As promised, with our home currently in the process of being refinanced for the fourth time since 1997, I have finished doing an analysis on whether or not to continue prepaying the mortgage early. After running the numbers, I have come to the conclusion that I should continue to prepay my mortgage, as I have been doing faithfully ever since buying the house. In fact the more I looked at it, the more I realized that prepaying my home mortgage has been among the smartest financial decisions I have made as the family household CEO!
For those of you that missed my earlier post where I discussed the benefits of living within your means (one of which was being able to refinance in hard times), here are the statistics regarding my new (and previous) mortgage(s):
Approximate Balance: $120,000 ($118,000)
Interest Rate: 4.625% (5.5%)
Term: 30-year fixed (20-year fixed)
Total Interest Paid over 30-years: $104,000
Approximate Monthly Payment: $640 ($1120)
My analysis considered two options which I creatively dubbed, um, Plan A and Plan B.
Plan A continues to make payments on the new loan at roughly $1250 per month (the same payment I was making under the previous loan) in order to ensure it is paid off in slightly under 10 years. For this option, I end up paying roughly $31,000 in interest payments.
Plan B would forgo paying the extra $480 in principal each month, instead writing a monthly check for only the minimum $640 payment over 30 years. With this option, I end up paying about $104,000 in interest over the life of the loan.
Of course, to realize the $73,0000 in interest savings from Plan A I will need to commit roughly $5760 per year toward the extra principal payments. That’s a commitment of about $55,000 across the nearly 10 years it would take to payoff the mortgage that I don’t have with Plan B.
Comparing Returns on Investment
By prepaying my mortgage with Plan A, I am essentially earning an annual return of 4.625% on the extra principal.
But those in the Don’t-Pay-It-Off (DPIO) crowd like to point out that I could make more money on that extra principal by investing it elsewhere! Sounds great, but can I really?
Their argument generally goes like this: The stock market is earning returns of 10% over the long term, therefore the money I put toward extra principal payments would be much better spent there, where I could be effectively earning an additional gain of 5.375% (i.e., market return minus my mortgage rate). But that doesn’t count any taxes paid on the investment returns nor does it include the effects of inflation! And I expect inflation to rise substantially in the coming years as all of the market liquidity unleashed by the Fed finally gets into the economy.
Here’s another thing to consider. That 10% annual market return the DPIO crowd loves to quote is based on a period of over 100 years. But this conveniently overlooks the long periods known as secular bear markets where buy-and-hold investors saw market returns approach zero.
One such secular bear market occurred from 1966 to 1982 where the annual average return of the Dow was just over 1%. That time period was marked by a long bout of high inflation not unlike what I expect to see hitting us in the coming years.
It is generally agreed that we are currently in the midst of another secular bear market. People can debate exactly when it started, but there is no denying that between Jan 2, 1998 and Jan 2, 2009, the Dow declined 200 points from 8799 to 8599 — a net loss of roughly 2%. So while those who chased mythical 10% returns during that long period lost money, the roughly $30,000 I put toward extra principal payments returned about 5% annually!
Considering the depth and magnitude of the current economic crisis I think the current secular bear will continue for another 7 to 10 years and, as a result, the average buy-and-hold investor doesn’t have a prayer of averaging 10% annual returns over the next decade.
Of course, the DPIO crowd will tell you that money can always be made in secular bear markets by buying on the dips, but this argument is folly for the average investor who has neither the time nor the insight to make the correct moves year in and year out.
I think it is clear that prepaying and retiring the mortgage in 10 years actually is a better investment bet than stretching the payments across 30 years and playing the market.
So much for the effective gain the DPIO crowd loves to talk about.
Inflation Effects and Time Value of Money
The DPIO crowd will cite the effects of inflation and the time value of money as being in the debtors’ favor because high inflation makes your loan cheaper over time. Yes, I did say high inflation can be a blessing for those who carry high amounts of debt, specifically saying that people with fixed-rate mortgages should be rooting for high inflation. While that is true, it must be remembered that there are caveats that high-debtors must adhere to if they intend to benefit from high inflation, two of the biggest being: 1) income has to continue to keep up with the rate of inflation; 2) temptation to take on additional debt must be avoided.
So does high inflation over a long period of time make it more reasonable to keep the mortgage?
Remember, by paying off the mortgage early, Plan A offers a savings of $73,000 in interest payments. If the Fed managed to keep inflation to roughly 3.5%, my interest savings would be over $51,000 in today’s dollars. And if inflation is 8%, which is what the United States experienced from 1973 to 1982, the interest would still be worth roughly $33,000 in today’s money.
In either case, those are still impressive numbers. So the time value of money argument doesn’t work here either.
One last argument the DPIO crowd likes to make is that mortgage interest is tax deductible. If you itemize, and assuming you are in the 25% federal tax bracket, a 6% interest rate could cost as little as 4.5%. But this has always been a weak argument as the tax benefits dramatically decrease the longer you have the loan. And if your total itemized deductions fall below the standard tax deduction, then this benefit ceases to exist.
As an engineer, I spend much of my time identifying and analyzing risks and then making trades based on those analyses. In this case, the analysis shows that choosing to limit my interest payments today provides me with a guaranteed rate of return in a secular bear market and more cash to invest in the future — even after considering the effects of high inflation.
Sure I could gamble and try to beat the market, but those of you who have been following this blog know that my goal for success is about finding and maintaining financial freedom, not getting rich.
For most of us who are not professional investors, paying the mortgage early is clearly the right choice. This is especially true for those who want to reduce risk by agreeing to trade the desire of making more money over the short run in exchange for the security and promise of a steady, risk-free return.
Early mortgage payoff is smart. It’s secure. In fact, it’s an absolute no-brainer.