Should I pay my mortgage off early?

Is paying off a mortgage early for everyone?

One important thing to note before you read further. Every month or year, if you don’t have left over savings after paying off all your expenses, funding your retirement accounts and other commitments, then this is not for you. In your financial order of priorities, paying off a mortgage early almost always is one of the last items. This is even if your mortgage rate is pretty high. In general, in my opinion, any mortgage rate above 6% is considered high but as I said, paying extra on your mortgage is something you should do after taking care of all your essentials. Dave Ramsey, the famous financial guru in the US would disagree with me  – he believes mortgages should be fully paid off and ranks somewhere in the top in the financial order of priorities. So in full transparency, there is a bit of a debate on the right approach. I disagree with Dave Ramsey because even if you have a high enough mortgage interest rate, at some point, you have the ability to refinance it to a lower rate. 

Making it personal

I have personally been grappling with this question for a while now. Here is why – my wife and I were one of the fortunate people to lock in an ultra-low, possibly once in a life low mortgage rate of 2.8% for 30 years at a fixed rate. People look at me and tell me I am crazy to even think of paying such a loan off early, because financially it makes very little sense. However, there is this deep desire within me to be financially independent and an important part of becoming financially independent is to be debt free. (Btw side note – in the US, even if you have paid off your mortgage, you still have to pay insurance and taxes and if you default on your taxes, the government can seize your home. So there is no such thing as being fully free of any payments, at least in the US 🙂 ). Nevertheless, the idea of not having any mortgage debt about the time I turn 50 is something of a mental milestone for me personally. 

So why is it financially a poor decision to pay off a low interest rate mortgage? Most people know why but I will just explain for those who may not fully understand it. The logic is simple – instead of the extra payments you make to pay off the mortgage early at a 2.8% interest rate, invest that extra cash in the stock market to make a 6% – 8% return. Over a period of 30 years, this number is staggering – you have the ability to earn much more money investing the money than paying it off. This is also called the Opportunity Cost. Financially, this is a no-brainer. However, this equation becomes different if you have a mortgage rate that is over 6%. Unless you refinance to a much lower rate, paying off your mortgage is going to make sense in that case. 

However, in my case, as I explained above,I have this dream of becoming financially independent by my early 50s and as I mentioned, eliminating all personal debt by then is key in my mind to becoming financially independent. It will allow me to sleep well at night I guess. 

So I have been grappling with this for a while until I had a discussion with my wife’s cousin’s husband (I am going to refer to him as MV through the rest of this article) who also lives in the US. He is a smart man who I have looked up to for many financial decisions and guidance. He suggested an approach he is taking which I really feel bridges the gap between wanting to be financially independent and still making the financially sound decision. So I take no credit for this approach I am going to lay out – all credit goes to him. I really appreciated this approach and have decided to follow this – so I felt the need to write a blog post about this. 

The principle

One of the things MV explained to me was the principle of ‘feeling financially independent’ did not necessarily mean the mortgage had to be paid off. But rather, he explained the idea that he wanted to have the cash available and ready for him to pay it off if he so chooses. So in essence, he is keeping the entire cash available on hand and will slowly drain it down until the mortgage is paid off (or we end up selling the house). This is an important point – as life changes happen, we might decide to sell the house and at that time, rather than keep all the money locked into an asset like a house, we might have the option to keep the cash. Or who knows – we might have other plans. The point is – we buy ourselves optionality and flexibility. His comment to me was  – I can sleep well at night knowing the money is always there to pay off the house in case I need to, but I don’t need to actually pay it off right away. Understanding this principle is key to the approach I am going to lay out. 

The two step approach

So what is MV’s thinking here? He came up with this interesting two-step approach.

First step is simple – decide how many years you want this to be paid off in and accordingly decide the amount you would need to pay off / set aside each month. Then, you take that amount each month and put it into a low/zero risk instrument like a CD or high yield savings account. We want to put it in a low risk instrument because we don’t want to lose any or all of the money by investing in riskier investments like the stock market. Note – you are not paying off the mortgage early but simply setting aside the money each month. 

So let’s say you have $400,000 outstanding on your mortgage at a 2.8% fixed rate mortgage, and decide you want to pay it off in 6 years from now. So that would mean you would need to set aside $5,555.00 each month approx. (If that feels like a lot of money to save each month, you just have to recalibrate to a longer term and reduce the amount per month). You then move that money each month into a high yield savings account and by the end of 6 years (or a bit sooner with the interest you will earn), you will have set aside $400,000 in this account. (Note: FDIC insurance for single account holders is $250,0000. So you either split this amount into 2 accounts or have it as a joint account with your spouse where the FDIC insurance amount is $500,000). 

The next step gets a bit interesting and honestly, I think can go in different directions. Here is what MV suggested. He said after the 6 years, he was going to take this entire amount and invest it in the stock market. I was very puzzled when I first heard this. If we were going to invest it in the stock market anyway, then why not do it in the first place? His response to me was that his intent of financial independence was that his monthly mortgage needs to come from a pot of money that needs to be first created. During the duration of ‘creation’ of this pot of money, we want to keep it risk-free. But after it’s created, he prefers to put it in the market to not lose out on any more of the opportunity cost. So a $400,000 amount invested in the stock market generates approx 6% returns each year which is around $24,000 per year and more or less equivalent to the principal + interest of the mortgage to be paid each year. 

His feedback was that we would give up 6 years of stock market returns to keep the money safe. But, after we establish the pot of money, we are now ready to invest it in the stock market because now we can pay the monthly mortgage using the pot of money. What will happen is that for most parts we will use very little of the principal and pay most or all of the monthly mortgage from the dividends + stock returns. The intent is simply to not pay it off right away but to be able to sleep well knowing the money is there if you ever wanted to pay it off. And also, MV’s point was – he was not sure how much longer he was going to live in that house, especially after his kids are off to college. So why deliberately make himself house-rich and cash poor? 

One obvious drawback of this solution is what we normally refer to as sequence of returns risk. What that means is that what if immediately after we invest in the stock market, the market tanks? A big wipeout could then make the $400,000 turn into a smaller amount – say $350,000. Then not only are you not earning a return, you are also seeing the principal shrink. The response from MV is this is a bit of a price you have to pay for ‘buying the optionality’. So yes, there is a possibility you may have less money but in reality, you have to make a personal decision at that point as to what you want to do. If you are very risk-averse, you can simply pay off the mortgage and call it a day, or continue to keep it in the high yield savings account and pay it off each month. That’s perfectly fine too – you just continue to miss out on more market returns at that point. 

Doing this requires a lot of discipline

Setting aside so much money and being committed to not touching it for anything else requires a lot of discipline that honestly, the best of folks have a hard time doing this. But,  at the end of the day, if there is a critical need for the money for something else, you have the flexibility to use the money for a different purpose. That is the beauty of this optionality. But for this to work, you need to be able to set aside money each month and as much as possible not touch it for anything else. One way to do it with less inertia is to make the transfer of the money automatic each month. It can be very effective. 

It’s about setting aside money each month at the end of the day

At the end of the day, whatever I have talked about is basically setting aside money each month – nothing else. You did not need to read a big blog post about that :). However, as I have explained, this is as much about dealing with your emotions and behavior as it is about financial savviness. Some might say, this is the good old ‘envelope’ method where you set aside money for specific purposes in an envelope – which really is what it is. And some others might say, this is simply a way of tricking your brain to put different buckets of money for different financial goals. For me, that’s exactly what this is – I like to be able to compartmentalize these to feel a sense of achievement on checking off another financial goal. 

Concluding thoughts

Knowing your financial goals is key and also knowing the financial order of priorities is also key before you do any of this. It’s insane to carry high interest credit card debt or paying off your mortgage and borrowing more money to fund your lifestyle. Paying extra on your mortgage is a want and a bit of a luxury in my opinion – but as I said, if you have extra money, it’s probably a good use of money. 

Thank you for reading and I wish you success in your financial journey!