If you’ve received a windfall of cash or saved a sizable sum of money over the years, it may be tempting to pay off the mortgage loan early. Whether or not paying off the mortgage early is a good decision or not can depend on a borrower’s financial circumstances, the loan’s interest rate, and how close they are to retirement.
Another consideration includes whether to invest that sum of money versus paying down the mortgage. This article explores the interest cost that could be saved by paying off a mortgage ten years early versus investing that money in the market based on various investment returns.
A mortgage is a loan to a borrower for the purchase of a property or home. When all of the legal documents are signed during the mortgage closing, the borrower signs the loan documents and agrees to repay the mortgage lender in monthly payments until the loan is paid off.
Typically, the loan term is 15-30 years. In return, the financial institution pays the seller the full price of the home and, in exchange, charges the borrower interest on the loan balance.
Mortgage payments are made up of two components; interest on the loan and a principal amount, which goes to paying down the total outstanding balance.
For example, a $1,000 monthly payment might have $300 go to interest and $700 reduce the principal loan balance. Interest rates on a mortgage loan can vary depending on where interest rates are in the economy and the borrower’s creditworthiness.
The loan payment schedule over a 30-year period is called an amortization schedule. In the early years, the payments for a fixed-rate mortgage loan are mostly comprised of interest. In the later years, a larger portion of the loan payment is applied towards reducing the principal.
The table below illustrates five loan payments at different intervals for a 30-year mortgage with a starting balance of $200,000 and a fixed interest rate of 3.5%.
The table above shows that a larger portion of the fixed monthly payment went towards paying interest for the first 10 years. However, as time went on, the percentage of the monthly payment that went towards interest versus principal reversed.
For example, in the 20th year, $611.45 went towards principal while $286.64 towards interest. For the last payment, all but $2.61 of the monthly payment went toward paying the principal balance.
The portion of the loan payment that's applied to principal and interest changes over the years because the loan balance is higher in the early years and smaller in the later years. This makes sense since the interest amount is higher early on since there's a larger loan balance outstanding.
As the monthly payments eventually reduce the outstanding loan, there's less interest owed, leading to a smaller portion of each payment being applied towards interest and more towards the principal.
Some homeowners choose to pay off their mortgage early, and the benefits can vary, depending on a person's financial circumstances.
For example, retirees may want to reduce or eliminate their debt since they're no longer earning employment income. In other cases, people may want to free up their monthly cash outflows by paying off their mortgage.
Let's assume a borrower has received an inheritance of $120,000, and there are 10 years left on the mortgage. The original mortgage was $200,000 at a fixed interest rate over 30 years.
The table below shows what it would cost to pay off the loan 10 years early and how much interest would be saved based on three different loan rates: 3.5%, 4.5%, or 5.5%.
As we can see from the table above, the higher the interest rate, the larger the amount remaining on the loan with 10 years left on the mortgage.
For the mortgage with the 3.5% interest rate, the total interest cost for the 30-year loan would be $123,312, and the borrower would save $20,270 by paying it off 10 years early.
Although saving more than $20,000 in interest is significant, the interest amount saved represents only 17% of the total interest cost for the 30-year loan. In other words, $103,042 in interest has already been paid in the loan's first 20 years ($123,312 – $20,270), representing 83% of the total interest over the life of the loan.
As mentioned earlier, the structure of the amortization schedule for a mortgage leads to most of the interest being paid in the early years.
If a homeowner is considering paying off their mortgage early, it might be worth considering whether some or all of those funds would be better off invested in the financial markets. The rate of return earned from investing might exceed the interest paid on the mortgage for the final 10 years of the loan.
In other words, the opportunity cost—meaning the foregone interest that could be earned in the market—should be considered. However, many factors go into evaluating an investment, including the expected return and the risk associated with the investment.
The table below shows how much could be earned on $100,000 if invested for ten years based on four different average rates of return: 2%, 5%, 7%, and 10%.
The above investment gains were compounded, meaning interest was earned on the interest and no money was withdrawn during the 10-year period.
If a homeowner decided to invest $100,000 versus paying down their mortgage in 10 years, they would earn $22,019 based on an average rate of return of 2%. In other words, there would be no material difference between investing the money versus paying off the 3.5% mortgage (based on the $20,270 saved in interest from the earlier loan table).
However, if the average rate of return was 5% for the 10 years, the homeowner would earn $62,889, which is more money than the interest saved in all three of the earlier loan scenarios, whether the loan rate was 3.5% ($20,270), 4.5% ($28,411), or 5.5% ($37,618).
With a 10-year rate of return of 7% or 10%, the borrower would earn more than double the interest saved from paying the loan off early even with using the 5.5% loan rate.
One of the reasons for such a difference between the investment gains and the interest saved from paying the loan off early is the power of compounding. If the $100,000 investment is not withdrawn during the ten years, the interest earned each year is reinvested, leading to interest being earned on interest, which can magnify the investment gains.
Before investing money in the market, it’s important for investors to determine their level of risk tolerance, which is the amount of money they’re willing to risk in order to make an investment gain.
There are various types of investments to choose from, and each has its own risk associated with them. For example, U.S. Treasury bonds would be considered low-risk investments since they’re guaranteed by the U.S. government if held until their expiration date or maturity.
However, equities or stock investments have a higher risk of price fluctuations, called volatility, which can lead to losses for the investor.
Going back to our example, if the homeowner decides to invest their money in the market instead of paying off the mortgage ten years early, there's a risk that some or all of that money could be lost. As a result, if the investment loses money, the homeowner would still need to make ten years' worth of loan payments.
A person's level of risk tolerance is often determined by their age, the amount of time remaining until the money is needed, and their financial goals. For example, retirees might be risk-averse since they're not earning employment income any longer.
Conversely, younger people in their 20s or 30s have a longer time horizon, which means their portfolio has more time to recoup market losses. As a result, a younger person can invest a greater share of their portfolio in higher-risk investments such as equities.
Although the stock market can provide sizable returns, there's also a risk for sizable losses. In other words, just as taking on more risk can magnify investment gains, it can also lead to more losses, meaning the market risk is a double-edged sword.
In our earlier example showing the various potential returns, a 10% investment gain is not an easy goal to achieve, especially after factoring in fees, taxes, and inflation. As a result, investors should have realistic expectations as to what they can earn in the market.
Before deciding to pay off a loan early, it’s important to consider the interest rate, the remaining balance, and how much interest will be saved. Borrowers can use a mortgage loan calculator to analyze the amortization schedule for their loan.
Also, how that money could be used versus paying off the mortgage should be considered. For example, some of that money could be used to establish an emergency fund, save for retirement, or pay off credit card debt with a higher interest rate.
It's also important to consider that mortgage interest is tax-deductible for many homeowners, meaning the interest paid reduces your taxable income at the end of the year. Before deciding whether to pay off your mortgage early or invest that money, a financial planner and tax advisor should be consulted.
Mark Struthers, CFA, CFP®
Sona Financial, LLC, Minneapolis, MN
A lot depends on the nature of the mortgage and your other assets. If it is expensive debt (that is, with a high interest rate) and you already have some liquid assets, like an emergency fund, then pay it off. If it is cheap debt (a low interest rate), and you have a good history of staying within a budget, then maintaining the mortgage and investing might be an option.
Some people’s instinct is to get all debt off their plate, but you want to make sure you always have ready funds on hand to ride out a financial storm. So the best course is usually somewhere in between: If you need some liquidity or cash, then pay off a large chunk of the debt, and keep the rest for emergencies and investments. Just make sure you take an honest look at what you will spend and your risks.
Treasury Direct. "The Basics of Treasury Securities."
Financial Industry Regulatory Authority, Inc. "Evaluating Investment Performance."
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