It’s A Terrible Idea To Pay Off Your Mortgage Early

If you have a bit of cash on-hand, it can be tempting to pay off your mortgage early. But if you care about long-term financial success, you should do the opposite.

The Dream

We all daydream about quitting our jobs or telling particularly unpleasant clients to take a hike. For most people, the need for income outweighs our frustration and we swallow our pride and soldier on.

This coping strategy works well for most people. If you’re reading this blog, however, you’ve probably transitioned from daydreaming to better understanding how to make your dreams a reality through the power of personal finance.

When you start to grasp the fundamental relationship between spending and investment returns, you realize pretty quickly that the fastest route out of long-term employment hell is to slash your spending. This is essentially what the Financial Independence Retire Early (FIRE) movement is all about: figuring out ways to live off much less so that you can live much more.

The Trap: “Cutting” Spending By Paying Off Your Mortgage

In the quest to cut spending, housing looms large. Housing costs typically take up between 25-30% of Americans yearly budgets. [source] This is one of the biggest spending categories, right up there with transportation and food. But unlike transportation and food, your mortgage bill is large and consolidated. It’s much easier to imagine getting rid of that one huge expense than it is to imagine spending 10% less on all of your dozens of food purchases.

So it’s no wonder that lots of people think seriously about paying off their mortgage early. It feels like instant savings. After you pay it off, you get to keep thousands of dollars the first week of every month. With the added financial flexibility, you could get a job that pays less. You could take more time off. You could generally just breathe easier.

If only that were the case! Minimizing monthly home expenses is certainly a good path to reaching financial independence earlier. But the way to do that isn’t to pay off your mortgage. In this post, I’ll go into detail explaining why it’s an illusion to pay off your home loan early and what you should do instead with your money.

The Ridiculous Hidden Costs of Home Ownership

Before I dive into why it’s a bad idea to pay off your home mortgage, let’s call a spade a spade: housing is very expensive. If you think that your monthly mortgage payment is bad, I’m sorry to say that your home is actually costing you a lot more than that. Let’s work through an example to explain why that’s the case.

An Exceptionally Average Home

Here’s an exceptionally average home in Kentucky:

It is exceptionally average in a number of ways: 

• The median home in the US costs $416,000. [source] This home costs $415,000.
• The average home in the US is 2,014 sq. feet. [source] This home is 1,984 sq feet, which is only 30 sq feet smaller.
• This home is in the greater Cincinnati metro area. As of 2020, more than 86% of Americans live in large metropolitan areas. [source]

In short, this is a highly typical American home in almost every way. One dimension in which this home is not typical is its age. The average home in Kentucky is only 40 years old, whereas this one is 100 years old. [source] But this one looks to be in very good shape for being older than 97.3% of people alive today. [source] Without a home inspection report in hand, it’s hard to be completely confident, but I would wager that this home doesn’t need any major work done to it. 

That’s all great, so what does it actually cost to own this home? Here’s the snapshot from the Zillow Monthly Cost calculator:

$2,755 is a good place to start our analysis.

The Exceptional Costs of An Average Home

If you bought this home today with a 30 year fixed mortgage, your monthly payment would be $2,236. Remember: even if you paid off your loan, you will still have to pay tax on the property while you own it. There are no states in the US that exempt residents from property tax, so you’re stuck there. 

Maintenance

A good rule of thumb for home ownership is that upkeep costs 1-4% of the home’s value per year. [source] This home is likely to be on the higher end of that scale due to its age, but let’s split the difference evenly and say this will only cost your 2.5% per year. This home’s value is $415,000, so your yearly maintenance should be around $10,375. 

You shouldn’t expect to spend that every single year. The year you get the roof replaced you’ll probably spend more than $10,375. Hopefully you’ll spend less than that the next year. 

Closing Costs

Buyers purchasing in Kentucky should plan to spend 5-6% of a home’s value in closing costs. [source] Let’s split the range here too and assume you’ll pay 5.5%. For this $415,000 home, that’s $22,825. If you own the home for 30 years, you can spread that cost over a long period of time, but that’s still another $761 per year. 

Opportunity Cost of Money

Money isn’t free. I don’t mean that you had to work to get it, I mean that anything you use your money to purchase represents a tradeoff. To buy a $415,000 home with a fixed-rate mortgage, you’ll need to come up with a 20% down payment. That’s $83,000 of your hard-earned money. 

Instead of buying a home, you could invest that money in the safest known asset class: US Treasury securities, or T-bills. At the time of this writing, t-bills are paying 5.35% yearly. [source] You could also invest the money in an index fund and presumably make closer to 7.5%. [source] 

So we also have to count the cost of lost income that you miss out on when you buy the house. Here’s what your $83,000 could grow to over 30 years if you invested in T-bill at 5.35% per year instead [source]:

Spread over 30 years of ownership, that $396,382 works out to an additional $13,212 per year.

Resale Value

If you stay in the home for 30 years, at the end of that time, you could sell it and use the proceeds to help reduce the overall cost of ownership. A safe rule of thumb for yearly real estate appreciation is 4%. [source]

Here’s what your home would be worth after 30 years:

Total 30-Year Cost to Finance a $415,000 Home with a 20% Down Payment

The surprisingly high cost to own a modest 1,900 square foot home property near Cincinnati, Ohio. 

Principle & Interest	$2,236 * 12 = $26,832
Taxes	$374 * 12 = $4,488
Insurance	$145 * 12 = $1,740
Maintenance	$415,000 * 2.5% = $10,375
Closing Costs	$415,000 * 5.5% / 30 = $761
Opportunity Cost of Money	$396,382 / 30 = $13,212
Total 1 Year Cost to Own	$57,408
Total 30-Year Cost to Own	$57,408 * 30 = $1,722,240
Resale Value	$1,346,009
Net 30-Year Cost	$1,722,240 – $1,346,009 = $376,231
Source: OverthinkingMoney.com

First, that’s a lot of money to be paying for the privilege of owning your own house, but it’s not catastrophic. $376,231 spread over 30 years is only about $1,045 per month and it’s actually a bit less than that due to interest rate tax deductions.

What Can You Save By Repaying the Loan Early?

As we saw in the last section, owning an extremely average home in the US will cost you ~$57,408 per year or $376,231 over 30 years.

So how much less would you end up paying if you paid off the loan early? 

Let’s start with a more extreme version of the question: how much would it cost you over 30 years to buy the house outright with cash rather than get a mortgage? If we think that paying off a home loan early is net-positive, this should be the best possible case.

We only need to change a couple of the fields from the above table to figure out what affect this has on the 30-year outcome:

• ⬇Principal and interest will drop to zero because we aren’t borrowing any money.
• Taxes will remain unchanged. Still gotta pay the state.
• Insurance will remain unchanged. The value of the asset being insured won’t change.
• Closing costs will remain mostly unchanged. Even though there are mortgage underwriting fees that contribute to closing costs, the bulk of that money is paid to the realtors and they get paid regardless of how the home is paid for.
• ⬆Opportunity cost of money will go up dramatically. Basically, we’re choosing to use money that could have otherwise been invested to outright buy the house.
• Resale value will remain the same. The market doesn’t care whether you outright own or finance the house.

The opportunity cost of money is what really ends up having the biggest effect here. Because in this scenario, you put down $415,000 instead of a downpayment of $83,000, you lose out on a lot more compounding at the higher market rate of 5.35%. Here’s what that looks like:

Putting this all together:

Total 30-Year Cost to Buy an Average $415,000 Home with Cash

The surprisingly high cost to own a modest 1,900 square foot home property near Cincinnati, Ohio. 

Principle & Interest	$0
Taxes	$374 * 12 = $4,488
Insurance	$145 * 12 = $1,740
Maintenance	$415,000 * 2.5% = $10,375
Closing Costs	$415,000 * 5.5% / 30 = $761
Opportunity Cost of Money	$1,981,912 / 30 = $66,064
Total 1 Year Cost to Own	$83,428
Total 30-Year Cost to Own	$83,428 * 30 = $2,502,840
Resale Value	$1,346,009
Net 30-Year Cost	$2,502,840 – $1,346,009 = $1,156,831
Source: OverthinkingMoney.com

So it would cost you $1,156,831 to outright buy the home over 30 years. That’s after you factor in the sale of the home. 

That’s massively more expensive than the $376,231 it cost to loan the money with a 20% down payment.

It’s Cheaper to Finance? Really?

It’s not just cheaper to finance the purchase of your home, it’s massively cheaper. Over 30 years, you’ll pay an additional $780,600 for the privilege of owning your home outright.

What’s going on here?

If you buy your home with cash, you’re buying an asset that appreciates slower than other stuff you could invest in. And you’re putting a lot of money into that slow-growing asset. The growth rate of that asset is so low in relative terms that even borrowing at the prevailing rate is better than paying cash. 

There are two other supporting data points:

1. Due to interest rate pressure, I think home prices will continue to decline or at least remain flat for the foreseeable future. 
2. Due to shifting national demographics, I think inflation will remain high (and thus interest rates) for at least the next 5 years.

If I’m right about those two trends, then financing becomes even more appealing.

If You Can Afford it, Put Down Less

If it’s better to finance, shouldn’t you try to reduce your down payment to the absolute minimum? That is indeed what looks like the best move.

So let’s run the numbers again, but this time assume that you can afford the higher monthly payment associated with a scant 5% down payment and private mortgage insurance (PMI).

Here’s how our key variables change in this scenario:

• Principal & Interest won’t change much. I used NerdWallet’s PMI calculator instead of Zillow, though, so the numbers are ever so slightly different, but they are materially identical. 
• ⬆Private Mortgage Insurance is net-new. But you only have to pay PMI until you have paid the equivalent of 20% down. For this home and down payment amount, that’s ~10 years. 
• Taxes. No change.
• Insurance. No change.
• Maintenance. No change.
• Closing costs. No change.
• ⬇Opportunity cost of money. You’re putting down substantially less to buy the house, and using the saved money to invest.

Here’s how all of these variable changes come together:

Total 30-Year Cost to Finance a $415,000 Home with a 5% Down Payment

The surprisingly high cost to own a modest 1,900 square foot home property near Cincinnati, Ohio. 

Principal & Interest	$2,364 * 12 = $28,368
Taxes	$374 * 12 = $4,488
Insurance	$145 * 12 = $1,740
Maintenance	$415,000 * 2.5% = $10,375
Closing Costs	$415,000 * 5.5% / 30 = $761
Opportunity Cost of Money	$99,096 / 30 = $3,303
Total 1 Year Cost to Own	$49,035
Total 30-Year Cost to Own	$49,035 * 30 = $1,471,050
Total 10-Year Cost of Private Mortgage Insurance (PMI)	$322 per month for 10 years ($322 * 12 * 10) = $38,640
Resale Value	$1,346,009
Net 30-Year Cost	$1,471,050 – $1,346,009 = $125,041
Source: OverthinkingMoney.com

As predicted, it saves a bunch of money to spend less on the down payment. At $125,041 in total costs over 30 years, the monthly cost is an incredible $347 per month. 

PMI FTW?

Putting together all of the analyses to this point, we arrive at a really surprising result. If both of the following two things are true for you, then it pays to put down less than 20%: 

1. You can afford the higher monthly costs of paying for private mortgage insurance.
2. You are disciplined enough to regularly invest your savings in a safe asset class like treasury bills or index funds.

Here are all the costs together to highlight the point:

Total 30-Year Costs of Owning a $415k Home Compared 

How You Buy It	How Much it Costs Over 30 Years
Buy it with cash	$1,156,831 total$3,213 per month
Buy it with 20% down	$376,231 total$1,045 per month
Buy it with 5% down and PMI	$125,041 total$347 per month
Source: OverthinkingMoney.com

What’s Next?

I’m not going to wade into the rent vs buy debate in this post. That’s a long and complex analysis that would make this long even by OverthinkingMoney standards.

But it seems pretty clear that it doesn’t make sense to put any additional money into your mortgage. Take the cheap money that our society has earmarked for home owners and use it to invest in assets that have higher long-term returns.

And if you have a mortgage rate that you locked in more than a year or two ago, definitely don’t pay down your mortgage. High inflation cuts both ways. It makes newly-purchased things more expensive, but it also makes financed things cheaper. So if you got a good mortgage rate 2+ years ago, you are actually being paid in real terms to hold your loan.

Even if you don’t have a spectacularly low rate, it makes financial sense to grit your teeth and deal with your unpleasant boss, find a new job, or generally do what you can to have “normal” monthly expenses. It might not feel good in the moment, but at least you can reassure yourself with the knowledge that your decision is making you wealthier every single day.

Happy overthinking!