Episode 12: Should I pay off my mortgage early?

(transcription) Should I pay off my mortgage early?

Kevin Lao 0:17
Hello, everyone, and welcome to the planning for retirement podcast where we help educate people on how retirement works. I’m Kevin Lao your host, I’m also the lead financial planner at Imagine financial security. Imagine financial security is an independent financial planning and investment management firm based in Florida. However, this information is for educational purposes only and should not be used as investment, legal or tax advice. This is episode number 12. Should I pay off my mortgage early? I hope you enjoy the show. And if you like what you hear, leave us five stars, it really helps and make sure to subscribe or follow to stay up to date on all of our latest episodes.

So this is such an important question and one I get all the time for not just folks that are approaching retirement, but younger folks that just took out their first mortgage and they’re trying to figure out, you know, should they pay it off in 30 years?

Should they pay it off early? And this particular question was was fielded because my client was speaking to a work colleague that’s several years of senior to her. And they recommended that she take $500 a month and apply it towards principle every month, and that would essentially pay down the mortgage after 20 years instead of 30. I mean, that sounds great on paper, I mean, after 20 years, you have no mortgage and free cash flow that you can do whatever you want with. You can invest all of that free cash flow at that point in time. But what is the opportunity cost to not investing that $500 a month, let’s say in a side fund? And so that’s really what we’re going to be addressing today. And really, the concept of paying down your mortgage early or not, comes down to three things. Number one is your personal risk tolerance. And number two is your ability to generate a certain rate of return in that side fund. And then number three is liquidity concerns. Okay, so we’re gonna address all three of these. So the first thing to talk about is risk tolerance. The first challenge of investing that into a side fund versus paying down the mortgage early is that the side fund is generally not going to be a guaranteed rate of return. Even if you look at CDs, or Treasury rates,. Yes, certainly interest rates have come up a little bit, but where are you going to get a four and a half percent, or even a 5% guaranteed rate of return? Nowhere, it doesn’t exist at this point in time. And so paying down the mortgage, just for the simple fact that it’s a guaranteed rate of return of four and a half percent. And that might be aligned with your risk tolerance. In this case, maybe you do pay down that mortgage, over 20 years, because four and a half percent is a pretty damn good rate of return on guaranteed money. Okay? Now, let’s say we take that out of the equation, we understand that the money in the side fund is not going to have a guaranteed rate of return of four and a half or 5%. But let’s say you’re okay with that. You say, Hey, I understand diversification, I understand how investing in stocks work or mutual funds or ETFs. And I am confident I can get a five or six or even 7% rate of return in the side fund over time. What happens to that side fund over 20 years or 30 years or 40 years? Okay, and so that’s what I did for her I crunched the numbers, I just pulled up Excel and I literally just took the the mortgage calculator amortization schedule from bankrate.com. And I plugged everything into Excel. And we calculated after 20 years that mortgage would be fully paid off if she applied that $500 of additional additional principal every single month for that 20 years. Okay, then I ran the second scenario. So let’s call a client a, let’s call client a the one that pays the mortgage down in 20 years, okay, and let’s call client b be the one who pays the mortgage off over 30 years, which is the scheduled amortization. And they invest that $500 a month into let’s call it a side fund. And I ran three different scenarios, let’s say you earn 5% or 6% or 7%, what is the difference over the duration of your life expectancy. So the first thing we found out is that after 20 years, client a has paid off the mortgage but client B has enough in their side fund to pay off the remaining principal if they wanted to, assuming a 5% return! And so this goes back into what I mentioned earlier about liquidity. Your house is not technically liquid. Sure you can tap into it via a cash out refinance which would then reset a new amortization schedule or you could do a HELOC, but that’s also debt against your property. And so it’s not technically a liquid asset whereas the side fund if you set it up properly, it is 100% liquid, you can tap into it at any point in time. Now, of course, if you’re investing that money into a 401 k or a 403 B plan, there’s penalties if you tap it before 59 and a half, but you might not really care about that. On your balance sheet, you have enough saved and invested assuming a 5% rate of return, that equals the remaining principal on your mortgage. In my opinion, client B is winning here, because they have money on their balance sheet that’s 100% liquid. And if they felt like it, they could pay off the mortgage just like client a did. Now, after 20 years, what happens to client A is they have 100% of that principal and interest payment to invest in the side fund. So now they begin their side fund after 20 years as opposed to on day one. So then I tracked after 20 years, what happens to the side fund of client B versus the new side fund of client A. Assuming a 5% rate of return, assuming we stay disciplined, and we’re investing those payments every single month. For client B, it’s that $500 per month of excess principal that they weren’t applying against the mortgage. And now for client A, it’s roughly $31,000 per year that they’re now applying to the side fund. Well, after another 10 years, once the mortgage is fully paid off for client B, client B still has 10% more (just over $40,000) in their side fund, then client A. So if you look at it mathematically a 5% rate of return for someone that’s reasonably aggressive, maybe a balanced investor, they mathematically have more money in their side fund, then did client A even after client a paid off the mortgage, and then reinvested all of those payments into that side fund. Now, what happens when you do 6%, or even 7%? Well, now the multiples go up even higher, instead of having 40,000 more, client B has over $200,000 more in that side fund than client a assuming a 7% rate of return. And if you look at the s&p 500, historically speaking, just over nine and a half percent annually over the course of the last 30 years. I mean, who knows a lot of people think returns are going to be lower over the next decade or two, no one has a crystal ball on this. But I think 7% is a reasonable return for someone who’s fairly aggressive. And so again, it goes back to the first point of risk tolerance. Are you comfortable with taking on some more risk? And are you comfortable with understanding that comparing this to paying down your mortgage is not apples to apples. Paying off your mortgage is a guaranteed rate of return of whatever the interest rate is. Whereas if you invest in the side fund, you might get six, you might get five, you might get seven, but you might not. Maybe we go through a period of time over the next 10 or 20 years, like the lost decade of 2000 to 2010. No one has a crystal ball on this. But if you understand that, you know what your appetite for risk is, and you apply that principle to paying off the mortgage or not, it’ll help make a decision that is best for you. Now, how you invest that side fund, there’s also many factors there. Are you disciplined with the investments? Are you investing in a very well diversified portfolio? Or are you trying to hit homeruns by investing in let’s say, digital assets, or, one or two concentrated positions or stocks that you really, really think you like. Because if those don’t pan out, that negates the entire purpose, because the likelihood of you earning that 7% over the course of the 20 or 30 years, is lower than if you’re well diversified, well disciplined, and well positioned to capture the market returns, as opposed to swinging for the fences. And the last thing is liquidity. All along the way, as you’re investing into that side fund, that money is liquid on your balance sheet, if you had an emergency pop up, let’s say it’s a major medical expense or you lost your job, you could tap into that side fund, whereas during emergencies, you might not be able to tap into the home equity. Maybe you lost your job. How are you going to take out the HELOC or do a cash out refinance? No bank is going to give you a loan. Or what if you have a major medical bill? It might take 30 to 60 days to underwrite your home equity line of credit or do the cash out refinance. So having that side fund that is liquid right away on day one is a huge benefit to that client B who is investing into the side fund versus paying off their mortgage sooner. Personally if you want to know I am client b. I like to leverage the bank’s money, I like to stretch out the debt as long as possible just given how low interest rates ar. The first home I purchased in 2016 had a three and a half percent rate. This home that we just purchased has a 3% mortgage, so I’m confident I can get a five, six or 7%. And that’s a much higher multiple than comparing it to what my interest rate is on my mortgage. But I understand the risk there on the side fund, I understand it’s not guaranteed. And I also understand that I have much more liquidity in that side fund than I do in my home. Now, as interest rates continue to go up the argument to paying off that mortgage early pendulum is beginning to swing in that favor, especially if rates go up to maybe 6%. Then, your appetite for risk needs to be fairly high to to accommodate that higher return in that side fund.

Now, with all of that being said, I talk to clients all the time that are approaching retirement, and they’ve had this goal of being debt free in retirement for many, many years! 15, 20 or even 30 years! Using math to convince them to invest more on their balance sheet versus paying down the mortgage by the time they retire is completely irrelevant to them. Because the qualitative factor of owing nothing to anybody is that much more important than how much they have on their balance sheet. So if that is you, pay off that mortgage by the time you retire, get aggressive, figure out that amortization schedule that lines up with your anticipated retirement date. And don’t feel badly about losing out on those opportunity costs. Because the psychological benefit and that peace of mind you’re going to have by checking that box off of being debt free in retirement is that much more meaningful for you.

Thanks, everybody, for tuning into this episode of the planning for retirement podcast. I hope you learned something valuable. We really appreciate your support and following our podcast journey. If you have any feedback on the show, or even if you have questions that you want answered on the show, send me an email at [email protected]. Just write in the subject line “podcast” and who knows, maybe your question will be answered on the next episode. Until next time, this is Kevin Lao signing off.

Kevin Lao

I am the founder of Imagine Financial Security. We are a Flat Fee, Fiduciary Financial Advisor based in Jacksonville, FL. We specialize in retirement planning for blended families, tax optimization and investment management. We can work with you locally in Jacksonville or St Augustine, as well as virtually anywhere in the United States.