The Pros and Cons of Accelerating Your Mortgage Paydown

When it comes to accelerated payments towards large debts, such as paying down your mortgage, student loans, or a business loan, I consider three things before setting up any recurring or lump sum payments.

1. Opportunity Cost: What is the opportunity cost of using my money here? Is there somewhere else it would be better used?

2. Liquidity: What amount of liquidity and monthly cash flow am I comfortable giving up, and what is responsible?

3. Duration: How long will it take to recoup a lump sum payment, or how long will my monthly cash flow be constrained?

Opportunity Cost

Return: Solving for the breakeven interest rate you need to earn to equal the benefit of paying down your debt is more complicated than earning 7.1% in the market being better than paying down a 7% interest rate debt.

When comparing your debt’s interest rate of 7%, you must earn around 8.2% to equal the “same” return. This is because when you earn an investment return, you must pay taxes before you have your net return. And when you pay down debt, there is no tax on your interest rate savings. Assuming a 15% long-term capital gains tax rate, you will need to earn 8.235% to be comparable to paying down a 7% debt.

Risk Adjustment: However, the debt payment is a risk-free return. You can try to calculate an equity risk premium for a comparable stock return. But I like to simplify this math by giving a flat 3% equity risk premium. This means you will need to earn 3% more than the risk free return in order for the risk to be worth it.

If we account for taxes and a simplified equity risk premium, we would need to earn 11.235% to consider investing more advantageous than paying down debt. (7% + 15% tax rate) = 8.235% + 3% (equity risk premium) = 11.235%.

11.23% seems high. Maybe I should put all my money towards my debt? Not just yet. Keep reading.

Liquidity

The downside to the high guaranteed rate of return associated with paying down your mortgage is that the money you place in your home equity is highly illiquid. Someone with a lot of home equity but no cash in their investment or bank account is called house-poor. This means that they are worth a good bit of money on paper, but their lifestyle and budget do not reflect it. And most avenues you can use to take money out of your home will charge you a higher rate than your mortgage.

Access home equity examples: HELOC, cash out refinance, reverse mortgage, or home sale.

Because rates associated with accessing this home equity are often higher than your mortgage, you should be sure that whatever money you put in there isn’t needed. Of course, if rates decrease, you could refinance a mortgage or apply for a reasonable HELOC to access your liquidity.

Duration

How long will your cash flow be restricted? If you need to tighten the belt and pay a debt down over 1-2 years, I’d say that’s feasible and could be life-changing. But if it’s a 10-20-year debt paydown, you need to settle into an endurance-level pace of cash restriction—something you are OK with living on indefinitely, as 20 years can feel like forever.

I’ve seen many recent graduates with student loans, new homebuyers with 7% interest rate mortgages, and new business owners with a business loan who want to rid themselves of that debt weight around their ankles. And for good reason! The debt is uncomfortable. But I would encourage you to do so in a way that isn’t emotional before you sink $200k into your $800k mortgage with very little to show for it besides a lot fewer financial options.

However, if you have $50k left on your mortgage at a 7% interest rate and paying down the last $50k will increase your cash flow by $2k/mo, then it could make a lot of sense to pay a lump sum to realize the benefit of your freed-up cash flow.

Closing

Debt is an emotional topic and can encourage rash decision-making, such as plugging large sums of cash into it without an end game. Sometimes, this can be the right move, but other times, it can put you in a financial corner for decades. If you’re struggling with what to do surrounding your debt paydown strategy, then I encourage you to discuss it with a fiduciary financial planner to help you come up with a plan that inspires confidence in your financial future. And, if you're looking for a useful calculator to help review accelerated monthly or lump sum payments towards your mortgage paydown numbers, I like to use the one from totalmortgage.com found HERE. Have a great week!