Embracing our 38 year mortgage into retirement


Pay off your mortgage, pay off your mortgage, quickly, fast, don’t even think about not doing it!  Stop, don’t pass go until you pay off ALL your mortgage first.  You must work forever if you don’t pay off your mortgage as early retirement is impossible without doing this first. These are the near universal words in the FIRE community.

What is a 38 year mortgage?

Is there such a thing as a 38 year mortgage, you might be asking?  The Finance Patriot has lost his mind. No, there is no such thing as a 38 year mortgage offered from start to finish.  For the first 8 years of owning our home, we had a 5-year ARM (adjustable rate mortgage) with ING Direct (now Capital One 360).  In the summer of 2016, we refinanced our remaining principle into a brand new 30 year mortgage with Third Federal Savings & Loan (5 year ARM).  The mortgage principle we refinanced was approximately $212,800, at a five year fixed rate of 2.89%.  This interest also has the added benefit of potentially being tax deductible (crazy, as if 2.89% wasn’t cheap enough).

Link:  Benefits of a long mortgage

Investing vs. Paying off your mortgage early; an inconvenient truth

I think the best way to describe the decision making process, which we encountered, is by sharing two hypothetical examples.

Scenario 1

Johnny

Johnny wants to retire early.  Johnny is 38 years old and has a $212,800 mortgage, which is financed at a 2.89% rate.  On a 30 year payment plan, his monthly payment is $884.60.  In order to pay it off early, he spends the next five years making payments of $2,000 per month, with the additional funds going to principle.  Given this extra “investment” in his mortgage, here is the outstanding principal balances after each of the first five years;

Year 1 Year 2 Year 3 Year 4 Year 5
Outstanding Principal           194,716           176,103           156,945           137,225         116,928

This is a phenomenal result on the surface.  After ten long years, Johnny only owes $116,928 on his mortgage.  He has increased his overall net worth by $95,872.  More importantly, that psychological burden of a monthly mortgage payment is nearly paid off.

Scenario 2

Let’s take a look at Marcus.

Marcus is a risk taker.  He’s been known to drive above the posted speed limit, remove tags from pillows and even jaywalk.  Marcus knows how to live life on the edge.

Marcus is also 38 years old and has a $212,800 mortgage, which is financed at a 2.89% rate.  On a 30 year payment plan, his monthly payment is $884.60.  Marcus is very frugal.  Outside of the occasional tattoo (hidden from plain sight), he keeps his expenses low.  Instead of paying extra on his mortgage, he invest his funds in a low cost, total stock market index, say like VTI (Vanguard Total Stock Market ETF)

He continues to make regular mortgage payments, but invests the surplus $1,045 per month, in his Vanguard account into his stock index fund (VTI).  After his minimum monthly payments on his mortgage, here is the outstanding principal balances after each of the first five years;

Year 1 Year 2 Year 3 Year 4 Year 5
Outstanding Principal     196,477        192,812        188,997        185,027        188,810

This is a mediocre result on the surface.  After five long years, Marcus still owes $188,810 on his mortgage.  He has increased his overall net worth by $23,990.  More importantly, that psychological burden of a monthly mortgage payment seems to be going no where.

We’re not done with Marcus yet though.  He still has invested, $1,045 per month, in the total stock market index, VTI, and here are his returns over the last five years, assuming a 9.7% return (SP500 with dividends included);

Year 1 Year 2 Year 3 Year 4 Year 5
Investment Value, VTI           13,219           27,778           43,815        61,478        80,932

This is a fantastic result on the surface.  After five years, Marcus now has additional invested assets of $80,932.  Combined with his reduced mortgage principal, he has increased his overall net worth by $104,922.  More importantly, that psychological burden of a monthly mortgage payment is quickly disappearing.  He should be early retired in no time.

Analyzing the results

Scenario one ended up with a total increase in net worth of $95,872 vs. $104,922 increase in net worth in scenario 2.  The clear winner is investing the surplus (scenario 2), by about $9,050 over the first five years.

However, mortgage interest is tax deductible.  Since many components go into itemized deductions, including mortgage interest, property taxes, state income taxes and charitable contributions, we’ll say that about 50% of his interest ends up being a tax deduction.  That makes his effective interest rate even lower than 2.89%.  For example, after taxes, the interest rate may only compute to 2.5%.

Is a 5 year adjustable rate (ARM) risky?

Not in my opinion.  With our current mortgage, after the five year fixed period, the rate will float based upon the Wall Street Journal Prime Rate.  That is usually in tandem with the federal funds rate.  Today that rate is 3.75%.  However, with our Third Federal 5-year ARM, we have an option to “re-lock” at existing rates offered, by paying a $295 fee.  So assuming we had to re-lock our rate today, the current rate offered is 3.14%, only marginally higher than our existing rate of 2.89%.

Compared to a 30 year fixed rate, you are paying a large premium for the safety of a longer fixed period.  The current rate offered is 4.34%.  On a $200,000 loan, that’s a difference in payments of $995 for the fixed rate, vs. $858 for the 5 year ARM.  That’s $1,644 in savings, per year, which could be invested.

Is the stock market spooky?

Stock market investing is less risky than this dude

There is no question the stock market carries risk.  The 9.7% historical stock market returns quoted do not happen linearly.  In fact, most stock observers will tell you that there is no guarantee that you will achieve these historical returns.  However, they also won’t tell you that there is also a chance that your returns may exceed historical averages as well.

most stock observers will tell you that there is no guarantee that you will achieve these historical returns.  However, they also won’t tell you that there is a chance that your returns may exceed historical averages as well.

For fun, let’s take a look at my daughter’s 529 returns over the last five years.

Returns that never should have occurred, from my daughters 529 account

 

Helpful link:  2016 Berkshire Hathaway Annual Letter detailing SP500 returns, 1965-2016

In each time-frame listed, returns are over the historical 9.7% I quoted.  Should I use the longest time-frame from this sample, my assumptions for returns, going forward, would be a whopping 12.9%.  Alas, I am a conservative guy that likes to use more realistic assumptions.  I’ll stick with my measly 9.7% compounded assumptions.

Final Word

There are both benefits and drawbacks to paying off your mortgage early.  My goal in this post was to show you some of the opportunity costs that exist when you pay off your mortgage early.  We have no intention to pay off our mortgage early, but if rates were to go well above historical norms, we would take some of our stock investments and perhaps consider paying it off early.  In the meantime, we are placing our bets with that spooky stock market, who eventually is good to us.

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Do you plan to pay off your mortgage early?  Why or why not?

12 comments

  1. I paid off my mortgage early. It was an incredibly freeing feeling and I recently ran the numbers to see that the stock market only beat my mortgage interest rate by 0.1% So it wasn’t that big of a loss for me but it definitely could have been way worse if I had paid off my mortgage after the recession.

    1. I can understand the “feeling” of wellness of not having a mortgage. However, as our taxable investments have ballooned in value, I actually find greater comfort in these dividend paying machines than I ever would have felt in shedding our mortgage payment, which is now down to $885/month for 2900 square feet (not very Mustachian but hey, it is what it is). Did you calculate the lost mortgage interest deduction from paying your note off early, in your “returns?” In the 25% Federal income tax bracket, those deductions we have gotten, marginal as they are, have come in quite handy. It’s sort of the equivalent of having a 25% immediate 401k match, if I could relate it to something else.

  2. I like your argument. Too often people presume a personal finance tactic will always relate to their situation, which may not be true.

    With your numbers and rates, your tactics are sound! (I’m also jealous) out here in crazy land West Coast, I have to deal with property values 2-3x as high and mortgage rates 2x as high. It alters my tactics somewhat. Investing in paying off your mortgage at a 2.8 % rate? Yup, madness.

    Would you feel different at a 4.5% or 6.8% rate?

    1. Yes, I would. My margin of safety is around 5%. So if the interest rate were above 5%, I might consider paying extra. Right now with a big market upswing, I would probably pay extra. Compare that to a big downturn, and hopefully I would shed my emotion and invest instead.

  3. Great post. If more people looked at their mortgage (and homeownership in general) with a more unbiased and critical eye, they’d probably come to the same conclusions you did. Take whatever “feelings” of security you might have from owning your residence free and clear out of the picture, and compare it to any other asset or investment in your portfolio. The opportunity cost of tying up that much of your wealth into a house vs. another investment vehicle can be eye-opening. Don’t forget that “home as asset” has downsides – a home is an illiquid, risky, high transaction cost box that you sleep in and store your stuff in. If you pay off your mortgage, you’re left with fewer opportunities to deploy that capital elsewhere – in places that offer potentially higher returns, with high liquidity, and low transaction costs.

    I was recently “shaken out of my trance” with respect to mortgages and paying them down sooner than required by a divorce that forced me to sell the house in a hurry in order to split up total assets. Now that I’m in financial rebuilding mode (and renting a house again for the first time since my college years) I’m stepping back and doing the math not only on aggressive mortgage repayment strategies, but on homeownership in general. I had paid down my last mortgage (and build up a lot of equity in the house as a result). But had I invested the money elsewhere, and just made the regular mortgage payments? Id’ve had greater ROI, and a less traumatic time accessing it later to split it up during divorce proceedings. And Id’ve had more money left in my portfolio to help with my rebuilding efforts.

    A house is just a box. Never forget that. If you can live there via a low interest payment called a “mortgage” – why on earth would you not take advantage of that low interest rate?!?!?

    1. Great comment and I came to the same conclusion over time. Here I was making extra principal payments as the market was recovering from the financial crisis. My timing couldn’t have been worse.

    1. Thanks, it seems to be a hot topic in some FIRE groups. Most people prefer the comfort of paying off a mortgage early, but we do a “mortgage payoff ratio” instead. We take our taxable investments, plus cash in savings, and divide that total by our outstanding principal. As the ratio gets higher, we’ve had a lot of comfort in our choices. We now have investments, plus cash, worth 105% of the outstanding principal balance. That feels great.

      Even if you decide not to make extra payments on a mortgage (assuming you can secure a great rate), you can still take comfort that just making ordinary mortgage payments reduces your principal each month. What we owe today is far below the original loan we took out in 2008 🙂

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