Why paying down your mortgage could be a good investment strategy

Photo of a happy young couple enjoying a summer day, sitting on lawn furniture in the back yard of their home.

By Bill Bischoff, MarketWatch

Paying down your home mortgage balance faster than required is not a new idea. But you may be surprised to discover how powerful it can be. I will explain. But first, note the following.

This is not for everybody

The accelerated mortgage paydown idea can only work for folks who have positive cash flow and/or available cash. It’s not for people who are struggling to pay their monthly bills.

The idea is only appropriate for folks who are looking for a very conservative, risk-free way to invest some surplus cash flow or funds. Obviously, if you believe you can earn 8% to 10% annually with other investment strategies, you are not going to be very excited about the idea of expending cash to earn 4% (or whatever your exact home mortgage interest rate may be) by paying off your mortgage early.

Finally, the idea is far more powerful when you intend to continue pumping the monthly accelerated mortgage paydown amount into a retirement account after your mortgage has been paid off.

With these thoughts in mind, here’s how the accelerated mortgage paydown strategy can work in the form of some sample scenarios.

Sample scenario

Pilar is in good financial shape. She has cash on hand and positive monthly cash flow. She expects to be in the same position for the foreseeable future. She has a $400,000 balance on a recently refinanced 30-year first mortgage that charges 4% interest.

Pilar’s monthly payment for principal and interest is only $1,910, but she has a whopping 30 years to go before the mortgage will be paid off, if she sticks to the prescribed monthly payment schedule. That means she will be a wizened 75 years old when the mortgage is finally extinguished.

Being 75 years old before your mortgage is paid off probably does not sound so great to most folks. Collecting a guaranteed, risk-free 4% (or whatever rate applies) return by paying down your mortgage quicker (thus avoiding the interest that would otherwise be charged on the principal you pay off early) probably sounds like a solid investment idea to many homeowners. After all, the stock market is looking rather frothy, and fixed income investments are still paying pitiful interest rates.

Say Pilar adopts the accelerated mortgage paydown strategy and immediately starts paying $3,500 per month instead of the scheduled monthly payment of $1,910. She will pay off her $400,000 mortgage balance in about 12 years, at age 57, instead of paying it off in 30 years, at age 75. She will earn a guaranteed 4% rate of return because that’s the interest rate she avoids on the accelerated principal payments. Not bad.

Loss of mortgage interest deductions

One objection against the accelerated mortgage paydown idea is that you will lose tax deductions because interest charges will go down more rapidly than if you stick to the scheduled monthly payments. This may be true, but so what? Consider the following points:

• The TCJA imposes stricter limitations on home mortgage interest deductions for 2018 - 2025. See here for more information.
• The TCJA’s greatly increased standard deduction amounts for 2018 - 2025 mean that many more folks won’t be claiming itemized deductions.
• Even if you itemize, the larger standard deduction reduces the incremental tax benefit from itemizing. See here.

Impact of future inflation or deflation

While the accelerated mortgage paydown strategy will yield guaranteed results, it is not foolproof. If we have a period of roaring inflation, paying down a mortgage with a relatively low interest rate earlier than required may no longer make sense. In this situation, it may be better to stop the accelerated paydown program, allow the mortgage term to stretch out, and pay the remaining balance back with cheaper inflated dollars.

On the other hand, the accelerated paydown strategy will work great during a period of deflation, because the mortgage is being paid down sooner when dollars are cheaper rather than later when dollars are more expensive.

Big advantage to continuing program after your mortgage is paid off

The accelerated mortgage paydown strategy can clearly be beneficial in and of itself because interest charges are avoided, and debt is eliminated from your personal balance sheet. Another advantage is you can stop and restart the program anytime you want (for example, when inflation or deflation strikes). However, the biggest payoff from following the strategy will probably be reaped by folks who have the cash flow and self-discipline to continue the program even after the mortgage is extinguished. This involves taking the monthly amount that was previously dedicated to the accelerated mortgage paydown strategy and stuffing it into a retirement savings account (whether taxable or tax-advantaged).

In our sample scenario, let’s say Pilar continues the program after her mortgage is paid off by putting $3,500 a month into a retirement savings account that earns 4% annually for another eight years. At age 65, she will have accumulated about $395,000 in the account. This seems like a much better plan than sticking with the status quo and making mortgage payments until age 75.

More sample scenarios

Here are some additional illustrations of how the accelerated mortgage paydown strategy can work.

Faster paydown

Now say 45-year-old Pilar pays $4,500 per month under the accelerated mortgage paydown program instead of making the scheduled monthly payment of $1,910. She will pay off her $400,000 mortgage balance in eight years and 10 months, at age 54, instead of paying it off in 30 years, at age 75. She will earn a guaranteed 4% rate of return because that’s the interest rate she avoids on the accelerated principal payments. If Pilar continues the program after the mortgage is paid off by putting $4,500 a month into a retirement savings account that earns 4% for another 11 years, she will accumulate about $745,000 by age 65. Sweet. Once again, this seems like a much better plan than sticking with the status quo and making mortgage payments until age 75.

Slower paydown

Let’s now be a bit less ambitious and assume that 45-year-old Pilar pays $2,500 per month under the accelerated mortgage paydown program instead of making the scheduled monthly payment of $1,910. This only requires an additional payment of $590 per month. Paying $2,500 per month will allow Pilar to pay off her $400,000 mortgage balance in about 19 years and two months, at age 64, instead of paying it off in 30 years, at age 75. She will earn a guaranteed 4% rate of return because that’s the interest rate she avoids on the accelerated principal payments.

Older individual

Finally, let’s now assume that Pilar is 55 instead of 45. She pays $4,000 per month under the accelerated mortgage paydown program instead of making the scheduled monthly payment of $1,910. She will pay off her $400,000 mortgage balance in about ten years and two months, at age 66, instead of paying it off in 30 years, at age 85. She will earn a guaranteed 4% rate of return because that’s the interest rate she avoids on the accelerated principal payments. This seems like a much better plan than sticking with the status quo and making mortgage payments until age 85.

The bottom line

You get the idea. With financial software, you or your financial adviser can put together your own accelerated mortgage paydown scenarios. Think about it.