Should I pay loan balance down early even if I can't pay the whole thing off?

Question

I have a home mortgage with an outstanding principal balance of $150,000 and a fixed interest rate of 3%. My loan was a 15 year loan, of which I have 13 years left. However, I plan to pay my loan off within the next 2-3 years, and have amassed a savings of $50K to put towards doing that (this savings amount grows by around $3K each month).

I know that by paying the loan off early, I will save in interest. What I'm not sure is whether it matters if I wait until I can pay the loan off with a single large lump sum payment, or whether I should make large additional ongoing payments (I.E., put my $50K towards the loan right now). Is there any interest advantage to putting my money towards the loan right now to pay down my principal balance? Or would I end up paying the same amount in interest if I waited 2-3 more years when I can pay the entire balance off in a single payment?

Answer 1

If your goal is to save money, then make payments (of whatever size) as early as possible and don't wait. There is no benefit in paying it in large chunks. Think of it this way: Your interest is a monthly payment based on the total amount outstanding on the loan as of that month. Reducing that amount means you are paying for fewer months on whatever you pay early.

That said, you might reconsider paying down your mortgage early unless you can do so while maintaining a 3-6 month cushion of liquid cash for expenses. Also, in the grand scheme of things paying down a 3% loan probably is not a wise financial decision versus investing that same money in something with a better return and that is a more liquid asset that you could withdraw from in an emergency.

Answer 2

Depends.... what is the tax rate on the interest on your savings (if any?) By paying as much as you can off the mortgage you are effectively "investing" in a tax free vehicle at 3%. Maybe not big money, but where I am I have a mortgage at 9.5%pa. So paying spare cash into it means I am effectively "making" 9.5% tax free (in the form of interest saved). To get the equivalent earnings from a savings account, which will attract tax, is not only very difficult, I suspect it is impossible.

Answer 3

In order to answer your question accurately we need to go through some numbers.

You have a 150 000USD loan @3% over 15 years.

In a financing point of view you SOLD to the bank a 150 000USD bond at 3% over 15 years (approximately).

In order to value this, the simplest way is to assume a fair market with zero arbitrage opportunity. In order words if I BROUGHT a bond from a reputable provider with the same tenor, the difference in the yield would be the value of your mortgage.

If the value is positive then it's a better idea to keep the mortgage going (and probably buy that same bond for some free money).

If that value is negative, then you should spend your money on "buying back" your bond (closing out your mortgage).

A good benchmark to compare to would be the US T Bond rate. Today the 10 year T Bond is at 2.88% (according to Bloomberg). However, I'm not sure how easy it is for you to buy T Bond, not would you be able to buy back your mortgage for free...

Source: I work in a Credit Derivatives tech team

Answer 4

The one thing no one has mentioned is, where are you in your loan repayment? If you are reasonably early in your loan, it makes more sense to pay off. Consider this. If you were to pay down $50k in principle from the first day of your loan, you will save right around $22k in interest, and reduce the number of payments by about 70. That takes almost 6 years off your loan. However if you wait until the end of your loan, when you have a $50k balance, that same $50k principle payment will only save $3k in intrest, and only reduce the payments by 51. That would now only take a little more than 4 years off your loan. This is because all the interest is paid up front in a traditional loan. The longer you wait to make extra principle payments, the less you will save, and consequently, the less benefit to you.

Now that does not take into account investing the money which others have suggested. Due to your low home loan rate, some interesting things show up. If you just save that $3k each month in a savings account that returns 0.75% annually, after 15 years you will have around $571k. If instead you were to use it to pay off the house (and had been doing so since the inception of the loan), then at the end of the loan investing the $3k + your payment through the end of the 15 years, you would end up with around $594k, so it seems better to pay of the loan than to invest the money over a 15 year period, but if you put it into paying off the loan, you have no savings until the house is paid off, and though your savings grows quickly, it will take at 9.5 years after the loan is paid off to catch up. Maybe not something you want to wait for.

A good financial adviser can help, not only with investments, but also with crunching these numbers to fit your specific situation.

Answer 5

After having done this many times, I've changed my practice and no longer pay down debt. So the answer is a resounding "maybe".

1. a. Do pay it down only if you can't properly invest what you would be paying down. There may be reasons that you can't do this, like inexperience, commissions and fees, or general low returns, or a high interest rate, like with a credit card.

2. b. If your debt-to-income ratio is high or credit score low, prioritize that until it reaches a more reasonable level. A high DtI ratio will prevent you from being able to get additional credit in emergency situations.

3. Otherwise, invest the money you would be paying down into some kind of security. I do not know your tax situation, and this is not advice, but for most people, a Roth IRA from a brokerage is a good way to start. After funding the account, choose stocks to invest in. How to choose is beyond this post, but what you will find is that the investment account should be appreciate faster over the life of the debt than paying it down.

For your specifics: I'd rather you invest $50k into the stock market and have $4k additional in 12 months (assuming 8% YoY return). In 3 years, that's $63k, about 25% more. Also, consider that a mortgage also has a mortgage interest tax deduction. Paying it down will reduce that deduction.

One thing I might recommend is paying bi-weekly/semi-monthly if your lender allows it. It does not change the amount paid per month, but does give you a small interest advantage for free.

I recommend playing with the calculators at http://www.dinkytown.net/ with your real numbers.

Answer 6

My answer isn't about paying of any old debt early, it relates specifically to your mortgage.

I presume you have a mortgage where you are also paying of the debt and not just an interest only mortgage.

Nothing feels better than knowing your house is now your own house. Even if you lost your job, you would still have a roof over your head.

Pay your mortgage off as soon as you can.

Answer 7

I know that by paying the loan off early, I will save in interest. What I'm not sure is whether it matters if I wait until I can pay the loan off with a single large lump sum payment, or whether I should make large additional ongoing payments (I.E., put my $50K towards the loan right now). Is there any interest advantage to putting my money towards the loan right now to pay down my principal balance? Or would I end up paying the same amount in interest if I waited 2-3 more years when I can pay the entire balance off in a single payment?

As Jan Doggen notes in his comment, you need to check the terms of your mortgage. But assuming there are no limits/penalties on prepayment, you will absolutely save money by paying off a loan early.

The interest you pay every month is calculated based on the current principal balance. Less principal, less interest. Any prepayment on interest, no matter how small is going to reduce the interest you accrue over the following billing cycles. That's why it generally not useful to pay extra at the end of a mortgage since almost all of your payment goes to principal anyway.

If your plan is to pay off the mortgage (assuming you can with no prepayment penalty) then it makes absolutely no sense to hold it in an account and wait. The earlier you prepay, the better. Also if your mortgage has limits on how much you can prepay per year, the idea of trying to do it in one lump sum might not even be possible.

BUT WAIT! Depending on your cost of living, $50K is a pretty good emergency fund. You should really reconsider your plan to prepay. 3% is a tiny rate. It's possible that inflation will be more than that in the near future. Inflation (and other factors) cause the money you have now to be worth more than that money will be worth in the future. Your first priority should be to have 6 months to a year of living expenses in cash. Once you have that, you should be investing. If you want to be rational about this instead of emotional, paying off the mortgage is pretty low on the list of things to prioritize. the monthly payment is part of the living expenses your emergency fund should cover.

Answer 8

Some topics no one has mentioned...

Taxes. Your mortgage is far too low to for the mortgage interest tax deduction to apply, you're getting the standard deduction instead, unless there are special situations (check last years return...) so this means you're paying off a 3% loan with POST tax income. The problem is some people will propose you invest to obtain, perhaps, 6% of additional marginal PRE tax income instead of paying off the loan. Extremely superficially in a tax-free world that would be a profit of 3% per year. However, my marginal total tax rate is far over 50%, so merely to break even I need to get, perhaps, 7% rate of return on a $100K investment to have enough cash left over after paying about 4% of that back in income taxes just to break even on paying a 3% $100K loan. And I'm not doing all this complicated financial shuffling for less than, say, $3K per year, which is an additional 3% return on a $100K investment, so just to make it worth my time and effort to do complicated financial shuffling vs paying it off, I need a rate of return around 10% per year on my $100K investment, which is essentially impossible.

The second issue being carefully ignored is risk. The odds of your mortgage payment being due next month and every month until you pay it off or foreclose are approximately 99.9999%. I'd give perhaps a 1 in a million chance of financial collapse or asteroid strike or nuclear war in which case you don't need to pay your monthly mortgage payment every month. The only financial investment I'm aware of with a 99.9999% or higher likelihood of on time payment every month is federal bonds. So all you need to do is find a T-bond paying somewhat over 10% per year and todays rate is ... Oh... 10 year t-bonds are running 2.98% this week. So unless T-bond rates quadruple (which would result in their own financial crisis...) then you're FAR better off paying the loan off than attempting to invest and stay ahead of the steamroller every month.

The third topic not being discussed is its VERY easy to go back in historical records and find a financial investment paying perhaps 10% with 100% odds it'll happen, because it already happened. Its VERY difficult to find something like that looking forward. If you have a crystal ball to loan me, please do so. Worse, you'll find plenty of extremely long term stats that if you invested in the stock market last century you'd get an average return of X percent blah blah even with the effects of the great depression, but your house mortgage will foreclose in mere months and the great depression lasted years. You cannot pay a monthly bill using "decade long average returns", you need that cash each and every month like clockwork or you lose the house. The financial market is very loan shark ish and responding to "Where's this month's money?" with "well on century length average I give you lots of money" is just going to get you kneecapped with a foreclosure.

Using the concepts above you're almost infinitely better off paying the loan off early rather than trying to invest in a very risky high rate scheme to generate enough marginal pre-tax income to make a profit after paying the loan with post-tax income.

Something to keep in mind is if your monthly mortgage payment is maybe $2K then when it's paid off you'll have maybe $5K/mo to invest in financial schemes per your claim. So investing $3K/mo with large amounts of debt probably won't win in the long run vs investing $5K/mo a short amount of time in the future without any debt. If the mortgage were a microscopic fraction of your total monthly investment plan then it wouldn't matter, but you could nearly double your lifetime investment rate. Sending interest money to a bank in NYC will never make you rich, you have to send investment money to a broker working for you; you want to invest in the cash cow not be the cash cow.