Should I Pay Off My Mortgage?
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For many of us, housing is one of the largest expenses in our monthly budget. Here in Chicago, housing prices seem like they keep going up regardless of interest rates or other factors. One reason housing continues to rise is that there is not enough housing for all the people who want to buy a home. As our population’s lifespan increases, older folks often choose to age in place, meaning they are still living in the home they purchased 40 years ago where they raised a family. This puts pressure on inventory since there aren’t as many homes for young families to buy. So the young family stays in their “starter” home 10+ years longer than they originally planned. Which means that the first time buyer is squeezed too, since those starter homes are not available either.
Along with many other personal financial questions, new clients sometimes wonder if they should pay off their mortgage. The monthly expense is one of the single largest, and cutting this expense would lower the monthly “nut” it costs them to live.
What Is Included In A Mortgage Payment?
Your one “mortgage” payment is typically a combination of several expenses:
Principal, the amount you pay towards home equity.
Interest, the expense you pay to borrow the principal.
Escrow, which usually includes both property taxes and homeowners’ insurance.
Mortgage companies typically require buyers to pay escrow so that the mortgage company can make sure taxes and insurance are paid. The mortgage company pays the taxes and insurance from the amount in escrow, and if the actual expense is more or less than the escrowed amount, they are required to settle with you later. Mortgage companies typically require this because they have a large investment in the home, and don’t want that investment to be lost through unpaid property taxes or through a catastrophic event without insurance.
Using a Real World Example
Say you own a home in Chicago that you purchased for $800,000 with a 20% down payment. You have a 3% mortgage rate, and you pay taxes and insurance through escrow. After 5 years, here’s what your monthly payment might look like:
Principal: $1,311
Interest: $1,387
Escrow: $1,317
Total Monthly Payment: $4,015
If you were to pay off the mortgage loan, you would eliminate the principal and interest portions of the monthly payment, however you would still need to pay the property taxes and insurance. Property taxes in Chicago are broken into two annual payments usually due in March and August. Homeowners insurance can be billed differently based on your insurance provider. But the key point here is that you must pay property taxes and homeowners insurance premiums each year, even if you don’t have a mortgage.
Considerations for Paying Off Your Mortgage
In our example mortgage, after 5 years the outstanding balance on the mortgage would be about $555,000. What money will you use to pay off the mortgage? Is it in a savings account earning a small amount of interest? Or is it invested in a taxable brokerage account, earning a much higher rate of return?
The US stock market has historically generated about a 10.5% average annual return. 10.5% return – 3% mortgage rate = 7.5% real return after the mortgage rate has been factored in. That means it would probably be better to keep the cash invested earning 7.5% after paying the interest. 7.5% x $555,000 = $41,625, which is additional money you would have forgone had you paid down the mortgage. In this situation, why not let the bank foot the bill while your investments work for you? Historical returns are no guarantee of future performance.
But say your mortgage rate is 7%, and you’re earning 10.5% in your investments. 10.5% return - 7% mortgage rate = 3.5% real return after the mortgage rate has been factored in. 3.5% real return x $555,000 = $19,425, which is a less meaningful return. In this case, it might be worthwhile to pay down the mortgage since the real return is so much lower.
How Does A Mortgage Make You Feel?
The other point to consider is something we talk with our clients about often – how you feel about your circumstances. Sometimes, the ‘best’ decision is not the one that makes the most financial sense. For example, I had a friend who felt very strongly that he wanted to be debt free. He didn’t have credit card debt, student loans, or a car loan, but he did have a mortgage. He lived well within his salary, and he received very large quarterly bonuses. Instead of investing the bonus cash, he used it to pay down his (very low interest) mortgage. The mortgage was paid off in about 5 years and he very proudly told me he had finally achieved his goal of being debt free. He didn’t care that it would have made more financial cents (haha) to keep the mortgage and invest the cash instead. Years later, he’s still very glad he paid off the mortgage.
I hope this has provided a framework for considering whether to pay off a mortgage. Have questions about your personal situation?
