By Dr. Jim Dahle, WCI Founder
Thinking about paying off your mortgage early? There is an idea out there that is common but needs to be shot down. Because it's stupid. There are many benefits of a paid off house. Those who disagree with this idea simply have not thought it through. Yet I see it casually considered as an obvious truth when used in real-life conversations; on social media; and in blogs, podcasts, and books. The idea is this:
“Money in your home is being wasted, thrown away, tied up, or doing nothing.”
It is a complete and total falsehood. That money absolutely IS doing something—both before and after the home is paid off. Let's talk about what it is doing and what that is worth.
The ROI on a House Down Payment
First, let's consider a simple down payment. Classically, a down payment is 20% of the value of the home. If you put 20% down, you can get a conventional mortgage. As a general rule, these mortgages are easier to get. They have lower fees, and they have lower interest rates than the mortgages where you don't put down 20%. A conventional mortgage also avoids the need for Private Mortgage Insurance (PMI), insurance the borrower must purchase to protect the lender from the borrower potentially defaulting. I know all about physician mortgages and how you can avoid PMI without having to put down 20%. I'm even aware that occasionally you can get an interest rate and terms on a physician mortgage that are comparable to or even better than a conventional mortgage despite not putting down 20%. But most of the time, a down payment saves you fees, PMI, and interest.
The typical PMI cost ranges from 0.5%-2% of the original mortgage. Let's say you pay an additional 1% in upfront fees by not getting a conventional mortgage and perhaps 0.5% more in interest. Adding it all up, let's call it 2% a year. So, if you were going to put down 10% and you put down 20% instead, what is the return on that additional 10%? Let's use some real numbers and calculate them.
Let's say it's an $800,000 house. You were going to put down $80,000, but instead, you put down $160,000. What is the return on that additional $80,000? Well, it allows you to save 2% × $720,000 = $14,400 a year. That $14,400/80,000 = an 18% return. Pretty nice GUARANTEED return on that money, huh? You're certainly not going to get that out of any other investment that offers a guaranteed return, like a Treasury bond, CD, or insurance product. Heck, you're probably not even going to get that long term out of a non-guaranteed investment, like stocks or real estate.
More information here:
How to Buy a House the Right Way
Benefits of Paying Off Your Mortgage Early
You have to consider the return on home equity when the mortgage is paid off.
We talked above about the beginning of the home-owning process. Now, let's talk about the end when you have the mortgage completely paid off. That $800,000 home now has no debt whatsoever. Is that home equity doing nothing? Absolutely not. It is doing one of two things, and we can look at both to try to assign a return to the home equity.
The first thing it is doing is saving you rent money. Since you own the home, you don't have to pay rent. The home provides free rent. To determine the return on that $800,000, you have to determine what comparable rent would be. That's an easy process if you can find comparable homes for rent. The numbers vary by geographic area, but it certainly would not be unusual for monthly rent to cost somewhere in the range of 0.5%-2% of the value of the home. For an $800,000 home, that would suggest a rent between $4,000-$16,000 per month. On an annual basis, that saved rent would be $4,000 × 12 = $48,000 to $16,000 × 12 = $192,000. That would suggest a return on your home equity of 6%-24%. Truthfully, the more expensive the home and the higher the cost of living in the area, the more likely you are to be on the lower end of that scale. Maybe a $100,000 home can rent for $1,500-$2,000 a month, but it's pretty hard to get $12,000-$16,000 a month out of an $800,000 home.
However, that isn't entirely accurate. Remember that there are more expenses to homeownership than just a mortgage. That homeowner is still paying maintenance, repairs, insurance, and property taxes. A useful rule of thumb for real estate investors is that 45% of rent goes toward non-mortgage expenses. Some of those expenses, such as management fees and vacancies, don't really apply to your primary home. Maybe it would be OK to use 35% or 40%, but we'll just use 45% for simplicity. If you reduce that 6%-24% return by 45%, you bring the range of returns down to 3.3%-13.2%. That money is certainly not “tied up;” it's earning a significant return.
The second way to look at this is simply to compare it to the mortgage that you could have on the property. If you have a paid-off home and the going 30-year fixed mortgage rate is 7%-8%, you're earning 7%-8% on your money in the home. Guaranteed. That's a whole lot better than other guaranteed investments are paying these days. As we publish this, a one-year Treasury bond is paying about 5%, and a one-year CD is paying somewhere between 5.0%-5.2%. That 7%-8% looks pretty good compared to those other numbers. To be technically accurate, you might have to reduce that 7%-8% a bit if you are in a tax situation that allows you to reduce your taxes with a mortgage interest deduction. But if we're going to look at after-tax numbers, you will need to apply taxes to the returns of those Treasury bonds and CDs, too.
What About as the Mortgage Is Being Paid Off?
In between purchase and payoff, you have a mortgage. Paying extra toward that mortgage doesn't reduce your monthly payment; it doesn't help your cash flow at all. However, it still provides a return. What is the rate of return? Precisely the same as the mortgage rate. As the principal is paid off, that principal no longer generates interest each month. If you pay extra one month, more of your next payment will go to the principal. That means a 7% mortgage = a guaranteed 7% return.
Separate the Mortgage from the Value of the House
Why do so many people get so confused about all of that? I think a lot of people forget that the house is completely separate from the mortgage. If you put 20% down on a house, you don't own 20% of the house with the bank owning the other 80%. If the value of the house falls by 20%, you don't lose 4% of your money and the bank loses 16% of its money. You lose all 20%. Likewise, if the house goes up 20% in value, you get to keep the entire increase. You own the whole house. There just happens to be this other liability associated with it—a mortgage.
The return from paying down that mortgage has nothing to do with the return on the change in the value of your house. The house will go up and down in value the same whether you have a big mortgage, a small mortgage, or no mortgage at all.
More information here:
The Real Reason for the Housing Unaffordability Crisis
Is Renting Better Than Buying? Why We’re Financially Independent and Renting
Non-Recourse Mortgage States
Some people in non-recourse mortgage states (Alaska, Arizona, Washington, Utah, Idaho, Minnesota, California, North Carolina, Connecticut, North Dakota, Texas, and Oregon) feel like paying down their mortgage is putting their money at risk. Their reasoning is that if the value of their house drops dramatically, they can simply mail their keys to the lender (or better yet, quit paying and squat in the house for a few months until the lender forecloses and boots them out). Then, the lender cannot come after them personally. While that is true, it's a pretty rare situation that this really works out well for the borrower. There are two reasons.
The first reason is that most of the time the value of the home doesn't fall enough that it wipes out all of the borrower/homeowner's equity. If you put 20% down and the home appreciates 20% and you pay off another 10% of the mortgage, you might now have a 50% debt-to-income ratio. The price of the house now has to fall 50% just to wipe out your equity. It would have to fall even more for you to really “come out ahead” with this strategy and stick it to the bank. Housing prices don't fall by 50% very often. So, it's really only available to people who put down less than 20% and haven't been in the house very long at all when a huge housing correction occurs.
The second reason is that, morality and ethics aside, defaulting on your mortgage is going to ruin your credit. That will be on your credit report for the next seven years. Maybe you could get another mortgage in five years, but the point is you can't just turn around and buy another house with a mortgage. You'll be missing out on an opportunity to buy during a major housing correction/buyer's market. By the time you can buy again, it'll likely be a housing boom and a seller's market, and you won't get nearly as good of a deal.
But what if you are super rich and have tons of money in cash and can just buy your next house with cash? Then, you don't care what your credit score is, right? I suppose so. But consider how rare this situation is. People with that kind of wealth don't typically get that way by screwing over people who lent them money. I've interviewed a lot of millionaires on the Milestones to Millionaire podcast, and none of them got rich this way. In my experience, the same drive that causes people to save and invest enough money to get rich also seems to cause them to pay off their debts rapidly.
Finally, there is a cost to being in a non-recourse state or having a non-recourse mortgage in a state that offers both. Did you really think the lender was going to give you the same rate and fees on a non-recourse mortgage as they would on a recourse mortgage? Bankers aren't stupid. They charge a little more to make up for the occasional non-recourse default. On average, you're not coming out ahead.
Leveraging Up Your Investment Portfolio
Fine. At this point, you admit I am right. You admit that your home equity is providing you with a guaranteed return at least equal to your mortgage rate. But what if mortgage rates were way lower like they were when I originally wrote this piece in 2022 (when you could get a mortgage for 2.8% or better)? You might argue,
“I can beat that rate with my investments. I expect a higher return from my stock index funds and real estate than 2.8%. If I can't beat that over the long term, I will have much bigger problems than my home equity being tied up.”
You may be entirely right. Naturally, once you pay taxes and adjust for risk, the difference will not be as big as you might think. But you are still likely to come out ahead over the long run. As a leveraged portfolio goes, borrowing against your home is a pretty good way to do it. You get long-term, fixed, non-callable debt at a pretty low rate. That will usually beat your credit cards, your broker's margin loans, and even dragging out your student loans. You simply need to decide whether that leverage risk is a risk you need to run (and for how long you need to run it) to meet your financial goals.
You should also take a look at your investment portfolio. If you're deliberately dragging out a 2.8% mortgage to leverage up your portfolio and your portfolio is composed of 40% bonds paying 2%, that's probably not going to work out nearly as well as you think. Paying 2.8% to make 2% is not a winning strategy. The more conservatively you invest, the better off you are paying off that mortgage.
As you can see, your home equity is not “tied up.” It is performing a very useful service, saving you rent and earning you a return. Is there an opportunity cost to only earning a relatively low but guaranteed return? Of course, but it's probably not nearly as high as you think once you adjust for risk and taxes. We paid off our mortgage in 2017 and have yet to regret it. If we ever did, we could always go out and get another one. Don't even get me started on the psychological benefits of not owing money to anyone; using your cash flow for whatever you want; and knowing that, even in a worst-case scenario, your family will still have a roof over their heads. The fact that almost nobody with a paid-off mortgage ever does that should tell you something.
What do you think? How do you calculate the return on your home equity? How do you decide whether to leave the equity in your home or use it elsewhere?
[This updated post was originally published in 2022.]
Hello
I read your article as well as your previous articles
I think you sold me on pay off mortgage rather than invest in stocks
My situation is I have 30 year mortgage at 3%
I might move in 2 to 4 years
1) I max out retirement accounts and IRAS each year do this first
2) save money with combination of ibonds tips municipal bonds and treasury bonds all if paying greater than 3% or pay down the mortgage faster
3)at what percentage is it worth to put money in a bond versus paying off mortgage I guess it depends on tax bracket and capital gains. The house is a 300k mortgage
4) what proportion of tips to ibonds to treasuries to munis do you recommend
3) Year to date you’d be better off paying off the mortgage than buying any kind of bond besides an I bond. But otherwise it varies by year. You can do a fairly straightforward comparison between the after tax yield on a bond fund and your after-tax mortgage rate though. If the bond yield is higher, it’s probably a better bet, but it’s still not guaranteed because bond values can fall and paying off debt provides a guaranteed return.
4) I recommend you pick something reasonable and stick with it. My ratio of inflation indexed to nominal bonds is 1:1 and has been for almost 2 decades. It is certainly reasonable but it isn’t the only reasonable mix.
I discovered an additional advantage of being mortgage-free when I had a dispute with a contractor who had done work on my house. He slapped a mechanics lien on my house, smugly comfortable that my mortgage bank would not permit the existence of such a lien on my house. Being mortgage-free enabled me to ignore his lien and eventually settle the dispute for much less than he had hoped.
Thanks for a great addition to the list.
I would also add if the situation is rent vs paid off mortgage that your rent will be paid with post tax dollars.
Jim- I’ve thought about this a lot. I finished training (crna) and found you. I paid off my student loans and then paid off our house (30 year fixed 3.65%) within 7 years. At the time, the market was cranking and all the internet advice was it was a dumb move to pay off a house. I had been making extra payments every month while also maxing everything we could for retirement. We paid it off anyways and right as we did, the pandemic hit and market tanked and inflation followed. I used all that extra money I was putting into the mortgage every month to increase retirement savings while the market struggled to recover and it paid off big time. Not only is the house paid off but I was able to put tons of cash into a down market that then went on to hit all time highs and we have seen that return. I wasn’t trying to time the market and maybe some people will do math showing it was dumb but I would do it again in a heartbeat if I had to. We still save all that extra money we were using to pay a mortgage. It’s been a very good decision from a psychological standpoint and a retirement savings standpoint.
In my experience, the people who save a lot of money are the same people who pay off their debts. So rather than being the “either/or” academic discussion we usually have online, it’s usually both.
If one were to use theoretical ROI for this analysis, how do you handle renovations and or upgrades after initial purchase? As an example, we purchased our house for $550k, did $125k renovation before moving in, and a subsequent $200k renovation. Both were paid with cash; no mortgage refinancing or HELOC. Would your ROI calculation use original $550k as the denominator, or the current basis of $875k, which lowers the ROI? Does the calculation matter whether these renovations were paid in cash vs cash-out refinancing vs HELOC? For those who might use this, want to understand which numbers would be used in the calculation.
Most of that stuff is just a consumption item, returning a relatively small amount of value for dollars spent.
Always keep the financing separate from the value of the home of course.
Makes sense for most, but I owe $170,000 on my mortgage at fixed 3.9%. I could pay off tomorrow but doesn’t make sense for me, especially considering with tax deduction that 3.9 is actually about 2.8. Schwab money market is paying 5.
But that 5% MM is pretax, so i think you’re comparing apples and oranges? My personal scenario is a mortgage at 2.75%. I don’t itemize, so after tax I’m paying that 2.75%. Fidelity treasury only MM is paying 4.94%. I pay 35% federaland 3.8% NIIT, so after tax yield is 4.94*(1-0.35 – 0.038) = 3.02%. If I were in non treasury only and paid state income tax on the est it breaks even. And as soon as rates dip a little, payoff versus the no risk return of MM will be back in favor of payoff.
Yes 5% is pretax, but that’s the lowest and guaranteed. After tax would be about 3.6 which still compares favorably to 2.8. Sure if rates drop the equation changes, but I’d rather put my cash to work for a better return right now. And I can always pull that money out to pay off should I desire.
These are fun academic conversations to have and I love when people are willing to nerd out with me on the theory/philosophy.
In practice, it just doesn’t matter, the decision is not going to impact most people’s short or long term financial goals. In this example, by putting cash to work you are ahead 0.8% (3.6% after tax MM return – 2.8% after tax mortgage return).
How much cash do you have “at work”?
$100,000? That’s $800/year you are “ahead”.
$200,000? That’s $1600/year.
Most people reading this blog do not have financial plans whose success or failure hinge on $800-1600/year. Most of my clients find that their initial spending projections just in the dinning out (restaurants/bars/take out) category are off by ~$800 per MONTH after I have them track their spending for one year.
In other words, there are many areas of personal finance that do have a material impact on our goals that get little attention (i.e. detailed understand of our spending) and many that do not have a material impact that get lots of attention (i.e. this topic).
I think $1600 is a lot of money, it’s a whole month of dining out for many, so I’m all for an extra $1600/year. I’m also for putting decisions in context so that we can devote our executive bandwidth in proportion to actual impact.
As far as the PMI goes, the savings may be less significant than the article suggests.
Our lender (and many others) allow you to drop the PMI once you get to 20% equity or 80% loan to value.
We had enough cash to put 15% down on our home and get a conventional mortgage with PMI. The doctor loan products had no PMI but higher rates.
We took the conventional lower rate loan then just aggressively made extra payments until we got to 20% equity. The bank then dropped our PMI after we filled out a simple form. All in we only paid about 5 months of PMI and ended up with a lower interest rate.
That’s good it was just a simple form. Some have required you to pay for an appraisal.
Great post! One additional benefit I have experienced with what are now two paid off home mortgages (our primary residence and a vacation home) is diving into the payoff process was a great way to get on the same page with my better half with financial matters. It carries on the other things, sort of like getting to watch Proverbs 31 come to life.
Great article. I agree 100%.
After we paid off the house (and cars, of course) we could put all that ‘wasted’ money into retirement accounts. It’s amazing how fast it accumulates when you aren’t sending huge chunks of cash to various lenders every month!
WCI, working it through, I still don’t see the early pay off math working out well. Do you think I am missing something here?
Hypothetically, if I pay off a $1,000,000 mortgage (rate is 2.9%), I’d no longer have to make the monthly payments. The P&I is 50k/year, and if I invest 50k/yr for the next 15 years and it earns 7%/yr I’d end up with about $1,250,000 in the investment account.
If I invest the $1,000,000 now and it earns the same 7%/yr, I’d end up with $2,750,000. I would still be paying the 50k/year on the mortgage P&I which is $750,000 over 15 years, so that leaves $2,000,000 total.
So leaving my $1,000,000 invested in the market and making my mortgage payments means my net worth in 15 years will be $750,000 more than if I paid off the mortgage now.
Just making a guesstimate that your total interest owed for that 15 year period would be about half of the 1m, so 500kish? So the difference is “only” about 250k after 15 years
The interest paid was already accounted for prior to getting to the 750k difference.
I don’t think you can just pencil in 7% a year x 15 years. That’s not how risk works, right? Have to use the risk free rate, which is going to be much closer to the mortgage.
Also, when calculating the after tax mortgage rate, you have to consider the value of the standard deduction. Up to 750k of that mortgage is deductible (assuming it was originated in 2018 or later), so that’s $22,500 that’s deductible. The standard deduction for a couple is $29,200. If you don’t have a lot of other itemized deductions then the mortgage interest deduction is meaningless.
I can’t imagine the math is going to work out well on paying off a 2.9% mortgage while MMFs are paying 5.3%. And if you take additional risk (which isn’t the right way to do this analysis) you are likely to earn even more.
You’re going to need a different reason to pay off a 2.9% mortgage early than math.
Top tax bracket, in a high income tax state, and that math is close to being a wash depending on whether you have a lot of other itemized deductions. But of course, liquidity is useful so that favors keeping the mortgage. I also think a big fat taxable account helps me sleep well at night far more than a paid off mortgage does, and with a mid 2s fixed rate mortgage I’m in no hurry to pay it off either.
P- as far as I am concerned, you are 100% correct. I have read a lot about the subject and for me, it comes down to peace of mind versus what your true return on investment is. I have roughly a $1 million mortgage taken out at a 2.3% fixed 30 year interest rate. I see no scenario whatsoever where it would make any sense to pay down my mortgage. In fact, if they would offer me a 40 or 50 your mortgage, I would surely take it at that interest rate. I can take cash now and invest in a vanguard, low cost index fund and over time, my cash investment in doing so will FAR outweigh me paying down my 2.3%, risk free loan for “peace of mind”. Someone tell me different. Also, I stumbled upon this website a few weeks ago and absolutely love it!
Let me see if I can come up with a scenario. Let’s say your mortgage is $22,000 and your net worth is $60 million and cash is now paying 1% and treasuries are paying 1.5%. Still wouldn’t pay it off? Really?
WCI-
Thanks for the reply. Again love your website, very well done.
Not that it matters to the above scenario or math, but mortgage is $4275 a month due to a 2.37% rate and net worth is ~$8mm. 41 year old in a very high cost of living area.
I guess I am not following you quoting current cash and treasury rate sheets. Can you elaborate? What I am saying is that it makes very little economic sense for me to pay down/off a mortgage at a 2.3% (risk free) when I can employ any and all cash that I have laying around into the market or real estate or whatever investment I choose (mind you not risk free) however over time (I have time, right?) has proven to far outpace a 2.3% return rate. It’s simple arbitrage at this point. Yes?
If you can only make 1% in a savings account or from treasuries, like a few years ago, then a guaranteed 2%+ return by paying down a mortgage represents a higher risk free return. It’s dumb to carry cash (barring liquidity/emergency needs) if you can earn more paying off debt.
But right now you can make 4-5% on cash. So you can sit on your 2.3% mortgage and arbitrage the difference. But at a certain wealth level, who needs the complexity? I mean, you got $8 million right? And let’s say it’s a $100K mortgage. So you’re earning 5% and paying 2% so making 3%. 3% of $100K is $3K a year. Does that really matter to the guy with $8 million? Not much. And if it still does, will it matter at $80 million? At a certain point, it’s worth paying it off just to get rid of another account to keep track of.
We paid off a $200K+ 2.75% mortgage back in 2017 because it just didn’t matter any more. It was irrelevant to our financial life and we’d rather be debt free than to have held on to that for another 5+ years until cash paid more than 2.75%.
You can’t compare your debt to stock or real estate returns without adjusting for risk. That’s not simple arbitrage, no. Simple arbitrage is comparing it to a money market fund.
WCI-
I hear you on carrying cash, believe me there. For a little more context, we have no debt other than our primary mortgage @ $1.05mm and a vacation property at 4% but is almost paid off. So for us, thankfully that does not apply to our current equation. We also carry very little in checking and savings accounts, just enough to pay bills and monthly expenses so very little exposure to low cash/treasury rates. Furthermore, unfortunately our mortgage is not $100,000, it is just over $1mm so with investment timeline before retirement so I have to factor that in. Also I don’t have an issue with having an extra account I have to manage, it is automated.
I feel very confident that the rate of return that we will achieve over this journey to retirement timeframe given what specific asset class we choose assuming extremely low expense ratios with Vanguard (for example VTI also pays a 1.2%+ yield with a nonexistent .03% expense ratio) will far out pace ROI on vigorously paying down our risk free mortgage rate of 2.37%. Also agree with you 100% on being careful to compare the two from an “arbitrage” perspective as both options offer very different risk/return profiles, you are spot on there. With that said, we currently choose to use historical data (and a little common sense) to employ cash in the broader market, forgoing paying down the mortgage at an accelerated rate, and will take my chances with retirement timeline of 15-18 years or so. Historically, having the opportunity to borrow a lot of money @ 2.37% on a major asset is unprecedented.
What’s your plan with that mortgage in retirement? Gonna carry it to your death or pay it off at some point?
Make sure you carry enough cash to meet short term and emergency needs. No problem with investing the rest. Nor do I have a problem with you carrying debt despite being wealthy in hopes of earning more than the cost of your debt so long as you are making reasonable, intentional decisions with it.
You might consider reading the book The Value of Debt. I think it’s the best book I’ve ever read on the merits of debt, how much to use, what kind etc. I think your use of debt would fall within the author’s recommendations.
WCI- yes, absolutely, I will definitely check that book out. I appreciate your insight, again keep up the good work, what a great website with so much useful information!
Here’s a taste of it: https://www.whitecoatinvestor.com/the-value-of-debt-in-retirement-a-review/
I am three years from retirement, and I had two home mortgages and invested aggressively for several years and just thought that was normal to just keep paying my mortgages and interest. However, 4 years ago I decided to pay off both mortgages since I had the cash. This was the BEST move I EVER made!!
Your biggest wealth building tool is your income. I now have no debt, and all my income goes to investing or to whatever I want it to. The peace of mind you have not owing anyone is PRICELESS!!
We think if we invest this amount of money at a supposed higher percentage, it is a better financial decision, BUT that does not take into account any risk. No money scenario works perfectly as planned…look at the stock market in the past month…there is ALWAYS risk.
If I could advise a young physician, do not take out a 30-year mortgage. Take out at most a 15-year mortgage, invest monthly, and pay down your mortgage as quickly as possible.
You home is one of your largest assets.
I’m not the brightest investor but I’ve done all right. About 15 years ago I refinanced my home in SoCal for a 15 year loan. I always wanted to be able to retire without a huge mortgage. I was able to pay off the mortgage in 7 years. I worked another 5-6 years and made some decent investments. I retired 2 years ago with no debt except my monthly credit card bill. My house has appreciated $1.5M since I refinanced and my retirement and investment assets are over 3 times that. My monthly bills are easily paid with my Navy retirement income and my wife and my social security money we took at age 70. I’ll be forced to take RMD from my retirement fund next year and it will be like getting a 100% raise. We plan to increase the 529 payments to our grandkids and invest the rest. I was blessed with good health, a wonderful wife of 48 years, and some common sense.