds like a “no-brainer”. It’s the usual story, something like this: “If you have a $100,000 mortgage at x% and you take 30 years to pay it off, you’ll spend $200K in interest. But look…if we pay just a few hundred more a month, we could pay it off in 12 years…and you’d spend only $40K in interest. You’d save $160K!” (Note that I made up these numbers; they’re probably internally inconsistent.)

Almost without exception, it seems as though people ignore the time value of money when they’re talking about mortgages. There are other factors to consider: it’s nice to not owe a bank money, to not have the hassle of sending in payments, to have some more free cash flow…for some, all rational arguments aside, they’ll simply sleep better at night with a paid-off mortgage. We aren’t emotionless robots, and our psychology should play a role in our decisions. Situations will vary a lot, and I don’t have a panacea. In most cases, though, I’ll argue that paying off your mortgage early is a lousy idea.

So…back to the time value of money. I’m going to use an extreme case: I will gladly offer to give you ten million dollars, in exchange for a mere $100K. It’s a no-brainer for you, a profit of $9.9 million! However, there is a catch: you’ll get your money in 80 years (or, in the likely event of both of our expiring before that time, my estate will give your heirs the money). It’s a no-brainer for me; if I can make 6% annually on the $100K you give me, I’ll come out about $500K ahead at the end of our contract (not that that’ll be worth a huge amount). If I can make the stock market’s average return of 11%, I’ll be approximately $420 million to the better. In this case, I’ve borrowed $100K from you, at around 5.9%. I believe I’d be a fool to pay you off earlier, especially if I could deduct the interest paid (reducing effective rates to perhaps 4-4.5%), especially with the upside I’m looking at.

So…that’s an extreme example. Here’s the thing, though: rate differentials, even small ones, even over only 30 years, can make a big difference over time. For another simplistic example, let’s say I just inherited $100K that I could use to cash off a house or invest in the stock market. I won’t even consider the tax effects (on either the mortgage or stocks), since mortgage interest deductions might be somewhat offset by capital-gains taxes (though see below). Investing that in stocks at 11% would turn it into approx. $2.7 million in 30 years. If I used it to pay for a house (for which I’d otherwise get a mortgage at 8%), I’d free up $734 per month. Investing that each month for the 30 years would give me about $2.1 million of investments, plus the then-current value of the house. If the house’s value goes up by about 6 times in that 30 years, I’d have been better off–from a net-worth perspective–paying off the mortgage early. Otherwise, in what seems the more likely case, I’d have been worse off. Ironically, I think this is one thing that Robert Kiyosaki may actually have gotten sort of right; if I recall correctly, he doesn’t have much of a yen for early payoff either.

Anyway…just food for thought. A last word, though: I’m depressed when I see people encouraged to pay off a house early, without even a mention of putting money into an IRA. Your $4K per year opportunity comes once, and then it’s gone. If it’s in a Roth, you’ll never pay taxes on it again. Whatever IRA your money’s in, you won’t pay capital gains taxes, substantially reducing “friction” on your returns. So…if the decision is between paying off a house early or funding an IRA, it seems even more of a no-brainer. Again, I write from a pure long-term-net-worth perspective; emotional factors may legitimately play a part in your decision. Obviously, your assumptions about the future behavior of markets (and of your personal investments), your tolerance for risks, and other more quantitative factors may enter in as well.

So…that’s off my chest. If you’re still with me, I’m now returning you to your regularly scheduled programming.

Update: Also see the followup post, “More on Accelerated Mortgage Payments”.