Mortgage – Make Principal Payments, or Larger Retirement Contributions?

Nick Livers, Attorney at Hyden, Miron and Foster and friend-of-the-firm (check out his blog,) asks a great question:

Great post, Abigail. [9 Year Mortgage – Some More Mortgage Payoff Thoughts, -ed.] I have acquaintances that ask me about this from time to time. I tell them what I am doing, and that is adding extra principal payments to every payment.

I’d be curious as to your thoughts into paying a mortgage early vs. taking the extra payments and placing in an investment account. My mortgage is a 3.5% rate. At that rate, I’m beginning to think I would be better off placing my extra payments in my investment account for the next 15 years.

Thanks for the warm fuzzies, Nick!  I can’t give specific advice over the blog (and you wouldn’t want me to,) so here are some ideas about how I would think about the question of paying off a mortgage versus making larger retirement contributions.  The easy way to look at this is through modelling both plans and then comparing the value, today, of each decision.  The one with the higher dollar amount wins.  Another, harder way to look at it is as a judgement between a suite of risks.

Analysis

Before I get into the analysis, I want to be clear that I’m looking at the house in only financial terms.  Almost nobody lives that way, except maybe Hetty Green.  Making the home payoff decision can be invested with a lot of emotional meaning, which would have an effect on what the “best” decision would be.  Anyways, onwards to the analysis.

Here’s how I wold make my model in Excel.  First, I would make an input sheet for all the assumptions I would have to have in each model.  It would have inputs like the duration of the loan, the interest rate, the outstanding principal, and so on for the mortgage.  It would also have assumptions for the investment, such as an expected rate of return.

I would then create a model on another sheet which calculates the effect of adding extra payments to the mortgage.  After that, I would model paying off the mortgage normally and the extra investments in another page.  This is the part that can get really fine-grained, and insanely detailed.  For example, if you pay your mortgage off early, you may not need as much life and long-term disability insurance.  That could be added to the spreadsheet as a variable.  Tax effects could be added, too.  After all, if you pay off your mortgage, you lose your mortgage interest deduction.  You’d have to calculate the benefit lost beyond the standard deduction.  It could get really, really involved.

Finally, I’d toss the outputs onto a separate spreadsheet that show the difference in present value between the two, and maybe put up a nice chart.  What can I say, when I build a spreadsheet, I build a spreadsheet.  The spreadsheet would distill the decision into a pretty simple yes/no decision, if we didn’t take risk into account.  But, we will.

Risks

Whenever you make a financial decision, you are choosing between a suite of risks and rewards.  For example, if you choose to pay off your mortgage early, you are going to have higher cash flow (reward) but you’ve tied yourself up in home equity, which is generally illiquid.  On the other hand, if you invest instead of paying off your mortgage, you’re exposing yourself to investment risks, and the risk of carrying the mortgage.  A spreadsheet has a rough time expressing these risks, since they’re a giant pain to quantify.

Conclusion?

Nick isn’t the only one who has asked me this question in the last two days.  (Really, it’s been eerie.)  I’m working on a spreadsheet that compares the present value of the difference between the two scenarios.  I can’t guarantee I’ll get it done any time soon, since it’s tax season and I’m making it for my own amusement.  Should I ever get it done, though, I’ll see if I can share it.

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