Freedom Life Planning

The Ultimate Guide to Financial Planning

Does it Pay to Make Mortgage Payments Early

Most advice given to people is to stay debt free and pay down your mortgage as quickly as you can. Making early payments is then said to save you a lot of interest over the years of your mortgage. Even banks are advertising accelerate weekly or bi-weekly payment programs as great programs that will save you money in the long run. However, it may often not always be the best way forward to pay your mortgage quicker, as there are lost opportunity costs in doing so. Opportunity costs are a bit harder to determine as accurately as the savings in interest by paying down the mortgage faster. However, the opportunity costs could be significantly larger in many cases and cannot be ignored. Basically, if you take longer to pay your mortgage and instead stockpile your extra cashflow under your mattress, in a piggy bank or even a savings account, you will likely lose out by the end of your mortgage. But if you instead invest the extra cash saved by not paying your mortgage faster, you could generate a return on investment that exceeds the savings in interest.




Return on Investments

It is impossible to accurately predict the potential return on investments in the future. This is true even for mortgages as interest rates could quickly change on variable rate mortgages, or at the end your contract term for fixed rate mortgages. We can however look at historical averages to see how things would have worked out in the past.

Below is some data that I’ve collected of ROIs between the 25 year period of 1986 to 2010. This period is interesting as it has times of record low and record high interest rates.

Investment Type 25 year average Annual ROI Best 5 year period Annual ROI Worst 5 Year Period Annual ROI
Fixed Rate Mortgages

8.24%

11.85%

6.03%

Variable Rate Mortgages

6.92%

11.65%

4.30%

Canadian Stock Exchange Returns

10.32%

18.48%

2.50%

USA Stock Exchange Returns

9.73%

29.68%

-5.24%

International Stock Exchange Returns

8.90%

17.30%

-3.42%

30/30/30 Stock Portfolio (all 3 markets)

9.65%

20.47%

-1.31%

What we can see here is that over a 25 year period, the stock markets all out perform the mortgage rates. Considering these mortgage rates are undiscounted, the difference is even greater if you negotiate well with your bank on the lending rate. However, the stock markets are more prone to variability over a 5 year period, which could lead to short term losses by investing in stocks over paying the mortgage. However, it is best to look long term as mortgage amortization periods typically exceed 15 years.

While this data is a bit older (Pre-2010), it does cover a long period. If we were to also look at 2010-2017 data, the rate of returns (ROI) would even more so favor the stock markets over the mortgages.

Accelerated Mortgages

Banks also offer accelerate mortgages, such as bi-weekly or weekly payment programs that are shown to reduce your mortgage interest costs and pay it down faster. Paying the mortgage on a weekly or bi-weekly schedule is a great option to line up your payment schedules with your paychecks. There are two reasons that paying the mortgage on an accelerated weekly or bi-weekly schedule accelerates the mortgage.

The first reasons, which accounts for a tiny portion of the acceleration, is that less interest accrues against the loan when you make the payment as your paycheck rolls in, rather than wait until the end of the month. If the cash is just sitting in your bank account for a couple extra weeks instead of being used to pay down the mortgage, that’s a couple of weeks of interest saved. However, this accounts for a small impact on a 25 year mortgage. This factor alone will reduce a 25 year mortgage to 24 years and 11 months.

The larger factor comes from the fact that you are just increasing your annual mortgage payments without obviously knowing it. People often estimate that there are 4 weeks in a month, and an accelerated weekly payment is the monthly mortgage payment amount divided by 4, where accelerated bi-weekly is the amount divided by 2. But there are not exactly 4 weeks in a month. There are 52.1 weeks in a year or 4.35 average weeks per month. So, on an accelerated weekly payment schedule, you are making about 4 additional weekly payments per year against your mortgage. This results in a 25 year mortgage being reduced to about a 22 year mortgage. There is no magic here, you are simply choosing a shorter mortgage term, which will result in a potential for more opportunity costs by not investing those extra 4 yearly payments in the stock market instead. Accelerated mortgage payments are more trickery than actual savings. While doing a weekly or bi-weekly payment schedule may have practical benefits, be aware that you aren’t discovering untapped financial gain by doing so. You are simply playing with the math and pre-assumed conventions that there are 4 weeks in a month.

Calculations of different scenarios

Time to jump into the numbers and run a few scenarios to see how different mortgage payment strategies can play out. For these scenarios, here are the assumptions made:

Monthly Household Income = $5,000

Monthly Expenses (without Mortgage) = $2,000

Available Cash for Mortgage or Investing = $3,500 *Note that all extra cash is invested into the stock market, spending is not increased due to a lower mortgage payment.

Mortgage Rate over 25 year period = 5.92% (1% discount negotiated over the 25 year average rate)

Rate of Return on Stock Market = 9.65%

25 Year Mortgage (240k) Monthly Payments

25 Year Mortgage (240k) Accelerated Weekly Payments

10 Year Mortgage Monthly Payments

Cashflow Available for Mortgage and/or investing

$3,000

$3,000

$3,000

Mortgage Monthly Cost

$1,524

$1,651

$2,646

Total Interest Paid

$217,239

$175,610

$56,154

Amount Available for Investment (Year 1-10)

$1,476

$1,349

$354

Amount Available for Investment (Year 11-21)

$1,476

$1,349

$3,000

Amount Available for Investment (Year 22-25)

$1,476

$3,000

$3,000

Investment Value after 25 years

$1,724,210

$1,671,280

$1,437,193

Home Equity after 25 years

$300,000

$300,000

$300,000

Net-worth after 25 years

$2,024,210

$1,971,280

$1,737,193

As expected, the longer mortgage creates the most future net-worth due to the higher stock market returns over the mortgage interest rate. I’ve put no appreciation into the home value, however it has no impact on the calculations above as all scenarios will equally benefit by an appreciation in home value. The difference is especially pronounced when you look at the 10 year mortgage scenario. The 10 year mortgage scenario results in a saving of $161,085 in interest payments but a loss of $287,017 in total net worth when the opportunity cost is factored in.

Conclusion

Bottom line is that the stock market investments on average have historically provided a better return for your extra cashflow over paying down your mortgage. You will very likely come out ahead by taking the longest possible mortgage term, as long as you don’t pay a higher interest rate or additional insurance premiums as a result of the longer mortgage. However, due to the variability of the stock market, you are more exposed to risks and fluctuations. But these risks are reduced due to the long time period being looked at and diversifying into different index ETF funds as shown in The Perfect ETF Portfolio.

However, paying down your mortgage faster when compared to investing in the bond market is not as obvious. Bonds have had returns that are similar to mortgage rates and either option is a good choice for your fixed income portion of your portfolio.

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