To start off the year, my wife and I did a pretty in depth financial review. We took a good look at the past, present, and future. Most importantly, setting goals for where we would like to be in one, two, and five years.
After talking about our goals and the lifestyle we want to live, we both came to the conclusion that we should prepay our mortgage. If we can pay off the mortgage by the time we’re 30 that will give us a lot of flexibility when we start building our family.
The ability for us to be the one raising our kids is more important to us than any other goal we have including travel, a new car, etc…
Also, paying our mortgage off early isn’t coming at the cost of retirement savings. We’re both maxing out our Roth IRA’s and contributing to our 401K’s.
Last, we have an emergency fund. If something did happen, like a job loss, we can stop prepaying the mortgage and use our emergency fund.
Knowing these facts, is it a smart idea to pay off our mortgage?
First, let’s look at it from a mathematical perspective.
Essentially, paying off our mortgage, that has a 5% fixed interest rate, is the same as earning 5% in an investment account. (There are a lot of tax considerations that can make this more complex like tax brackets, tax deductions, availability of tax deferred accounts, etc… plus inflation. Unfortunately I have not found a calculator that takes into consideration everything that needs to be considered. Therefore, I simplified this calculation as much as possible.)
This 5% return is both good and bad. Good because it’s a guaranteed rate of return. With interest rates so low today, it’s impossible to find an investment that guarantees us 5%.
Bad, because it’s only 5%. We’re losing the opportunity to earn more. Historically, investments such as a total stock market index fund have returned about 10% a year.
Therefore, since our interest rate is so low on the mortgage, mathematically it doesn’t make a lot of sense to prepay our mortgage. If we were to put the money in the stock market, history has shown that we have a really good chance of earning more than 5% if we’re long term investors.
Knowing this information, we still decided to pay off our mortgage.
Here’s why:
Flexibility is more important to us than anything. Prepaying our mortgage gives us the flexibility we desire.
Even though we have the chance to earn more money elsewhere, returns are not guaranteed. With interest rates so low and the current uncertainty of our economy, a 5% guaranteed rate of return sounds very appealing.
If we were to choose to invest in the stock market, who knows what our returns would be. There is potential that they could be a lot higher than 5%. However, there is a potential that they can really decrease over the next few years.
In short, we choose not to let the economy decide if our kids will be raised by us or be in daycare, but we made that decision.
Do you agree, should I prepay my mortgage? Are there any other options that I’m not thinking of? How weird is that picture above? Please let me know in the comments.
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{ 13 comments… read them below or add one }
I think it’s Ok if you don’t have any other debts. I would also recommend the Emergency Fund have at least 3 months expenses before going gung ho. Good Luck!
Ken´s last blog ..Money Rules: Making More Is Not Enough
Thanks Ken. Our emergency fund covers us for 6 months of expenses. Sorry I didn’t make that clear.
Our mortgage is tiny (our house only cost 60k), so we aren’t in a hurry to pay off the mortgage. Instead, we’re putting our energy into paying off our student loan debt, which is much more debilitating. It’s the removal of those debts that will afford us the financial stability to allow one of us to stay home with our future (hopefully not too far in the future) kids.
This is an area where it really depends on the person. If the mortgage is your biggest liability, and you can prepay *while* you prepare for retirement, emergency, house maintenance, etc., I don’t see why not.
Thanks Melanie for the comment. I think you hit it on the head when you said, “It really depends on the person.” Not everyone has to have the same path towards financial freedom.
Having an emergency fund and starting to invest for retirement while we’re young, has allowed us to do this.
My husband and I are in a similar boat. We have a 15 year mortgage at 5.375% that we are scheduled to pay off in 11.33 years total (I’m thinking 10 years total or less), BUT we are also interested in getting a rental property.
Purely financially, we should probably stop making overpayments on our mortgage and sock that money away for a downpayment on a rental property since that interest rate will be higher.
But we’re not. What can I say? I’m stubborn. I rather own our home outright in 7 more years or less and pay off the rental property as quickly as possible as well. After our home is paid off, I’ll snowball those payments into the second property as well. Following this plan, we should own two houses completely by 2020…we will have just turned 36.
This is only possible if we stay at our current standard of living (living on less than $40,000 a year including the mortgage and overpayments) and don’t fall below our current $78,000 combined income level before taxes.
Just to clarify my personal summary above, I am on the side of paying your house off early. Like you said, take advantage of a guaranteed 5% return and peace of mind.
That is the very same subject my wife & I have been thinking about it and has not made a final decision on it. In the meantime, we are doing it both: contributing to retirement accounts and making extra house payments. We definitely want to be mortgage free way before retirement (we are both Gen Y) and aim to pay our 30 yrs mortgage, a large one, within 18 years (by the time our child, a kindergartner, goes to College.)
We also DO like the feeling of being “homeowners without mortgage”. Perhaps that goal is pushing us more toward paying it off.
To gen Y’s point, I am a late boomer (b 1962) but late to marry and have the kid as well. She’s 11, 5th grade. 7 more years of school. We’ve saved for college but would be extra comfortable knowing the mortgage is fully paid by the time she starts school. So, that’s what out plan is and we are on track for that.
While 5% return isn’t great, I’ve learned that you can’t put a price on sleeping well at night. Having no mortgage payment is freedom, not 100%, but a large payment you won’t have to think about. Freedom for one of you to stop working, or freedom to save more to retire early.
To those who would argue against the choice – sometimes a 5% fixed just makes more sense than 10% with a 14% standard deviation….
JoeTaxpayer´s last blog ..A Roth Roundup
I’m with Joe 100%. At this point the difference in return vs. the mobility and freedom of no payments is priceless. Personally I’ve reached a point myself where I’m ready to make a break for it, and not being saddled with a large mortgage would be such a blessing. Best of luck to you guys wish I was thinking about this stuff when I was your age.
Paul @ FiscalGeek´s last blog ..Save by Dropping Your GAP Automobile Insurance
A point my wife brought up in this discussion was what do you expect your house to be worth when you are done making all your payments? If your house was purchased for $60,000 and in 15 years is going to be worth $90,000 was it worth prepaying to get there?
Just a thought. Also, does anyone know an easy formal to use in excel 07 for getting a 5% growth on a house purchased for $225,000?
Patrick –
Here’s a subtle, but important point. The change in value in the house should be unrelated to this decision.
Think about it. Whether or not the house rises in value and by how much should be considered before you buy it, with cash or financed.
In the prepay discussion, whatever you decide, the choice is between the other return you might get on the cash, or the 6% return you get on prepaying the mortgage. Unless one has very little equity and ponders a ‘walk’ I don’t quire see why the 15 year price would be part of the decision. The house will grow to that value regardless. Make sense?
@Patrick – Great question and Joe is right on with his answer.
contributing to retirement accounts and making extra house payments. We definitely want to be mortgage free way before retirement and aim to pay our 30 yrs mortgage, a large one, within 18 years