The Guaranteed Return of Paying Off Your Mortgage

by Kevin on July 19, 2010

In my last two posts I’ve shown that paying mortgage interest doesn’t necessarily save you on taxes and that you would need a substantially large mortgage to get a tax break.

I’m not saying you shouldn’t buy a home or pay mortgage interest. I am saying that doing so to lower your taxes is foolish. And intentionally not paying off your mortgage to keep that supposed tax deduction is especially foolish.

Paying Off Your Mortgage is a Guaranteed Return

There are very few financial products that will guarantee you a substantial return. You won’t find a stock mutual fund that will agree that historical returns are indicative of future returns. In fact, they always seem to mention the opposite! Historical returns are no guarantee of future returns.

When it comes to paying off your house you’re getting a guaranteed return.

If your mortgage is 5%, you are earning 5% on the dollars you use to pay down the house note.

If your mortgage is 6.5%, you are earning 6.5%. And so on.

You cannot find many products that will guarantee a rate of return that high. Sure you can get a CD at 1, 2, or maybe 3% if you lock in for the rate long enough.

But 5%? 6%? 7%? We haven’t seen CDs like that since the fed dropped interest rates to historical lows.

If I’m Not Making Interest, How Am I Getting a Return?

Most people understand a rate of return like this:

  1. Deposit money in a certificate of deposit
  2. Money grows thanks to the interest rate of the CD
  3. End up with more money than you started with

So how is it possible that by giving the bank more money you are actually earning a return?

Simple: by paying additional principle on your home loan you end up paying less interest on the loan. The interest savings is the rate of return you’re getting.

It is harder to see, but by paying less interest over the life of the loan you end up saving money. And in this case not paying interest (saving money) is the same as the bank giving you money off of your CD. You end up with more money at the end of the day.

Compare Mortgage and Investment Returns

Over the last 3 years my wife and I have been aggressively paying down our second mortgage. We bought a house with a low down payment, and received an extra mortgage for our troubles. We’ve been striving to pay it off since we bought the house.

Would we have been better off investing instead of paying down our debt? I ran some math and you might find the results surprising!

In my next post I’ll show you whether or not paying off our mortgage was a good financial move. Stay tuned!


Finance Nerd July 19, 2010 at 6:22 am

Don’t forget, if you itemize, your guaranteed return is lower, as you lose the interest tax shield you were getting. If your marginal rate is 25%, and your mortgage is 6%, paying it off is a 4.5% after tax return.

Most investments you would choose are also taxable, so the comparison to CDs is apples to apples, as you would be taxed on the interest you earned.

So, it is not the comparison that is off, just the absolute value of the return.

Kevin July 19, 2010 at 9:27 am

Thanks for stopping by.

Regarding the tax shield, I wrote about this two articles ago:

For many people there isn’t a tax shield at all. Your mortgage interest chips into the standard deduction, but unless you have a massive mortgage (or very high interest rate) it won’t cover the standard deduction. Mortgage interest alone usually won’t save you much on taxes.

Finance Nerd July 19, 2010 at 9:49 am

Fair comment, and I remember when you discussed this earlier. For me personally it is material, but I know for many it is not.

Budgeting in the Fun Stuff July 20, 2010 at 2:28 pm

Since we don’t itemize ($92,200 mortgage to start with), we have overpaid from the beginning in 2007. Our 15 year mortgage is on track to be paid off in 10 years or less total. I’ll bank that 5.375% return over Smarty Pig’s 2.15% any day. We also just used a large chunk of our emergency fund to pay off our hopefully-last-ever car loan (4.6%), so the mortgage is the only debt left. 🙂

Oh, and before anyone bashes us for using our emergency fund, we waited until after my husband signed a one-year contract with his new school district, so we’re pretty safe (we can live and save off of his salary alone if we had to).

Wondering why everyone doesn't prepay July 23, 2010 at 12:52 pm

In theory I’ve got a really good deal on my mortgage — 5% interest, but then I get a quarter of the interest given back for taxes thanks to a mortgage credit certificate, so I’m really only paying 3.75%.

That said, I’m still trying my darnedest to pay off my mortgage, because earning 3.75% on something is spectacularly higher than anything else I’ve been able to find — my retirement account is invested in stocks and bonds in the ratio that’s supposed to be age-appropriate according to all the experts I’ve found… and has only broken even once over the 15 years I’ve had it.

I’d rather have 3.75% guaranteed income than what’s theoretically supposed to be a 8-10% gain from stocks and has actually turned out to be an approximately 5% loss. (And I’m hugely lucky to have gotten away with JUST a 5% loss, from what I’ve seen.)

I’m curious where people are finding these “5% guaranteed rate of return” things that are supposed to be better investments than prepaying mortgages, because the best rate of return I’ve seen on a bank account lately is 1.5% and the best CD I’ve seen requires locking up money for 10 years to get 2.5%.

Do those mythical 5% guaranteed rate of return things even exist anymore, or was all that advice written pre-2008?

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