Are Extra Mortgage Payments Smart When Your Interest Rate Is Low?

If you own a home, you might be contemplating how extra mortgage payments may or may not fit into your overall financial plan.

As is with all personal finance choices, your mortgage payment strategy is personal based on many factors.

You don’t find many people who paid off their mortgages and regret the paid off debt. Who doesn’t like being mortgage debt free can always re-borrow back into debt.

Still, this topic is one of the most controversial in personal finance. The purpose of this article isn’t to tell you what to do or judge your decisions. It’s meant to look at extra mortgage payments and being mortgage-free from different perspectives.

Everyone’s mortgage numbers, income, short and long-term goals, and housing needs are different.

I’ve made extra mortgage payments to our house and rental property in the past to take advantage of refinancing. I don’t regret those decisions, but I’ve stopped making extra mortgage payments because they aren’t part of a bigger plan to completely pay off our mortgage.

Plus our mortgage rate is so cheap.

I do still plan to be mortgage-free when I fully retire at age 55. But extra mortgage payments today at age 42 isn’t the path for me. For others, it may be.

This is a highly complex topic and I’ll only scratch the surface to spare you from a novel-sized post. Both math and emotion weigh heavily and people tend to change their views at different stages of home ownership. 30 years is a long time.

Rates Still at Historic Lows

Mortgage rates have hovered at all-time lows below 5% since the aftermath of the financial crisis of 2007-2009. If you secured a mortgage or refinanced in the past decade and your credit is halfway decent, you likely have a historically low rate.

It’s not too late, you can still refinance to take advantage of low rates. But your time may be running out. Never hurts to check out rates to see if you can save money. I refinanced my home and investment property not long ago using LendingTree to find the lowest rates.

This generation of home owners can enjoy their low fixed rate for up to thirty years, no matter what rates or currency does in the future. Not a bad deal, as long as the payment isn’t suffocating cash flow.

Check out the chart below of the average 30-year fixed mortgage rate since 1971 (turn sideways smartphone users):

Source: Freddie Mac, 30-Year Fixed Rate Mortgage Average in the United States© [MORTGAGE30US], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MORTGAGE30US.

Benefits of a Mortgage

A home mortgage is actually a pretty sweet deal. For a very low interest rate, you can move into a home that you “own”. The bank covers a big portion of the cost, and instead of tying up your money in home equity, you keep it in your pockets. With that money, you can invest it to grow wealthier, and/or, have peace of mind with more cash in the bank.

Other benefits of a mortgage include:

Mortgage Interest Deduction – Mortgage interest is tax deductible. That means when you itemize your tax deductions you lower your tax liability which lowers the overall borrowing cost.

Hedge against inflation – Your mortgage payment stays fixed as the value of a dollar depreciates. As the dollar buys less over time, your payment amount effectively decreases in real terms (inflation adjusted).

Leverage – A mortgage allows you to buy a better home that you couldn’t afford without a mortgage while freeing up cash for profitable investments.

By paying off a mortgage early, you lose these benefits. You’ll need to weigh the benefits of a mortgage against your goals and comfort levels.

Why no Mortgage?

If a mortgage is such a good deal (especially with today’s low rates), why would anyone want to be mortgage-free?

Some people just hate debt. That’s not a bad reason. No one ever went bankrupt when they were debt-free.

Even more appealing is that having no mortgage gives you freedom. Imagine, homeowners, if your mortgage payment was gone? Savings would increase. Work might quickly become optional. That business idea you’ve been putting off because you’re playing safe to maintain your lifestyle can finally commence.

The thought of freedom sometimes tempts us to make extra mortgage payments. The journey of a thousand miles begins with one step, right? But that may not be your best play if mortgage freedom is your goal.

For a lot of people, they may want to get rid of their mortgage because it’s too big.

Real estate agents and mortgage loan officers are often the ones to tell us how much house we can afford. Too often, the maximum affordability ceiling is not appropriate for the home buyer.

That sometimes leads people to buy houses that are too big and expensive. And that’s before maintenance costs.

The romance of buying a home can cloud financial judgment.

Once homeowners are in the home a few months they realize, wow, it’s expensive to own this home. When you have that feeling, you probably overspent and are now considered “house poor”.

Moving is one way to escape a suffocating mortgage payment. But once comfortable in a home and neighborhood and you don’t want to move, options are limited. Options include:

  • Make more money so the payment is more affordable
  • Refinance to lower the payment
  • Make the property a rental and rent somewhere cheaper, or…
  • Eliminate the mortgage

Making more money is easier said than done. Refinancing will lower your payment and help your cash flow, but a sizable payment remains. Renting the property and moving is a hassle.

So you’re left with eliminating the mortgage. Paying off the mortgage is a massive undertaking for most people since they often overspend on a house and have a long road.

Looking at a typical monthly budget, housing costs usually make up the biggest chunk of income. Eliminating the mortgage payment seems like a great solution to boost cash flow. The problem is, most of us can’t quickly pay off a mortgage. It’s a multi-year task. Sometimes multi-decade.

Small extra mortgage payments on a large long-term loan won’t buy freedom soon enough.

The Short Answer According to Math

The answer to this question about extra mortgage payments is dependent on a number of factors, including some personal preferences. So this short answer does not apply to everyone because personal finance is personal.

For simplicity sake, I consider extra mortgage payments to be any extra money paid toward the mortgage at any time of the month.

Strictly considering the math, the short answer is no, it is not smart to make extra mortgage payments if you are in a long-term mortgage with a low-interest rate and plan to stay in your home. Especially if you’re young and plan to work for the term of the loan.

The reason is, over long periods of time, you should be able to earn more from investments than by paying down your mortgage early.

Stock market returns are typically 9% per year over very long stretches of time. So if you have a 4% mortgage rate, long-term stock market returns should outperform the ~4% return you’d get from paying off mortgage debt.

That is the basic view. But you also need to account for the mortgage tax deduction, which lowers net borrowing costs, and capital gains, fees, and dividend taxes on the investing side which lower returns.

The investment strategy needs to handily outperform the interest rate on a mortgage. A conservative stock investing strategy such as buy and hold indexing should do the job over long periods of time. But it’s still investing, and money is at risk.

The return on using cash to make an extra mortgage payment is risk-free. But with rates being so cheap today and during the past decade, the return is quite low. Higher returns are easier to find elsewhere.

All told you’ll be wealthier if you choose to pay the minimum payment on a 15 or 30-year mortgage and consistently invest surplus money in 100% stocks or investments with similar returns to stocks.

But not everybody has the discipline to invest consistently or can stomach putting money at risk for higher returns over the long term.

The Long Answer (and why the short answer doesn’t apply to everyone)

First of all, the short answer above makes a few assumptions. The big one is that you can achieve consistent returns greater than the mortgage interest rate. U.S. stocks typically return about 9% over long periods of time. The longer the time period, the more likely this outcome is.

Even over the long-term, returns are not guaranteed. To earn 9%+ returns, the assumption also requires that the investor is heavily invested in stocks or investments of similar returns. Average Joe-schmo homeowner isn’t.

Also, a “low” interest rate is relative. The rate on my primary residence is 3.375% because we lucked out on the timing of our last refinance. That low rate makes paying the minimum on our mortgage more compelling because it’s so cheap.

For someone with a 5% mortgage, the rate is still at historic lows. However, it becomes more difficult to outperform the rate with investments. If you pay the minimum, and the expected return of your invested money is 8%, you’re putting your money at risk for an additional 3% return.

If this were the early 1980’s and interest rates were above 10%, the considerations are completely different. It’s not, luckily. But as the interest rate on a mortgage rises, putting money at risk becomes less desirable, though the benefits of the tax deduction and inflation protection are still there.

This is one reason why Wall Street pays so much attention to interest rates. As they increase, investors slowly become less likely to invest in stocks, driving down prices

Here are some other factors to consider.

Age and Extra Mortgage Payments

A 24-year-old with a mortgage lives under different circumstances than a 50-year-old.

Young people who own a home and intend to work a long career and stay in the same home can afford the risk of putting their assets into 100% stocks or high-yielding real estate for many years.

But a 50-year-old is unlikely to be 100% allocated to stocks. Therefore the 9% returns become less likely if assets are diversified into bonds and CDs.

As expected returns on investments revert to the mortgage interest rate, the risk of achieving those returns becomes less tolerable for someone closer to retirement age.

In other words, is it smart to put money at risk to earn 6% at age 50 or 60 when you can earn a guaranteed return of 4% from paying down your mortgage?

Time Horizon

Most mortgages don’t last to term. The average mortgage term is 5-7 years before being paid off or refinanced. If you expect to sell the home soon, you’re better off putting your money elsewhere.

If you plan to live in your home for the length of the mortgage term or longer and plan to work, and your interest rate is low, it does make sense to pay the minimum, according to the math. 30 years may be too long to wait to pay off the loan. Consider refinancing to a 15-year fixed.

Goals

Your mortgage or housing situation should play a central role when creating a comprehensive financial plan.

If your goal is to achieve financial independence in your 40’s and travel, your circumstances are vastly different than someone planning to work into their mid-60’s.

The Loan Balance

Depending on how large your mortgage balance is relative to your assets and income, it may be too large to attack. Small extra payments on a big loan have little effect in the short-term.

If your fresh 30-year mortgage balance is a $400,000 loan and you reached too far in terms of how much house you can afford, then you should focus your attention on growing your income more than tackling your mortgage if you want to stay.

Risk Tolerance

Even if you’re young, you may not be comfortable investing your monthly surplus cash flow into stocks. Many young people are skeptical of, or uninterested in stocks. If the investor has other means to achieve returns greater than the interest rate on their mortgage, then go for it. Otherwise, someone with a low risk tolerance may prefer to “invest” their money in paying down their mortgage.

You may not even know your own risk tolerance. Are you heavily invested in stocks or is your money mostly in cash? A good way to understand your asset allocation is to utilize a free online tool to consolidate your assets into one view.

Your Values

Some people hate debt. A lot of those people learned to hate debt AFTER they signed the dotted line on a mortgage. Dave Ramsey fans sometimes quote the bible to justify their distaste for debt.

Others may grow to dislike banks, or simply believe that the borrow is always a slave to the lender and don’t want to be a part of it anymore. Values-based decisions are where you can throw out the spreadsheet and make choices based on what you believe is right and wrong. The math might be worse, but you’ll sleep better at night.

How to Pay Your Mortgage Off Early

OK, so you understand the math, you know the benefits of a mortgage, and your rate is low. But you still want the freedom of being mortgage-free. What is the best way to go about it?

Before considering paying off your mortgage early, you should be in a healthy financial position… steady income (active or passive), fully insured, fully funded emergency fund, and be free of any high-interest debt.

Got credit card debt? Pay that off first. Suffocating car payment? Eliminate it.

Also be sure to first utilize tax-advantaged savings accounts such as a 401(k), IRA, or 529 accounts to save and invest while lowering your tax liability to the government.

If you’re confident your financial ducks are in a row, then you can consider paying off a mortgage.

To pay off a mortgage, you have four basic options or a combination of these:

  1. Pay the mortgage off over the term of the loan (usually 15 or 30 years)
  2. Sell the property and use the proceeds to pay off the house
  3. Make extra mortgage payments (or bi-weekly payments) and pay off the loan by a target date
  4. Build a lump sum of cash and pay off the mortgage in one big chunk

The first two options are most common and require no extra effort. You either pay your mortgage on time or, when you sell the property, you pay off the balance.

The last two options require discipline and sacrifice which most people aren’t willing to make. Deciding to choose option three or four should be based on your desired payoff time frame.

Generally speaking, it’s not smart to throw extra money at the loan willy-nilly.

Extra mortgage payments, if you’re going to go that route, should be associated with a goal. To determine your goal, follow this simple step-by-step analysis:

  1. Ask yourself, when do I want to completely pay off this loan?
  2. Run the numbers to see if that’s realistic.
  3. Adjust your time frame and payment to meet a realistic goal.
  4. Execute the plan

This process can be worked out on a spreadsheet. Creating a mortgage amortization spreadsheet is easy even if you aren’t a spreadsheet wizard.

I’ve created a free basic mortgage calculator spreadsheet you can use.

Let’s say you want to pay your mortgage off in five years. How much in regular extra mortgage payments do you need to make? The spreadsheet will tell you. Use the Goal Seek tool to help determine the payment amount to reach your payoff goal.

If you’re committed to paying off your mortgage, start with a spreadsheet before taking any action on your mortgage. Then create a plan and execute it.

My Personal Preference for Extra Mortgage Payments

With 29 years left on a 30-year-fixed mortgage, and a 3.375%, interest rate, I’m in no hurry to make extra mortgage payments. I’ve paid the minimum for the past year and will continue to do so for the foreseeable future.

If I keep that up and stay in the house, I’ll have the mortgage until I’m 71-years-old. That fact doesn’t sit well with me.

And it doesn’t jive with my plan to be completely debt free by the time I fully retire at age 55. So where does that leave us?

For starters, Mrs. RBD and I don’t expect to stay in our current home forever. We talk a lot about moving to achieve financial independence, living overseas for extended periods like my pal Chad, or moving into a smarter home nearby

Moving at some point is the most likely outcome but we don’t know where yet. We’re committed to not going further into debt for a different home.

But it’s possible we will stay in our home. We like our neighborhood. So far, we like the schools (though we’re just getting started). The region and climate are highly desirable.

In 13 years when I plan to fully retire, our mortgage balance will be significantly lower. Our invested assets will surely be higher with 13 years of compounding behind us. At that point, or in the years approaching my retirement date, I’ll consider paying off the mortgage in one big chunk or several aggressive payments.

Today, that’s my expectation. When I get there, it may be a different story.

By aggressively investing our monthly surplus into income producing assets between now and then, I’ll have options. That’s what is most important.

If you are committed to the goal of paying off your mortgage within five years, and if that is realistic based on your loan balance and cash flow you can pay extra against the loan, it is my opinion that extra mortgage payments are OK to make. Chances are you’ll completely pay off the loan even faster if you’re committed to the goal.

Also in five years or less, your investments are more susceptible to sharper market fluctuations.

Five years is also a reasonable period of time to pursue a financial goal. Any longer and it may be hard to keep focused.

However, if your goal is further than five years away, my preference is to save and invest the money to build a lump sum to pay it off when the balance is lower.

This opinion is based on a number of assumptions including that you plan to remain in your house. Five-plus years gives your investments more time to grow, survive market downturns, and achieve returns that are greater than your interest rate too.

Of course, just because I have an opinion doesn’t mean it’s right for you. It may not even be right for me. When I turn 50, I expect to do some serious spreadsheet wizardry if we remain in our house. At that point, my risk tolerance will be lower, I’ll be within five years of retirement, and I’ll be eager to lower my living expenses to before entering early retirement.

But I’ll still have that ridiculously low rate of 3.375%. So we’ll see how this plays out.

Do you plan to pay off your mortgage early? Have you ever made extra mortgage payments and regretted them? What do you think?

Photo by Dmitri Popov on Unsplash

14 Responses to Are Extra Mortgage Payments Smart When Your Interest Rate Is Low?

  1. FullTimeFinance August 31, 2017 at 8:37 am #

    We treat out mortgage payments like the bond portion of our portfolio. So contributions are risk tolerance based and balanced.

  2. dkvelo@gmail.com August 31, 2017 at 3:53 pm #

    If your mortgage has the option, and you plan to stay in the house, what about re-casting the mortgage when you are ready to retire and lowering the mortgage payments? (or cutting them in half). You can also do this with a lump sum instead of paying off the entire mortgage. I’d like your view on this subject; I’m in a similar position, but older.

  3. AdventureRich August 31, 2017 at 4:20 pm #

    We are paying extra on our mortgage with the goal of paying it off (30 yr at 3.5%) when our 2 year old son is a Senior in high school. This way, we free up cash flow before he hits college. It is something we are comfortable with right now, but we are open to changing our plan if we have a better opportunity or need the money 🙂

    • Michael L. August 31, 2017 at 7:54 pm #

      So my thoughts on this are that if you were to put your mortgage amortization in a spreadsheet you would see that the first 7 years are mostly interest. At about the 7 year mark it starts to flip and more of your payment goes to principal then interest. I have seen spreadsheets that show if you make extra payments do it during the first 5 years to cut the interest. After that the benifit of interest reductions are deminished you are only getting a dollar for dollar debt pay down, so you’re better off moving that extra money after that point to something with a better return.

    • Retire Before Dad August 31, 2017 at 10:19 pm #

      Rich,
      So that’s 16 years away, I guess. Close to my time frame. I don’t plan to be working when my kids go to college so planning to invest today to pay for it. I don’t expect to cover it all through the 529, but most of it. May use some passive income as well.
      -RBD

  4. Penny August 31, 2017 at 4:40 pm #

    You left out a major part about Private Mortgage Insurance. Never buy anything unless you can put 20% down.
    PMI will keep you in debt.

    • Retire Before Dad August 31, 2017 at 10:16 pm #

      Penny… Good point. PMI does suck. I’ve never had it, maybe that’s why I forgot to mention it. Great reason to refinance if you can get rid of PMI.

  5. rabbithutch August 31, 2017 at 6:05 pm #

    I understand both sides of this argument, and am fortunate enough to be able to fully fund 401k and IRA, 529s, and invest in taxable accounts. Of course I get the math, but I also want the psychological benefit of being free of a mortgage on my FI journey, even though I have a ridiculously awesome rate (We are 3 years into a 15 year mortgage at 2.75%).

    I do one of two things with extra money that I’d like to direct to the house. When the market seems high (like now) I make some lump sum payments here and there to the mortgage, guaranteeing a whopping 2.75% return. When the market looks like a good value or neutral, I invest in a separate “sinking fund” consisting of VG Ttl Stk to eventually use to pay off the mortgage (or not, maybe it will be used to invest in a rental, help with kid’s college expenses down the road, etc.). This method provides peace of mind.

    Of course, as you say, pay off “bad” debt and invest in the market first (maxing out retirement, etc). But if you have some freedom to spread it around, by all means do so.

    • Retire Before Dad August 31, 2017 at 10:21 pm #

      Paying down a mortgage is a way to sort of diversify. Guaranteed returns are hard to come by. Sounds like you’re in pretty good shape with that 15-year. I’d have preferred a 15 but would have stifled our cash flow.

  6. Kyle September 1, 2017 at 12:12 pm #

    In my opinion making those extra mortgage payments really don’t make sense most of the time:

    – You don’t get the benefit (decreased mortgage payment) until the mortgage is completely paid off
    – Home equity is not liquid…it’s not like a bank account that you can withdraw from whenever you need it.
    – Home equity is not safe…if real estate values drop, *poof* there goes your equity. The more extra payments you make, the more equity you have at risk. Let the bank keep the risk and don’t take more than you need to.
    – Think about it…you make extra payments…paying an opportunity cost of NOT investing that somewhere else…it doesn’t lower your monthly payments…and if you want that money back, you have to borrow it back from the bank on THEIR terms, and most likely at a higher interest rate!

    Houses are meant to shelter people, not money. That’s what banks are for.

    I can’t believe when people say they want the “peace of mind” of paying off their mortgage. “What if something happens in life…won’t it be much better if I don’t have a mortgage payment?” Think about what you’re saying…you want to park most of your life savings in a $200,000 house…if the economy goes bad and you need money, how easy do you think it will be to get a loan on that house…how easy will it be to sell that house???

    For people who want the “peace of mind” and have extra money, I say invest it into something more liquid like a savings account with 1% interest, or a bond ETF. And just don’t touch it unless you don’t have to. Then you have gigantic cash reserves as a rainy day fund. If the economy then takes a turn for the worse, wouldn’t you rather have $200,000 CASH (or liquid equivalents) versus a $200,000 house that is not only worth $150,000?

  7. Matt September 1, 2017 at 12:17 pm #

    I too have a 3.375, plan on retiring in 13 years , live in DC (and I think we like the same bad sports team). Anyway, I split the difference. Started a separate investment account, make payments to that and put that in the market and make extra payments to the mortgage. That way if Shiller/Bogle are right in their predictions that the market is going to be much lower in the next 10yrs or so, I am covered and if they are wrong I have something in the game as well. My goal is to have the house paid off at retirement.

    • Retire Before Dad September 1, 2017 at 12:19 pm #

      That’s quite some coincidence. Luckily, my favorite teams are in a different city.

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