Rule of Thumb: When To Pay Off The Mortgage Early

There was a lot of good discussion in my lengthy early mortgage payoff post. Now instead of lengthy details, let me try out a quick rule of thumb about early mortgage payoff. Recall from Wikipedia:

A rule of thumb is a principle with broad application that is not intended to be strictly accurate or reliable for every situation. It is an easily learned and easily applied procedure for approximately calculating or recalling some value, or for making some determination.

So roughly applicable to many – but not all – situations.

Early Mortgage Payoff Rule of Thumb

You should time your mortgage payoff date to coincide with the date of retirement, or semi-retirement. Here, I would define retirement or semi-retirement as a time when you’ll be wholly or partially dependent on non-work income like Social Security, pensions, annuity payments, stock dividends, or other investment income. A downshift into a lower-paying second career would count as a semi-retirement.

In my humble opinion, this quick and dirty rule will help you balance the opportunity to invest in potentially higher-returning investments (stock mutual funds, dividend-paying stocks, real estate, high-yield bonds) with pursuing the benefits of having a fully-owned house (less stress, less leverage, lower required monthly expenses, lower required withdrawals from investments and thus lower marginal tax rates).

Example 1. 20s, 30s, 40s with long future career. You love your job and/or want to be doing it for the next 25+ years. In this case you have lots of human capital and a regular stream of income. You also won’t be needed to cash out your retirement assets for a long-time, making it much more likely that your stocks will achieve their higher average returns. Take on the 4% interest rate fixed for 30 years, and over time your salary will rise with inflation while your payment stays the same.

If anything, you could do a DIY biweekly payment plan and pay off your mortgage in under 24 years with less “pain” due to a behavioral trick (works best for those on a biweekly paycheck schedule).

Example 2. Anyone with early retirement goals. If you want to retire early, I like the idea of either renting forever and keeping your options open (especially if you travel or move around a lot) or paying off the mortgage early. Early retirement with a paid-off house is great because your expenses are lower, which means you need a much smaller investment portfolio. Being able to live on a lower income also means a very low tax rate. In fact, with a mix of Traditional and Roth IRAs, we’ve seen that you could withdraw over $50,000 a year and still pay zero taxes on retirement.

If say you wanted to retire in 10 years, then you could try to set up an automatic extra principal prepayment to achieve that while still saving for retirement in tax-deferred accounts. Obviously, this is a lot easier said than done, you may need to adapt to a cheaper house if you don’t have adequate income.

Example 3. 50s-60s with traditional ~age 65 retirement goals. Similar to the scenario above, I wouldn’t take on another 30-year mortgage if I was going to retire in 10 years. As you get older, you’ll also want to shift your investments to more stable options like bonds and/or single premium immediate annuities. Stocks are still good in proper doses, but you’ll have less time to wait out a prolonged bear market. In addition, a mortgage-free couple could look forward to covering a large chunk of their expenses with Social Security (based on an average payment of ~$15,000 a year per person, $30,000 a year for a couple), further reducing the need to take on more risk. I simply hate the idea of having to worry about the stock market when I can’t simply jump back into the workforce.

Comments

  1. Home ownership is such a hassle that I’d prefer just to rent forever. (Maybe owning a condo would be a good compromise.) Before the housing bubble burst, people said that this was a waste, since you weren’t “building equity” with your rent payments. Nowadays, people seem to be saying the opposite. I guess, to be fair, some people have been saying that a home is a liability rather than an asset since even before the housing bubble (e.g., Robert Kiyosaki).

    If someone could demonstrate to me that a mortgage is financially superior to renting, I’d deal with the hassle in order to realize the benefit. So far, I haven’t heard a sufficiently good argument.

  2. graham weedon says:

    just posted this on Facebook, but here it is again for the web:

    being of similar mind on many matters, i say pay it off to free up more cash for other investments, like maybe a 529 plan for your newborn. Congratulations on being so close that you even get to consider the choices!

  3. Jennifer says:

    Our goal was to pay off the house before the three kids went to college. Our eldest is now a junior, we have one starting in the fall and the youngest will go in two years. We worked our butts off and made double payments when we could and we did make our goal. We also chose not to “move up” and are in the same house we bought when we got married 22 years ago. We’re aware that we might have come out further ahead if we had taken that money and invested it, but paying off the mortgage was a sure thing and it’s one less thing to worry about.

  4. I follow a hybrid approach. I have an early retirement goal of 12 years from now. Rather than paying down my mortgage (which was just refinanced at 3.5% for 30 years) I instead take an equivalent amount that it would take to pay off the condo in that much time and invest it. Betterment worked out as an easy vehicle to do this with, so I set up a 12 year goal with a goal amount equal to the principle remaining in 12 years. I chose 75% stocks/25% bonds for the portfolio mix. In 12 years, assuming decent market returns I should have more than enough to pay off the mortgage after taxes. As the goal date approaches, I will likely ratchet down the stock % to make the portfolio less volatile.

    If the market performs poorly, I can just work another year, or make up the difference from other sources to be without a house payment at retirement. Another option would be to keep the account going in 12 years and just withdraw money each month to pay the mortgage (if needed). This strategy involves some more risk than just making extra principle payments but I should be rewarded with a higher return than an after tax rate of ~2%. It also allows for some flexibility in the case of an emergency. Very easy to get money out of Betterment, not so with equity in a home.

  5. Well, I went over a similar exercise last year after receiving a windfall last year—not enough to pay off the house, but certainly enough to pay more than 50% of the balance. I’m in my 30s, so I could definitely invest that money for a long while. In the end I refinanced with just enough money in to bring my rate down as far possible, and used the rest of the money to remodel the house.

    I considered the possibility of investing the money elsewhere. I did some math comparing the 30-year interest savings of the lower balance and rate to the return of a same-sized investment on Treasuries, and well, Treasuries “win” this competition.

    But one thing I feel this math obscures is this very concrete difference: if you invest the money the return is uncertain and the bulk of it arrives toward the end of the 30 years; whereas if you pay down the mortgage, the interest savings are certain and the bulk of them come at the beginning.

    I know this falls under the general rubric of “risk tolerance,” but personally I found spelling it out like this was very helpful. I’m comfortable with the uncertainty of investment returns (I bought tons of stock from Oct. 2008 to April 2009, for example), so that didn’t scare me off, but in the end I couldn’t pass up the guaranteed short-term savings.

  6. @Andrew:

    “Home ownership is such a hassle that I’d prefer just to rent forever.”

    I used to say the same thing about home ownership, but it has its benefits, like being able to decide what the inside of your home is like (e.g., what kind of flooring would you like to have).

    “If someone could demonstrate to me that a mortgage is financially superior to renting, I’d deal with the hassle in order to realize the benefit. So far, I haven’t heard a sufficiently good argument.”

    This is wrong-headed. There is no absolute, all-or-nothing argument to be made here; it all comes down to numbers and preferences.

    Numbers means that you should calculate the cost of owning vs. the cost of renting, and let the result be an input to your decision. Those numbers change all the time, so you should periodically repeat the exercise.

    Preferences means that different people want different things, so they could rationally pay a more (but hopefully not too much!) to get them. Maybe you’re happy with not being able to choose your flooring or upgrade your residence, and can’t be bothered to pay more to have that option. Or maybe you really want this, but are only willing to pay 5% more for it. It’s your call.

    But as a general rule, you’d be just as wrong not to buy a house you like when it’s very cheap as to buy an expensive one you don’t like when it’s too expensive.

    Oh, and Kiyosaki’s a crank.

  7. I think a lot of it depends on your situation — I’m self-employed and so I may have patches where my income is very high and others where it is very low — so for me, paying off the house added stability to my life — I have a much lower monthly minimum expense level and so need to keep far less emergency cash around (I like to have at least a year’s expenses available). I paid my house off in 14 years basically refinancing about 8 times along the way to keep the rate as low as possible, and throwing as much extra cash at it as possible.

    The problem with throwing that extra cash in the stock market is that it’s not a sure thing (and in fact can take major dives). I would hate to have put a large sum into stocks, only to have the market crash and suddenly need the cash to pay the mortgage – it’s a double whammy if you have to pull money out in a major downturn.

    Now that the house is paid off – I’m investing the money I would have been paying for the mortgage into the market and into rental property.

  8. Luis – yours was one of them most reasonable responses I’ve seen around here, attached to a pretty reasonable post. My teenage daughter and I have this thing we do. she always says, “I’ve got a question” rather than just ask the question. So I started responding, “I’ve got an answer.” Being a smart alec like her dad, she thought she had me when she said, “Okay, you first.”

    To this I usually reply, “It depends.” And about 80+% of the time, I’m right.

  9. I don’t think there is a right answer. But my perspective is this: View paying extra principal as an investment in a bond. So if your allocation strategy calls for you to invest more in bonds, and your mortgage interest rate is higher than the bond rate, then pay down your principal the same amount instead of purchasing bonds.

    On the other hand, if your allocation strategy does not require you to shift more into bonds, then don’t pay down principal.

  10. @Steven

    Agree completely that the stock market is not a sure thing.. Few things are. :)

    I have other savings to cover emergencies, roughly a year’s worth of expenses, probably more, so I should hopefully not be in the position of having to sell stocks to pay the mortgage. I also have good short and long-term disability policies in place in the event I become disabled and cannot work.

    Most of the monthly contribution I am making to this account is money “saved” by refinancing the home. The payment was significantly lower (partly because of the lower interest rate but also extending the loan out to 30 years) and I am investing that savings (and a bit more), rather than continuing to pay down principle.

    Having been self-employed for many years myself in the past, I think I’d find that having lower expenses would cause me to be less motivated to go out and sell my services. Creating an artificial shortage of cash (by treating savings as a mandatory expense) has always worked well for me in terms of both reigning in spending and encouraging me to go earn more. You may not be motivated by the same things I am however.

    In the end it all comes down to what you are comfortable with and what works best for you.

  11. This is a subject I’ve been giving a lot of thought to lately. (Retired Army, 66 years old, happily married.) The wrinkle is that our house was bought with cash five years ago and now I want to take out a mortgage on it. Exactly the opposite of what’s being advised.

    And the reason is as a hedge against inflation. I don’t see how the national debt will be paid off except with cheapened dollars. My life savings will shrivel in value, I’m sure, but at least some of it will be protected by having a 3% loan that will never increase.

    Everyone I’ve talked to thinks I’m crazy. My wife does see my reasoning but says the government will find a way to protect the banks and anyway, there’s something about living in a paid-off house she likes so much.

    I hope to live long enough to see how this works itself out.

  12. @Steve K,

    The problem I see with that is that it will not be possible to find a 100% safe investment to store that money that earns a better return than you’ll be paying on the mortgage. You already own the house, that is an inflation hedge right there. If high inflation sets in, then your home should appreciate in value.

    I do tend to agree with you that we’ll see higher inflation at some point, but your strategy doesn’t really mitigate that unless you’re willing to take on some risk and invest that money for a higher return.

  13. @Bucky:

    “But my perspective is this: View paying extra principal as an investment in a bond.”

    That’s how I looked at it when I was first thinking whether to do a big money-in refinance vs. invest the same money in a bond portfolio. But closer analysis revealed what I mentioned in my first post: even if you assume the bonds are zero-risk, a lot of the return comes from reinvesting your gains so that they compound. But this means that the bulk of the return comes at the end of the investment term.

    When you pay down the mortgage, on the other hand, the portion of your monthly payment that goes toward interest reduces immediately. So the bulk of the “return” happens at the beginning of the “investment,” which is the opposite of what I described for bond portfolios.

  14. An interesting way to think about it. We recently purchased our first home and are expecting to sell it in the next 2 years (as we’re military, and will have to move). Like Andrew said in the first comment, owning is such a hassle I think I’d prefer to rent for the rest of my life, especially since for the next 10-20 years we’ll be moving every 2-3 years and even after that we don’t expect to ever live in anyone place for more than 5 years. Buying and owning a home has been a great experience and I’m glad we did it when the market bottomed out, but unless we were committed to keeping the house as a rental property, I don’t really see the point in purchasing real estate, in our situation. Of course in other circumstances I would be singing a different tune.

  15. @Steve – I’m motivated right now to be able to have enough money saved and enough income generation to be able to stop working (although not necessarily do that) – so what motivates me is to generate as much revenue as I can from all sources. Currently i have two businesses, rental property and stock market investments (mainly in stocks that pay decent dividends). Having lower expenses just allows me to stash more money in various investments, or in inventory for my secondary business, etc. It doesn’t make me work less by any stretch of the imagination…

  16. dorothea says:

    Think of a house as an expense, and as a way to live rent free in the future. Pay off your house by the time you turn 50, and then sock away that past house payment in addition to your regular 401K and Roth IRA deposits.

  17. dorothea says:

    To Steve K who said that he thinks a 3% mortgage would be beneficial because rates will go up in the future. Mortgage rates may not rise in the next 20 or 30 years. Overall, the current mortgage rates are not a bargain when I look at them over my lifetime. My first mortgage was 3% in 1973. I took out the biggest mortgage I could get (30 year fixed) because my savings was making 5.25 percent at the savings and loan. In 1979, I bought another house. I paid 11.50 percent interest. I got the biggest 30 year mortgage I could get because I was getting about 14 or 15 percent interest on my savings in the money market. Notice that in both instances, the mortgage interest rate was much less than the interest rate paid on savings. Today, the mortgage rate is higher than anything you can get on a money market or savings account. I would not be surprised to see mortgage rates go to 3% again in the future.

  18. dorothea,

    You got a heck of a deal on that mortgage in 1973.. According to Freddie Mac, the lowest contract rate in that year was 7.44%. (http://research.stlouisfed.org/fred2/data/MORTG.txt)

    This makes sense as there would be no incentive for an investor to lend money at a lower rate than the safe rate of return they could earn in a bank account.

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