It
is commonly thought that paying off your house as soon as possible makes good,
financial sense. However, this is often not the case. Here is an illustration
of why it is usually best to mortgage 80% of the cost of the house and not to
pre-pay on the loan.
Mr. Payment, Mr.
Pre-pay, and Mr. Cash are each buying a house for $100,000. Each has $100,000
in cash and each has $1,000 per month to spend on mortgage payments and/or to
save.
Mr. Payment uses $20,000 as a
down payment and invests the remaining $80,000. He takes on a 30-year fixed rate
mortgage payable at 7% for $80,000. His monthly payments are $532. Recall that
each buyer has $1,000 per month to spend or save, therefore, Mr. Payment has an
additional $468 to save each month for 30 years. In addition, he can invest the
tax savings from mortgage interest tax deductions.
Mr.
Payment's Initial Situation
Home
Equity | Investment
Portfolio | Monthly
Mortgage
Payment | Monthly
Savings | Monthly
Pre-
Payment | Total
Income Tax
Savings |
$20,000 | $80,000 | $532 | $468 | $0 | $37,630 |
Mr. Pre-pay takes
on the same mortgage for $80,000. He also puts down $20,000 and invests the remaining
$80,000 he has in savings. He too has a monthly mortgage payment of $532 and an
additional $468 per month remaining after making mortgage payments. However, instead
of saving, he pre-pays on the mortgage each month. After 9 years, the house will
be paid for and Mr. Pre-pay will then be able to save $1,000 a month for the next
21 years. He also saves income tax deductions to his investment portfolio for
the 9 years he is paying some mortgage interest.
Mr.
Pre-pay's Initial Situation
Home
Equity | Investment
Portfolio | Monthly
Mortgage
Payment | Monthly
Savings | Monthly
Pre-
Payment | Total
Income Tax
Savings |
$20,000 | $80,000 | $532 | $0 | $468 | $9,089 |
Lastly, Mr. Cash pays
for his house using his $100,000 in savings. Since he has no mortgage payments,
he is able to save $1,000 per month for 30 years. He receives no income tax deductions.
Mr.
Cash's Initial Situation
Home
Equity | Investment
Portfolio | Monthly
Mortgage
Payment | Monthly
Savings | Monthly
Pre-
Payment | Total
Income Tax
Savings |
$100,000 | $0 | $0 | $1,000 | $0 | $0 |
Let us look at the advantages
and disadvantages of each situation. Mr. Cash's house is paid for. He has no monthly
mortgage payments to worry about and he is not paying interest. This is generally
what most people consider the "sleep better at night" scenario. However,
what happens if Mr. Cash has an emergency and suddenly needs $20,000? All of his
money is tied up into the house. Selling the house is not a viable option. Besides
borrowing from friends or family, his only other apparent option is to take an
equity line of credit.
Mr. Pre-pay has
what most consider the best of both worlds. Mortgage payments and pre-paying will
end in 9 years and his home will be paid for at that time. He also has an investment
portfolio that has been growing the entire time and after the mortgage is paid,
he can begin saving $1,000 monthly. Unlike Mr. Cash, Mr. Pre-pay has easily accessible
emergency reserves. He can either sell a portion of his investment portfolio or
margin (borrow against) the account, often at a rate lower than an equity line
of credit.
Similar to Mr. Pre-pay,
Mr. Payment also has easy to access emergency reserves. However, Mr. Payment will
not own his home completely for 30 years and in that time he will have to make
monthly mortgage payments. His biggest benefit comes down to the end result. In
30 years, all 3 will have a paid-for home, but Mr. Payment will have the largest
of the 3 investment portfolios.
Investment
Portfolios 30 Years From Now
Mr.
Cash | Mr.
Pre-pay | Mr.
Payment |
$2,804,520* | $3,277,039* | $3,798,897 |
*Assuming 11% annual rate
of return on initial investment, monthly savings, and annual income tax deduction
savings and 34% tax bracket.
Mr. Cash
and Mr. Pre-pay gained nothing financially from paying off their homes early.
In addition to the actual cost of the home, it cost Mr. Pre-pay $521,858 (difference
between Mr. Payment's portfolio and Mr. Pre-pay's) to have his home paid for in
9 years. Mr. Cash has an even greater difference. The cost to "sleep better
at night" was $994,377. For many, that is a high price to pay for good sleep.
Is
it worth it? Each homeowner will have to decide what is best for him or herself,
but from a purely financial standpoint, it usually makes the most sense not to
pay off your mortgage early. In times of higher interest rates, borrowing becomes
less advantageous, but in times such as today when interest rates are lower, borrowing
is more advantageous.
