**Dear Banker, **

**Most months we manage to cover our costs and have a little extra left over. Sometimes I send the bank an extra $500 or $1,000 toward paying down our mortgage balance, which has another 21 years to go. Once I sent close to $5,000. Does this make sense? – Manny T., Chicago, IL**

Dear Manny,

Congratulations on doing the first-order hardest thing in personal finance – produce a monthly surplus in your household. Wealth for you – while not inevitable – is made possible by this monthly surplus.

I appreciate your question whether you should – or anyone should — pay off a mortgage early with small interim payments of principal.

This perennial question generates as many strongly held opinions as there are mortgage holders. There’s a thoughtful discussion to a similar question prompted on this personal finance site.

Like most interesting personal finance questions, the answer depends on a combination of personal psychology and finance math.[1] Your own personal relative weighting of this combination may lead you to a different ‘correct’ answer than that of someone else.[2]

My own short answer is that while paying off your mortgage principal in small early increments does not make much sense from a pure financial math perspective, it can be the totally correct thing for certain psychological reasons.

Therefore, while I don’t advocate paying off a mortgage this way, I fully acknowledge that for people with a different psychological approach than me, the incremental payments make plenty of sense.

**The math side of things – forward rates**

First, it’s helpful to understand mechanically what happens when you make an extra, partial, principal payment on your mortgage.

After making your regular monthly payment, let’s say you send an additional $1,000 to the bank for principal. The bank – actually the mortgage servicing company, but let’s not nitpick – applies that principal to the furthest-away-in-time mortgage payment. In Manny’s case, his $1,000 payment gets applied toward a payment due 21 years from now.

In other words, Manny’s total mortgage principal gets reduced by $1,000, but not in any way that affects his current monthly mortgage costs. He’s still obligated to make regular mortgage payments next month.[3]

You may have read, not entirely incorrectly, that when you pay debt principal early you get a guaranteed return on your money equal to your interest rate. If you have a 6% mortgage, the conventional wisdom goes, you get a 6% “return on investment” when you pay off your mortgage.

But this is not entirely correct either, in purely financial math terms.

I’m going to assume Manny’s mortgage (obtained 9 years ago) has a 6% interest rate. Since he’s eliminated by early payment the obligation to pay 6% interest on his borrowed money 21 years from now, we could more precisely say he’s invested the equivalent of $1,000 at “6% interest rate, 21 years forward.”

That may seem like an odd turn of phrase, except that the bond markets operate precisely this way – on today’s interest rate (you might call this the ‘spot’ rate) as well as tomorrow’s forward rates (incorporating the idea for example, of 1 year interest rates, one year from now, stated as “1 year rates, 1 year forward.”)

We don’t all have to be bond geeks to make good decisions about early mortgage payments, nor do we need to know exactly what I mean with this clarification, except you should understand the following: We don’t know with very much precision what prevailing interest rates will be 21 years from now. As a result, it’s not as obviously a ‘good trade’ to pay off your mortgage at 6%, precisely because it’s not actually true that you’re locking in a “6% return” on your money today.

21 years from now a 6% mortgage interest rate may be extraordinarily high or it may be extraordinarily low (I’m agnostic on the issue) but the imprecision around the question of forward rates makes it less obvious what your effective ‘return on investment’ really is, or what you should reasonably expect to earn on your money 21 years from now.

One major and obvious exception to my clarification on “forward rates” is that if you pay off your full mortgage balance early – entirely eliminating the need to make future monthly payments – then indeed you did lock in a 6% ‘return’ on your money.[4]

**Inflation scenario as an illustration of forward rates**

To return to the problem of unknown forward rates for a moment, it may be helpful to think of specific, possibly extreme, scenarios. I’ve written before that the combination of home ownership with a mortgage can be a very powerful inflation hedge. One way of seeing that is through the concept of forward rates.

A future high inflation rate can illustrate the ‘forward rates’ problem. If future inflation, say 10 years from now, runs at an annual 15% rate, with prevailing mortgage interest rates around 18%, then it becomes obvious that locking in a 6% return on your money in the final years of your mortgage was not a good idea, from a personal financial math perspective. In my example you might have earned 18% just leaving your money parked in a money market account. That kind of future interest rate can show us why we should be less sure of ourselves that earning a 6% return by paying of a mortgage early is the right decision, from a purely mathematical perspective.

**More on the math side of things – comparative rates of return**

I have not yet addressed the most common financial math reason why people claim you should not pay off your mortgage in small early chunks of principal payment.

Specifically, many argue that you may be able to earn a higher return on your money “in the market” than you can by eliminating personal debt and locking in the rate of return of your mortgage’s interest rate.

This is possibly true, although it depends on specific scenarios, like the following:

· If you are talking about credit card debt – with interest rates between 9% and 29.99% – it’s clear to me that paying off your debt offers a better return than you could reasonably expect from another investment “in the market.”

· If instead you are talking about current prevailing mortgage rates – like my newly refinanced 15-year mortgage at 2.75%! – then I heartily agree that a better return is quite likely available “in the market” rather than through paying down personal debt.

· If you are able to invest in a tax-advantaged 401K or IRA vehicle, and you have a sufficiently long time horizon to invest in risky assets, then you can stack the odds mightily in your favor to earn a better return “in the market” rather than paying down debt.[5]

**The Psychological approach – Arguing against myself**

So I’ve made the case that locking in a specific return on your money – by paying down mortgage debt – is not as clear-cut as it first appears, from a purely finance-math perspective.

However, I do think the psychological aspect of making early mortgage payments should not be forgotten. We are all humans,[6] responding irrationally to myriad inputs. For many of us, money left on a monthly basis in the checking account gets spent, so the key to not spending is to not leave extra money lying around.

If Manny’s realistic choice every month is between sending $1,000 to the bank to pay his mortgage early or instead – like many of us – to spend $150 more on Amazon Prime downloads, $300 on jewels in Farmville and $273 on One Direction concert tickets, leaving just a $277 surplus at the end of the month, then the choice is clearer.

All the possible market returns in the world cannot undo the simple fact that paying off debt *guarantees* an incremental increase in net worth. If you can’t stop yourself from spending your surplus – and this really comes down to the psychological imperative: “know thyself” – then paying off the mortgage in small extra increments makes total, perfect, unassailable sense.

**And then there’s risk tolerance**

In addition, there’s the “*know thyself*” imperative applied to risk tolerance.

Investing money in the market – instead of paying down debt – makes an increase in net worth possible, even likely, but has no guarantee. If you hate losing any amount of money ever, then by all means pay down all of your debts before investing in anything risky.

Earning a 6% return by paying off your mortgage[7] early may sound much better than shooting for a possible 10% compound annual return but with a possibility of a 25% sudden loss in any given year.

Few investments in the long run are worth 3AM insomnia. A fully paid-off mortgage may do more for encouraging restful sleep than all the Posturepedic mattresses in the world.

Please see related posts:

On Mortgages Part I – I Am a Golden God

Part III – 15 yr vs. 30 yr mortgages

Part IV – What are Mortgage Points? Are they good, bad or indifferent?

Part V – Is mortgage debt ‘good debt’ A dangerous drug? Or Both?

Part VI – What happens at the Wall Street level to my mortgage?

[1] My bond sales mentor memorably told me once that bond sales consists of 5% bond math and 95% child psychology. Personal finance strikes me as a similar deal, although probably even more weighted toward the psychology part of the spectrum.

[2] And since I’m always looking for an excuse to quote Jack Handey, let’s review this gem: “Instead of having ‘answers’ on a math test, they should just call them ‘impressions,’ and it you got a different ‘impression,’ so what, can’t we all be brothers?”

[3] I’m assuming for the purposes of this example that Manny has sent the money to the bank to be applied to principal since that’s how his question is phrased, rather than specifying something like ”I’m paying the next 3 months early.” Presumably that’s also possible, but non germane to the question.

[4] At this point further math geeks will point out that the tax-deductibility of mortgage interest means that your effective interest rate is probably closer to the 4% than 6% rate, making your effective ‘return on investment’ lower than it seems.

[5] As always, if you can get an employer match for 401K contributions then that use of money trumps everything except paying off high interest-rate credit card debt.

[6] All of us, that is, except for my Rihanna-bot, who takes care of me in my old age, on my hovercraft. She’s not human, just human-like.

[7] Yes, closer to 4% after taxes, and yes, actually “6% 21 years forward.”

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Tags: ask a banker, forward rates, mortgages, personal finance, risk tolerance

Well there you have it Manny. The answer is “maybe”.

I really like the bond analogy. In all the discussions I’ve read this is the first time I’ve seen the concept of forward rates introduced. It really distills down the discussion to what you think will happen in the future. Good luck with that. And if we copy Japan the golden god might not be too happy when the 10-year is 1%.

Here’s someone who has very definite feelings on the subject http://www.jamesaltucher.com/2011/03/why-i-am-never-going-to-own-a-home-again/

BTW, we should bear in mind that the past couple of decades have been a period of inflation and falling rates, both of which are very positive for real estate. Right now we have low rates and disinflation. Even if we do see inflation there will likely be a headwind of rising rates. I wouldn’t count on the inflation hedge aspect, but there I go predicting the future.

Demographically speaking we have low rates of new household formation and a Boomer overhang of future sellers. Wages are stagnant and wages are a major determinant of home sales. Will wages start moving higher? Given the rise of robotics and outsourcing that is questionable.

Ultimately you buy a house because you like having one. There’s the intangible warm fuzzy feeling you get from the happy delusion that you own it. Whether or not you prepay depends on your risk tolerance. Personally I’ll take the risk-free return, especially now when all the other options are “return-free risk”.

One important point: Eliminating what for many is your biggest monthly expense – your mortgage payment – provides significant financial freedom. One might take the job one really wants instead of the one that pays the most. Perhaps one spouse could stop working. Perhaps by not having a mortgage payment, one could plan to need less income in retirement. I think that human psychology piece goes further than just squandering money you don’t use responsibly, I think. Since freedom and choice are important to all of us, driving a stake through the heart of our biggest blood-sucking debt obligation could be more important than we give it credit for.

Very good points…I have to agree!

Put it this way-Banks loan mortgage money because they expect that the income returned to them is worth the effort of doing the appraisal, the paperwork, the underwriting, and taking the loan risks. It’s just a financial proposition.

However, this is your HOME so it makes sense financially AND emotionally. Financially, paying off a mortgage so gives the homeowner a guaranteed and virtually risk-free rate of return (in saved mortage interest). Not to mention having no debt, no monthly payment is financially awesome. Personally, the peace of mind of not being at the whim of the bank, owning the home, and being safe financially puts a person in a VERY solid position both emotionally and financially. Warren Buffett paid cash for his house…..think he might know what he is doing?

Hi – What about recasting a loan. Lets say you make a big principal payment and then recast your loan – then I assume it does not go towards paying the latest (30th year payment in a 30 yr mortgage) and so does that make more financial sense?

What does recasting a loan mean? I’m not familiar with the term. Is it similar to refinancing?

Mortgage Defense, Inc. provides mortgage industry consulting, compliance reviews and expert witness testimony for mortgage fraud cases. We work with Mortgage Brokers, attorneys, borrowers, and regulators in a multitude of areas from mortgage fraud to mortgage consulting to compliance implementation and review.

If the homeowner has a 30 year fixed mortgage (or a 20 or a 15), the ‘future’ interest rate really isn’t part of the consideration. My simplistic view is that additional principal payments should be made as early in the mortgage as possible. (Most simplistically, you can assume that you borrower 199,900 rather than 200,000; i.e., making a 100 additional principal payment in the first month. It is true that the payments never change. (I, personally, think that mortgage buyers should insist that loan payments be adjusted every time a certain amount of principal is pre-paid. Maybe a total of $5,000 or $10,000 or whatever. This could encourage borrowers to pre-pay their mortgage — minimizing, to some effect, the possibility of being ‘upside-down’ if housing prices fall.) OK…on to the point: making a $100 additional principal payment in the first month of the loan (or borrowing $100 less) at 6.0% means the 360th payment will be about $500 less than if the $100 was not paid. No matter how you kick it, calculate it, or psychoanalyze it, it’s a savings of $500 in interest on a $100 ‘investment’. Yes, you can PV it, discount it, whatever it — and it is and it does look different. My point, however, is that anyone can understand cumulative outgo — the interest saved. In all cases, the ages, stage of life, how long someone expects to live in a house, where else the $100 could go, marginal tax rates, whether they itemize or take the standard deduction, etc. ALL matter. But — keeping it simple — $500 benefit for $100 outlay is a pretty good decision.

Fair points. Also important: $100 ‘saved’ via a pre-paid mortgage principal payment has infinitely higher return than $100 spent at the dog track. Savings in its many forms always should be applauded!

I love the article, and the link to mine

I (along with many others apparently) had no idea about the forward rate concept. This actually gives my argument for keeping a long mortgage a solid reinforcement.

If you aren’t reducing the interest paid in the short term, because you’re paying off the end of your loan, your current money that you’re using for these “future payments” is worth significantly less due to the inflation that hasn’t occurred yet!

A thousand extra bucks today, will be the equivalent of about two thousand bucks in about 20 years from now (meaning that a thousand bucks will be easier to come by in the future).

Thanks for this!

Johnny, thanks for visiting.

That post of yours on paying of the mortgage has a seemingly infinite number of commentators…People clearly feel strongly about it. Good healthy dialogue!

This is the benefit of paying off at least some of the mortgage early: One mortgage payment NOW toward principle knocks of 4 MONThS of payments in years 27 to 30. (I am 6 years into my mortgage and my math is based on the Mortgage Professor spreadsheet).

I may not get this kind of “bang for my buck” in year # 20, but I do now when I am able-bodied and can slam the principle. Why doesn’t anyone look at mortgage pay-off this way? Thank you.

More on a side note, does it make more sense to pay surplus monies into a mortgage offset account rather than to pay directly onto the mortgage itself. Seeing that money in an offset account essentially provides a fixed return to the loan interest and provides flexibility to “invest” elsewhere if rates fall.

I think that makes sense, offering flexibility for investment.