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The Best Way to Payoff Your Mortgage Early

December 4th, 2008 · 11 Comments

   Written by J.P. Wicklein

     Recently I heard a suggestion about a unique way to payoff your mortgage early:  Instead of making larger mortgage payments each month, invest the money and use it to pay your mortgage off in one lump sum.  On the surface this sounds like a good suggestion.  When you make larger mortgage payments each month the extra money pays down your mortgage but, it doesn’t earn any interest.  If you put the money in a money market, or some other investment, it could generate even more money that you could use to pay off your mortgage. 

     Intrigued, I decided to run some numbers to determine the cheaper approach:  Making larger mortgage payments each month or depositing the extra money in an interest generating account and payoff the entire mortgage when the funds grow large enough.  Let’s look at an example.  We’ll assume the following:

·      You have a $250,000, 30-Year Fixed Mortgage at 6.0%

·      You have an extra $300 each month to either make larger mortgage payments or place in a money market account that earns 3% (after taxes).

 

     Using the extra $300 a month, Table 1 reveals that the mortgage will be paid off 28 months sooner with the Larger Payment Approach.  During the time that both mortgages are outstanding, however, the Money Market Approach will generate a larger mortgage tax deduction and earn interest on the money market deposits[1].  Ultimately, though, the Money Market Approach will incur nearly $47,000 in costs during the final 28 months of the loan period - all while the mortgage was already paid off under the Larger Payment Approach.  This discrepancy will result in the Larger Payment Approach being over $30,000 cheaper than the Money Market Approach. 

Table 1

 

 

Larger Payment Approach

Money Market Approach

Months 1 - 239

Months to Payoff Loan

239 (19 years & 11 months)

267 (22 years & 3 months)

Mortgage Payments

$429,925

$358,222

Mortgage Interest Deduction

$44,533

$61,014

Money Market Deposits

$0

$71,700

Cost

$385,392

$368,908

 

 

 

Months 240 - 267

Mortgage Payments

$0

$41,964

Mortgage Interest Deduction

$0

$3,469

Money Market Deposits

$0

$8,400

Cost

$0

$46,895

 

 

 

 

Total Cost

$385,392

$415,893

 

The Mutual Fund Approach

     It is possible for the Money Market Approach to be the cheaper of the two options.  If, instead of investing in a money market, the extra funds were placed in a mutual fund that earned more than 8% annually the Money Market Approach (which would then be referred to as the “Mutual Fund Approach”) could become the cheaper option.  To do this, however, will introduce more risk.  Given the volatility of stocks within a mutual fund it is possible that the returns provided by the 8% annual gains could be largely eroded by just one or two negative growth years close to the time that the funds would be used to pay off the mortgage. 

     Given the fact that the Mutual Fund Approach may present too much risk and the Money Market Approach is too costly, the Larger Payment Approach may be the best way to payoff your mortgage early.  Although the extra payments will reduce your mortgage interest deduction, they will also shrink the number of mortgage payments by paying additional principal each month.  Unless you are able to generate a return on the extra money that is at least close to equaling the interest rate on your mortgage loan, with a very low level of risk, making larger mortgage payments each month could be the best way to retire mortgage debt early. 

[1] The after tax interest earned from the Money Market account during the first 239 months is $24,207.  During months 240 – 267 the interest from the Money Market account is $7,354.  These amounts are reflected in the table through the 267 month payoff period.  Without the interest from the Money Market account the payoff period would have been greater than 267 months.

Tags: Loans · Mortgages · Real Estate · Save Money

11 responses so far ↓

  • 1 Tim B. // Dec 4, 2008 at 3:03 am

    You could combine the approaches - Mutual fund approach along with the larger payment approach to mitigate risk. Early on in the life of the mortgage you could make the regular mortgage payment and invest in a stock mutual fund. Let’s say after 14 years, you have a 10% annualized gain (after dividend and capital gains taxes). If disciplined, you could sell the investment to make a large payment, and then instead of making the monthly investment in the mutual fund, switch to making larger mortgage payments until the mortgage was entirely paid. This would help to avoid the risk of a market correction near year 20 while taking advantage of the rate of return over the interest rate for the first however many years. Still, you would have to account for a capital gain in the year of the sale.

  • 2 B. Estey // Dec 4, 2008 at 10:17 am

    For people who lack financial discipline, which is unfortuanately 90% of America, the best way to pay off a mortgage early is through force. Few people have enough discipline to actually follow a “complicated” plan of attack. Mortgage rates are ridiculously low right now. I say refinance at a low rate and opt for a 10, 15, or 20 year amortization depending on what you can reasonably afford based on the balace of your loan. Then you’re done within a specified period leaving no room for silly excuses like the “Well, I’m supposed to make this additional payment and invest in this account, but I really want that new thing I really dont need” syndrome.

  • 3 B. Estey // Dec 4, 2008 at 10:22 am

    …and for the record, I’m great with money, but apparently can’t spell the word “unfortunately”.

  • 4 Financial Fellow // Dec 4, 2008 at 9:53 pm

    I think Tim pretty much summed up the savvy approach for the sophisticated person - the comfortable middle between the two approaches.

    Excellent point B. Estey on assuming most people aren’t smart enough to even apply one of the two approaches - let alone a combination of the two. As sad as it is to say I think you’re right. For the majority of people they need to be forced to pay “x” per month and have everything spelled out for them.

    Thanks for the comments, guys. I think you captured both ends of the mortgage payer.

    John

  • 5 Dennis // Dec 4, 2008 at 11:10 pm

    How does this change if the choice is between paying down the mortage earlier or funding a 401k or IRA fully? (I suspect that the tax deferred instrument is a net win.) I suppose it really matters what income tax bracket one is in, but perhaps an illustration with 2 or 3 tax rate brackets would be instructive.

  • 6 Financial Fellow // Dec 4, 2008 at 11:44 pm

    Thanks for your comments, Dennis.
    I’ve applied the same thought regarding student loans: Does it make sense to pay down your student loan early or use the extra money to contribute toward a retirement account? http://financialfellow.com/2008/11/18/dont-payoff-student-loans-early/

    In the student loan article, however, I used a post-tax (Roth) retirement account as an example. I haven’t thought about it in regards to a traditional or pre-tax retirement account. My gut tells me that assuming your mortgage interest rate is less than the rate of return you expect to get in your retirement account, it makes sense to use the extra funds to contribute to retirement. That said, you pose an interesting question and I think it would require spending some time writing down the scenarios and working them through….tax brackets included.
    I may have to write a post on that option in the future…
    Thanks, again.

    John

  • 7 Darlene H. // Dec 12, 2008 at 3:17 pm

    Although we pay a small extra amount on our mortgage each month, I am interested in those, like me, who use their home for business purposes. I have a home childcare and each year 60-70% of my mortgage interest is deductable as a business expense. I would think that would change the picture quite a bit! By the way, we have a 6.75% mortgage interest rate and bought the house in 2005, so are not far into paying it off!

  • 8 Financial Fellow // Dec 13, 2008 at 1:15 pm

    Darlene -

    Glad to hear you are not far from paying off your mortage. That’s great! What an accomplishment! : )

    This is the first tax year that I will have business tax deductions. I will be deducting the appropriate allotment for office space. So, I don’t have much experience when it comes to business deductions.

    Are you saying that you are able to deduct 100% of your mortgage interest on your individual tax return and then another 60-70% on your business tax return?

    Thanks for your comments!

    John

  • 9 Darlene H. // Dec 14, 2008 at 1:17 pm

    John,
    You missed a word, NOT. We are only 3 years into paying a 30 year mortgage.
    As to you your question, a portion of your home is used for business, so according to how much you use, you can take that off as a business expence, INSTEAD of the regular deduction. How does this help? Because by using your home, you MAY be able to claim a portion of your utilities, home taxes and mortgage interest as business expenses, thereby lowering the income generated by your business and thus paying less taxes on that income! If you choose to claim all your house expenses (that you can) on your personal taxes and not on your business forms, your income is higher, resulting in higher taxes to pay. Ouch!!
    The amount you can deduct depends on various things, including the square footage of your house, the square footage used, what type of business you are doing… Either your tax professional or your tax program should be able to walk you through the process. And, of course, you can call or email the IRS, they have complete free booklets on it. I have used Turbo Tax and gotten good results.
    I say it depends on your business because home child cares can claim more of the house (100% in some cases) because many use their whole house for childcare, but how many hours each day also comes into the equation. Most do not do childcare activities 24/7. My time/space percentage (as it is called) is normally between 60-70% because I am open 6 days per week from 6am to midnight. Plus other childcare related activities count.
    Be sure to doublecheck your figures, and if you do your taxes yourself, my recomendation is to invest the $$ into a good business tax software program to help you. By the way, as it is doing your taxes, some of the expense of your tax preparation software should also be deductable.
    Good luck!

  • 10 Financial Fellow // Dec 15, 2008 at 10:29 pm

    Darlene -

    My apologies for missing the “not”. Thanks for all the great tax information/advice! I’ll be sure to keep it in mind when I file in a few months.

    John

  • 11 Darlene H. // Dec 17, 2008 at 6:25 pm

    We all make oops’s. I did, it wasn’t the not, it was the into. Just so we don’t goof on our taxes!!!!

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