FAQ: Should I make extra payments toward my 3% mortgage?

By Michael H. Fogarty, CFP®

This is a common question from our clients who are working hard to build home equity and save for their future. As a client reduces their student loan debt, car payments, any outstanding credit card debt, and any other form of loans, eventually they wonder if it might be time to start reducing the amount they owe on their home.  The answer may differ from person to person.

The Rate Environment

Let's start by reviewing how a mortgage works. Mortgage interest is typically front loaded. You pay more interest than principal during the early years of the loan.  This means that by making additional principal payments early over the term of a mortgage, a client can significantly reduce the amount of interest they pay over the life of the mortgage.  This equates to a guaranteed return equivalent to the interest saved.  With a low interest mortgage, the benefits of early payments are greatly reduced.  It becomes more important to weigh other considerations when choosing the best course.

Over the past 10 years Mortgage interest rates have been at historical lows. In the environment after the subprime mortgage crisis in 2008, the Federal Reserve held overnight interest rates at 0% for years. Just as rates started creeping up, the COVID pandemic created a new economic challenge, and again the Fed lowered rates to zero. Over this 14 year period of low interest rates, even long-term rates on mortgages fell to their lowest rates in generations. According to MIDFLORIDA Credit Union, in 2021, a 30-year mortgage sported an interest rate of 2.65%. The question is, how does this affect our decision making as we work to strengthen our personal balance sheet and build wealth. 

Opportunity Cost

We first want to identify the opportunity cost of prepaying the loan. Because a mortgage has a guaranteed negative interest rate, we want to compare the interest due to the amount of interest we could earn by investing discretionary cash flow in an appropriate alternative.  To match the risk level of eliminating a guaranteed negative interest rate, we should first consider similar guaranteed or low risk investment options. Over recent months we have seen high yield checking accounts with interest rates of 4% and high yield money markets in the same range. This means that without taking a significant amount of additional risk, we could earn a gross return 33% higher than the interest we are paying on the mortgage.

An investor comfortable with taking a higher level of risk with their investments could pursue even higher returns in investment grade fixed income or by investing in equities. These investments will not guarantee higher short-term returns, but have delivered higher expected returns historically then cash over long-term holding periods.

Tax considerations should be taken into account in reviewing the various investment alternatives. Money market and bond interest would be treated as ordinary income. Realized capital gains will also be taxed on asset growth. This would diminish the after tax value of the higher investment yields. Staying abreast of changes in tax rates will be important to be sure a strategy of making regularly scheduled mortgage payments continues to be the most effective approach. In some cases, foregoing mortgage prepayments might allow a client to contribute more to a tax advantaged retirement account (pre-tax or Roth) or a college 529 account, making the value of the investment even more attractive.

Liquidity Considerations

An advantage of foregoing payments to reduce a mortgage is greater cash flow flexibility. Home equity is generally not considered a liquid asset. By investing the money that might otherwise be used to prepay the mortgage, the mortgage holder could increase emergency reserves, address other financial goals, and maintain their mortgage has an inexpensive form of leverage.

There is a psychological value to being debt free. Quantifying this value will be different for each individual as different people will place a greater value on peace of mind. For some clients, the emotional and psychological benefits of being debt-free and the sense of security it provides may outweigh the potential for higher returns.

A Decision Making Framework

In some cases the decision to forego mortgage prepayments might be clear. However, modeling different scenarios might make sense for some clients. Looking at the impact of the different strategies over 10 year, 20 year, and 30 year time periods can create a more discernible value. The impact of expected market volatility can also be modeled to measure the probability of a more successful outcome. A skilled financial planner should be able to walk a client through these various considerations and help them determine the best course for their unique situation.

Though short-term rates on high yield cash and short-term fixed income accounts have risen to very attractive levels in relation to a low rate mortgage originated over the last 10 to 15 years, forgoing additional payments on one's mortgage should still take into account an individual's unique personal and financial circumstances.  One size does not fit all. Your Certified Financial Planner professional at The Foundry Financial Group is available to run a personalized analysis.