I penned my thoughts on the above question in Oct of 2019, (see here) and am revisiting this question again as I recently came across the following reddit post. The author of the post presents (an interesting) mathematical reasoning to provide a financial justification to pay off mortgage early. The argument may seem correct when viewed from the perspective of withdrawal rates, an important metric in the analysis of the decision to become Financially Independent and Retire Early (FIRE). The author presents the following scenario (verbatim):
Scenario 1 – Holding Onto the Mortgage: Portfolio Value: $4.5M (excluding $0.5M in home equity) Home Value: $2M Annual Expenses: $180K (includes mortgage) Withdrawal Rate (WR): 4% (aligning with the traditional “Bill Bengen safe withdrawal rate”)
Scenario 2 – Paying Off the Mortgage Early: Portfolio Value: $3M (after paying off $1.5M remaining principal on the house) Home Value: $2M Annual Expenses: $100K (no mortgage) WR: 3.3% (leaning towards the “Big ERN bulletproof withdrawal rate”)
For most households mortgage is the largest fixed expense in their monthly budget. In the scenario outlined above, paying off the mortgage will significantly reduce monthly expense budget from $180 K to $100 K. For a $3 M portfolio, this means, the withdrawal rate (the percent of assets that can be withdrawn from the portfolio to manage annual household expense) drops down from 4 % to 3.3 % (3.3*3 M/100 = ~100 K). As long as market returns are atleast 3.3 % annualized, (as of this writing the 10 year treasury yield is 4.21%) the pot of money should last a lifetime and viola FIRE goals met!
The math checks out, not to mention the incendiary benefits for paying off mortgage early — the peace of mind that comes with being debt free. More importantly, if one is at a stage in life where FIRE is top of mind, the goal post has probably changed from “maximize the likelihood of good outcomes” to “minimize the likelihood of bad outcomes”. What I mean is the alternative to not paying off the mortgage (assuming one has easy access to cash on hand) is to invest the funds into markets. Assuming 10 % nominal return and a 7 % real return, the investments, adjusted for inflation will double in 10 years, which would be a good outcome. However, there is a non-zero chance that we may face another lost decade or worst financial depression! Paying off mortgage on the other hand provides a guaranteed downside protection.
“Minimize the likelihood of bad outcome” is high on my mind as I pen this article. I want to pay off our mortgage, I really want to but having locked into a low (3.125 %) 30 year fixed rate, and risk free rate being ~4.21 %, the opportunity cost of paying off mortgage simply feels too high not to mention the loss of optionality for immediately parting with 100s of thousands of dollars, which could be put to better use!
How can I guarantee peace of mind, feel debt free and at the same time not be fallible to lost optionality or not regret the opportunity cost of parting with a lumpsum of money at my disposal?
I believe I have a solution.
To follow through, lets assume, that I took out a mortgage loan of $500,000 with interest rate of 3.125 % on a 30 year term and I still owe about $250 K on the mortgage. My monthly payment on this mortgage (principal + interest) would be ~$2145.
Assuming an annual household expense of $100,000, including the mortgage, the expenses would decrease to $74,260 after the mortgage is paid off. With a $3 million portfolio, and considering a $250,000 outlay, the withdrawal rate would reduce from 3.3% to 2.7%. Given the 30-year Treasury yield is at 4.35%, this portfolio would comfortably support a 100 % debt free FIRE lifestyle.
Now let us consider the scenario whereby, we decide not to use the available $250,000 K to pay off the mortgage. Instead, we take advantage of the current yield environment and do the following:
- Withdraw the funds necessary for 1 years’ worth of payments (~$26,000) and put them into an high-yield saving account. Current interest rate on HYSA account is ~5 %. Pay monthly mortgage from this account on auto pilot. Since the HYSA is ear marked to pay monthly mortgage, sight unseen, it is as if the account (and the money does not exist) and so does the monthly mortgage obligations. This in effect simulates lower monthly expense outlay and increased cashflow/savings.
- The remaining $224,000 (+ interest accumulated) is invested in an investment-grade corporate bond ladder with an average annualized interest rate of 4.5%. The ladder is structured so that the bonds mature annually. Each year, I withdraw the $26000 and transfer it to a high-yield savings account (HYSA) to cover my monthly mortgage payments. The table below provides a detailed year-by-year analysis of mortgage payments using this strategy.
By 2035 the mortgage gets paid off and I pocket an additional ~$23,750. The strategy presented above will take some work to set up, which is a onetime cost for a payout of >$20,000, over a 10-year period. I get to benefit from all the upside of being “mortgage free” and almost 7 years ($10 per day, 7 days a week) of starbucks coffee to splurge on! That is a win-win-win strategy!
Getting to the answer for the question I posed in the title of this post– Yes I should payoff mortgage early, but (and there is always a but), not in lumpsum, instead over a period of decade slow and steady, while at the same time enjoying a debt free FIRE life-style!