Paying a mortgage off early reduces the interest expense and the corresponding tax shield.īecause Lena has to pay her mortgage, or face significant financial repercussions, a risk-free investment of similar term is a natural alternative investment. In effect, the government is paying homeowners to take on debt. At a personal tax rate of 24%, this implies tax savings of $3,566 in just the first year of the mortgage. For example, Lena’s first-year interest expense totals $14,857. However, another cost of paying off a mortgage early is higher taxes. Investment earnings are taxable and, depending on the nature of the earnings (e.g., income versus capital gains), taxable at different rates. The “loosely speaking” caveat refers to tax considerations. Loosely speaking, if Lena could find an investment that offers a rate of return higher than the rate she pays on her mortgage, then she could invest any extra money, use the earnings from her investment to help pay off her mortgage, and still have money left over. Paying a mortgage off early comes with a cost namely, the extra money used to pay down the mortgage cannot be used for other opportunities. For example, paying 10% more each month allows Lena to pay off her mortgage in 26 years and save $22,590 in interest expense. The figure shows the more Lena pays each month, the more quickly she pays off the mortgage (shorter bars) and the greater the interest savings (larger numbers on top of the bars). Figure 1 shows the interest savings and reduction in time to pay off the mortgage that occur when Lena pays more than her required monthly payment.įigure 1: Present Value of Interest Savings and Years to Repay Mortgage Her monthly mortgage payment is approximately $2,108. To make things concrete, consider a hypothetical homeowner, Lena, with a 30-year, 3.0% fixed-rate mortgage of $500,000. Here I show data suggesting that many homeowners may be better off investing any extra money, as opposed to using that money to pay their mortgage off early. While there are psychological benefits of avoiding debt, the financial ones are less clear. Some are quite confident in the view that paying off a mortgage as quickly as possible is unambiguously good. There is no shortage of articles and videos discussing the pros and cons of paying off your mortgage early. Roberts explains why some homeowners should consider investing any extra money they have rather than using it to make additional mortgage payments. In the following article, Wharton finance professor Michael R. Roberts speaks with Wharton Business Daily on SiriusXM about why some individuals should reconsider paying off their mortgage early.
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