16 Mar Mortgage Vs. Payoff – Refinances and Discipline!

While I understand both schools of thought and participate in both camps, the great debate is about to begin.  Should I pay off my mortgage early, or reinvest my extra savings? While we all know there are benefits to both, the answer is going to come down to personal choice and whatever helps you the individual sleep at night.  When it comes to refinances where you are able to lower your interest rate and thus drop your payment, this is where I think math, logic, and emotional thinking all come together.

Let’s begin with the generalized thinking of a typical mortgage you’ve been paying on for 4-5 years, you have a solid interest rate of 3.75-4.5% and refinancing either isn’t an option or interest rates aren’t good enough where you would want to refinance to lower your rate.  Maybe you found yourself with a 4% raise at work or you found some other expenses you’ve reduced out of your budget and want to put that money to work and every time you see the amount of principle pay down on your mortgage versus interest it makes you cringe a bit or perhaps die inside a little.  You can certainly take that extra money you received and start paying down your mortgage faster and it will positively impact your net worth by that amount on that given day, and it will accelerate the power of your same additional payment next month as you’ve knocked down interest earlier than scheduled and began reducing the remaining length of your loan.

What’s wrong with this plan? While it isn’t something wrong, the math just isn’t always in the favor and the argument is you could be investing that money in other buckets, getting a better return and thus building your net worth and savings faster than paying down your mortgage. In general, I’m going to agree with this logic but as suggested earlier on, sometimes sleeping at night or fulfilling a desire to be debt free is worth it to you and that’s the choice you need to make.  What you get in exchange depending on your pay down cycle is perhaps a paid off house in 10-15 years instead of the 25 years currently remaining, while you still have taxes and insurance to pay, the mortgage is paid off and the home is yours as long as you pay the tax man.

For those that are in the camp above of wanting to pay off their home early I’d make one additional suggestion other than just paying the extra money you have each month when you make the payment.  Call your mortgage provider and ask them about making every other week payments instead of monthly.  This isn’t allowed by all banks, sometimes you can do it manually via bill pay or logging in and manually doing this, but you want to have a conversation with the bank to make sure this plan will be executed correctly on their end and result in your paying less interest over time.  The every other week payment structure is one of my favorites because instead of making 12 full payments a year, you make 13 payments in total so yes we are accelerating our pay down by making an extra payment but we’re also accelerating pay down by knocking out interest every 2 weeks instead of once a month.  The power in this is that your amortized loan accrues interest on a daily basis based on the balance of the loan on that given day, when we pay down half a payments principle amount due every other week, that means the next 2 weeks until your other half is due accrues interest more slowly since we lowered the balance.  Depending on the size of your loan and where you are at in the current  term of your loan this process can knock out about 1-3 years worth of payments off the back end of your loan!  If you aren’t interested in paying your mortgage down early but your spouse is and you want to compromise, maybe consider this method especially if you get paid every other week because instead of having those “two free paychecks” a year that you get, you still get two “free paycheck” months less the half mortgage payment.  Boom, saving marriages over here.

For those of you that do desire to pay extra to help pay off your mortgage sooner, please don’t forget to consider this method as the chances are the extra money you are paying meets or exceeds the 1 extra payment a year anyway, so you may as well invest the time in a quick phone call followed by executing on the follow up to get the process in place.  Some banks won’t allow this method, and that’s ok, I’d just remember that for the future if you ever end up in a position where you are refinancing to get a lower rate, consider other banks and ask this question up front.  You could find yourself in a situation where your current bank and a new potential bank are at equal interest rates or incredibly close but the new bank offers this feature which can accelerate your payoff timeline.

Refinances can be powerful, if you put the money to work for you after the fact.  Refinancing doesn’t save you money if you knock your payment down by $100 a month by lowering your interest rate and then you turn around and spend the $100 on something else or put it in a savings account.  That money needs to be put to work one of three ways.  The first way is to keep making the same mortgage payment you were making before, and while you started a new 30 year mortgage, your extra savings of $100 a month you are not required to pay, will help pay down principle quicker and eventually over some period of time you’ll pass up your previous point in the loan where you were, and pay it down faster.  Otherwise, you’ve just started a new 30 year term and put $100 in your pocket to go toward whatever you feel like spending it on.  The second option is to invest the money somewhere that you think will get a better return than whatever your mortgage interest rate is.  The most common places we’re going to see people stuff this money is a 401k, ROTH I.R.A, I.R.A, or a savings account to eventually invest that money into real estate or something else that will generate a higher return.  This comes down to fairly simple math, for example you want to stick the money into Index Funds inside of a 401k where over time you think you’ll achieve 7% interest over time.  Take the 7% and subtract the 3.75% you were paying in mortgage interest and you arrive at a net gain of 3.25% higher return overall.  I suppose there is an argument to be made for the amortized 3.75% in interest paid being higher than the simple interest calculation of the 7% compounding over time but in any case, its close and the point is you net gain a higher return.  This comes with a trade off of volatility however while you ride out the ups and downs of the stock market you’ll watch your investments fluctuate, with the mortgage paydown you are getting yourself a guaranteed safer return of the 3.75% interest rate or whatever your current mortgage is at.  The third way would be to use that extra payment to accelerate paying down other higher interest rate debt you may be carrying such as credit cards, student loans (with a higher interest rate than your mortgage), cars and more.  The math on the debt paydown aligns with the investment math above, run a calculator or two for comparison if you’d like to better understand how you can put this money to work.

While I can’t draw a conclusion for you on what you should do, I can share what my school of thought has been and remains the case.  When we were younger and just getting started in investing and refinanced our mortgage from 4.6% down to 3.62%, we started the new 30 year term and payed the new minimum payment because we had bigger buckets to fill and we had lost years of investing where we chose to pay down debt instead of invest.  We probably could have done both the mortgage pay down and investing but we were not as spending savvy and optimized at the time so the savings went toward investment accounts instead.  Fast forward to the 2020 pandemic year and interest rates are incredibly low so we took advantage and just closed on our personal residence at 2.75% fixed for 30 years and one of our two rentals went from 5.25% down to 3.12% on a 30 year fixed and we’ve decided to work toward paydown.  While I’m not maxing out my 401k and now my wife’s 401k, we could be and these are the only retirement accounts we have left to fill if we chose to.  Instead we set that cash aside and invest it where we think we’ll get a higher return which is real estate, laundromats or a business purchase.  While I realize the savings of roughly $250 on my primary residence and $200 on my investment property can and will likely get a higher return elsewhere, I just didn’t want to kick my mortgage payment down the road another 4 or 5 years since our last refinance as well as this one would effectively have resulted in a 40 year mortgage on this house.

Yes I realize the math says to invest the difference, I get it, but at a certain point the emotional side kicks in and we did the math on how this would impact our FI number and years to retire, it is a pretty small difference in time and we stuck with the paydown cycle along with the every other week payment option which our previous provider wouldn’t allow but our new bank does.  For those keeping score at home, the new loan was refinanced and I did something I don’t normally love which was to roll all the closing costs into the loan.  I did this because at 2.75% interest there was no way I was handing over $5k in cash to closing costs in exchange for 2.75% return when I have an investment purchase nearing on the horizon.  In addition to that, I ran the math and by raising the loan by the closing cost amounts and continuing to pay down the extra amount, and on top of that pay every other week, we are still on pace then to pay this mortgage off in 19 total years instead of the 25 year cycle we were on under the previous rate.  Regarding the investment property savings, we are not paying every other week because someone else pays that property down, not me, so I’m not letting it impact my cash flow.  We are however taking the savings received and paying down the mortgage to get back on track for the 27 year remaining payments.  Once we get back on that track, there’s a chance I’ll go back to the previous payment and take the rest as cash flow to then reinvest in other deals.  Again, in theory I should just take the cash flow now and keep it in my investment account to buy another house but this house has always been earmarked as my sons college or business startup fund and in 14 years when he’s 18 I’d like a good chunk of this property paid down plus appreciation so we can refinance it or take out a huge HELOC to fund whichever route he goes down.

Math and emotion.  That’s really it, while I can’t tell you what to do with your decision, at a minimum this falls in the “good problem to have” category where you are increasing your net worth by making any of the three decisions, accelerate your savings and investing, accelerate paying down the mortgage and reaching a status of paid off house which some people never achieve due to refinances, or paying down higher interest debt.  Good news too, you can change your mind at any time and go the other direction with no real downside other than some lost time executing one of the other options. Congratulations on having a good problem on your hands, stay disciplined in whichever route you so choose to ensure the refinance savings don’t end up spent instead of invested or paying down the house.