Ask the Readers: Pay Off the Mortgage or Keep the Money in Savings?
Published on - June 17th, 2011 (by J.D. Roth) It’s tough to write a personal-finance blog for five years without repeating topics. New readers come and old readers go. Meanwhile, the needs of existing readers are constantly changing. I try not to repeat material too often, but sometimes it’s clear it’s time to revisit a subject. Now is one of those times.
Lately, I’ve received several questions like this one from Robin, who wants to know if she should pay off her mortgage:
I’ve been reading your blog for a while now. It’s good for both entertainment and advice, and I like reading through comments on the articles I’m interested in and getting all the various points of view from people.
Something I don’t think I’ve seen addressed yet is this: I’ve saved up enough money to pay off our mortgage. Should I do it? Should I pay off part of it? Should I keep it as our emergency fund?
Here are some of the rough details of our situation:
- Current mortgage amount: $250,000
- Current mortgage rate 4.625%
- Years left on mortgage: 13
- Years until retirement (at 58): 15, solid salary expected until then
- Current place the money is parked: savings account making 1%
- Thoughts about moving: unlikely anytime in the next 4-5 years, can’t say beyond that
- Other retirement savings: substantial IRAs, 401(k), and other investment accounts (not concerned that this will be a problem even if we live to 100).
- House value: probably around $500,000 in Seattle
- Other debt: just monthly credit cards that are paid in full, no car payments, no student loans, etc.
I think it would be great to live mortgage-free, and I hope to do it sooner than later but I also get that there may be better uses for the money and we aren’t in any circumstance to rush about it. What do you think?
We’ve discussed this dilemma several times in the past. In fact, it seems to come up every six months! Let’s review the basics.
By repaying the mortgage early, Robin would generate a guaranteed return on her cash: She’d be getting 4.625% on $250,000, which is no chump change. On the other hand, this move has drawbacks. Most notably, cash in a savings account (or even in stocks) is liquid; it can be accessed when needed. But if that cash is converted to home equity, it’s more difficult to get at.
And, of course, there’s the opportunity cost. Sure, the 4.625% guaranteed return is greater than the one percent Robin would earn in a savings account. But it’s less than what she could probably expect to earn if the money were in a diversified investment portfolio.
Some other notes:
- First, this is a good problem to have. Whether Robin pays off her mortgage or keeps the money in savings, she’s in good shape.
- Second, the experts don’t agree on the best move here. Many argue in favor of getting rid of the mortgage, but many argue in favor of keeping it. There’s nothing close to universal agreement.
- Third, as with many money issues, this question is often more about psychology than it is pure math. For many folks, not having a mortgage provides peace of mind they can’t find anywhere else. There’s no way to quantify how much this is worth — but it’s worth a lot.
Whenever this question comes up, I offer the same advice: Unless your mortgage rate is very high, it makes more sense mathematically to invest your money. But psychologically, you should do what works for you. If paying off your mortgage would take a weight off your shoulders, then pay off your mortgage. Sure, you might be losing a bit in the long-term, but you’re still making a smart choice. It’s like choosing between an apple and an orange; one may be better for you, but they’re both good.
And, of course, it doesn’t have to be an “either-or” situation. Instead of paying off the mortgage completely, Robin might opt instead to eliminate some of the balance (or to make accelerated payments) while keeping some of the money for emergencies, or investing it elsewhere for potentially greater returns.
What do you think? Does it make sense for Robin to pay off the mortgage? If not, what should she do with her money instead? Have you been faced with a similar situation in the past? What did you choose to do? Would you make the same choice again?
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Saying that 4.625% is a guaranteed return on a $250,000 investment doesn’t completely jive…Robin would be netting herself out to zero if she paid the mortgage. She’s losing money on her $250,000 now and she’d be making 0% interest assuming she has exactly $250K in the bank and used it all to pay her mortgage. She’d be in a better position than she is now, but still not making money. Now if she were to save/invest her monthly mortgage payment (about $1900/month?) for 15 years at 1% annual interest compounded monthly, she’d have $370K. The avg. yearly rate of return on her $250K “investment” is now {[(370-250)/250]/15 years}=3.25%
Actually, with compounded monthly interest on both the mortgage and the savings/investment account: If you assume that she will invest her monthly mortgage payment as outlined above, she would have to make about 7.1% investing to come out ahead by not paying off her mortgage. (She’s going to pay out $96K in interest and could have the $370K if she was putting it in savings instead of paying her mortgage…total $466K lost)
If she didn’t invest the monthly mortgage payment (and blew it all on $8.25 thrift store dresses, 230 of them a month!), she’d only have to make 2.2% investing her $250K to break even paying 4.625% on her mortgage…again assuming monthly compounding for both.
Did I math that right?
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It really depends on how vested you are in the property. If you’re only a few years into the mortgage you’ll save a lot more paying it off because the interest is front-loaded.
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With only 2% of homes paid for, a quarter of mortgages greater than the value of the property, and foreclosures at all-time highs, paying off your home as quickly as possible sounds like a great idea. But this isn’t always the case. If you have an excellent credit report and qualify for a low mortgage rate, you’re better off investing the additional funds in an asset that will provide a higher return. In other words, the asset will pay your mortgage for you.
But if your mortgage rate is high, it might be better to sell an investment offering lower returns in order to pay it off. Much like with high interest credit cards, you forget about having an emergency fund because your home equity line of credit fills that role. Obviously, this means that whatever would have gone into your savings account must go into your home. Blowing it elsewhere defeats the point (and is the reason so many people got into trouble when house prices came down).
Ultimately, it comes down to numbers. Earning 5% income on an investment makes no sense if you’re being charged 10% on your mortgage while forgoing 10% on an investment makes no sense just to pay off a mortgage at 5%. If the mortgage rate is higher than the investment rate, put the money in the mortgage. If the investment rate is higher than the mortgage rate, put the money in the investment. Go where the numbers lead you.
A great way to pay off your mortgage faster than schedule is to pay your instalments once a week instead of once a month, effectively resulting in an extra payment each year. For example, instead of paying $1,000 per month, you pay $250 per week. This means that instead of paying $12,000 per year ($1,000 x 12 months), you pay $13,000 per year ($250 x 52 weeks). The extra $1,000 amortised to your mortgage means you pay it off sooner. Doesn’t that sound doable?
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What about recasting anywhere from a third to half the loan, and then renting out the house so the tenant now pays for the loan? That is, if she wants to become a landlord! True, renting out property can have its own risks, but the bottom line is that by recasting you drop the payment down, which would make it attractive as a rental. She could rent the house for two or three hundred dollars more than the payment and make a profit. All the while the renter is now paying her loan, and she still has a significant emergency fund. In our state there are tax benefits to the owner of a rental home, too. BUT, like I said, that depends on if Robin wants to deal with being a landlord.
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One other way I’ve been thinking about risk lately, I’m not sure it’s completely flushed out…
With a mortgage paid off, and an emergency fund, you are in a position to invest when others can’t and make real money. You can make money on risk because you have built a foundation for yourself.
You do like everyone and just put it into stocks and keep a mortgage and that means you also have to invest when everyone else does. At least if you’re like me and get squeamish when the market falls 50 percent.
Like Berkshire making 10 percent plus from GE right now?
I’m not sure this applies to her situation since she is close to retirement.
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Robin, here is another wrench in the machinery!
What about to keep a 50-75K emergency fund in your 1% account, place the balance in a diversified investment account and by the end of each year transfer your investment gain towards the principal of your mortgage?
Would love to have your problem…
and bos
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Pay it off!
This reader is set. As long as she has a good emergency fund after paying the mortgage, I say do it. It’s great to talk about how she *could* be making more in the stock market, or whatever, but her money is in a savings account, making a lame-o 1%! Pay it off now! These low savings rates are exactly why I am paying down my mortgage before age 30. It just makes good sense to be completely debt free, if you can, especially when you are nearing 60.
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Thanks to everyone for all the comments. It’s been really interesting to read them all and consider the various scenarios. This isn’t really a topic I’d feel comfortable bringing up at a dinner party with friends so having this opportunity to get all this feedback is very helpful. Thanks!
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I also agree that she should rather invest her savings in 401k and IRA to get the tax advantage and potential future returns. Maybe she can pay an additional $100 towards the principal, but I don’t think it makes sense to put your entire savings towards the mortgage.
We may see more than expected inflation in the next 10-15 years. If this is the case, there is further justification to invest rather than pay off debt.
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I think in these situations one should always pay off the debt. Then once you have paid off the debt make a savings account and put the mortgage payment you make every month in there. This way you will quickly build back up your savings and have the actual mortgage paid off. You will also not adjust your cost of living to being mortgage less too soon.
Just my thoughts.
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Keeping money liquid and investing it are two different things, so I think a 4-5% rate of return is pretty good, especially in today’s market. The pros to not paying off the house can’t simultaneously be the money is liquid and you can invest it in greater gains. You’re not going to be able to just pull your money out of the market at any time to get the gains you’re talking about.
If it were me, I’d probably put about 80% into the home, and keep the rest liquid (not taking into consideration tax benefits for possible retirement accounts).
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If it were me, and I had that 250K ready to pay it off, I’d do 50k on it, wait 6 months, making sure nothing huge had come up, pay another 50k and repeat…in that way, it would be paid off in a year and a half, but meantime, if she needed it, it’d be there. A yea ris not going to make that huge ammount of difference in the interest rate, vs the worry of what if that money was needed a month later.
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If I were in the situation, I would park the $250k in my dividend stock portfolio (high quality blue chip stocks PG, PEP, JNJ, KO, CL, CLX, etc.) Use the approximately $833/mo (4%) to pay extra on the mortgage (actually I would use it to buy more stock and continue the norm on the mortgage).
I would do this because my own retirement plan is to have a portfolio that will generate about $50k/yr in dividends.
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Not sure if someone has suggested this, but…
Even though we’re in a volatile market right now, blue chip value investments are at bargain prices, and many are paying safe, healthy dividends in the 3-4% range. My suggestion would be to isolate a group of securities (KFT, GSK, and 3 or 4 others) and invest 80% (say $200K) spread evenly among the securities with a hypothetical total yield of 3.5%. Take that $7K (pretax) and subsidize your mortgage with the dividend income.
You have potential for capital appreciation, as well as subsidized mortgage payments for the duration of your investment. You also still have $50K immediately available, as well as the securities should you need to sell them and access the cash within a week or so.
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My email isn’t working, so I’m sending my message here:
Hi JD,
I have been thinking about your post on June 17 for a while now. You said that paying off the mortgage versus investing the saved money in Robin’s case was like comparing apples to oranges. Is this because she only had 13 years left to pay on her mortgage? If she took out a 30-year mortgage, then at this stage in her amortization schedule she would be
paying more on the actual loan amount than she would on loan interest.
I was in a similar situation to Robin. My husband invested some money before we were married expecting to get a very large return. When the return came, we were 2 1/2 years into our 30-year mortgage (6.5% interest rate). We paid off our mortgage without a second thought. Part of this was because we had come through a year of unemployment and part was because we knew that if we held onto our mortgage, we would pay more than double the sale price of our home throughout the lifespan of the loan. Even though our situation is similar to Robins, I believe that we made the right choice not only psychologically, but also financially because of where we were in our loan. Do you agree? I’d love to her your thoughts.
Thanks,
Stephanie
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I suspect that Robin, like me, was raised by depression era parents to whom debt was bad. I remember when neighbors would have mortgage burning parties, and everybody would be happy that they were free and clear of the mortgage. I recently spoke with a Generation X professional, who does very, very well. He said his generation was raised to only look at the monthly payments, not overall debt. Completely the opposite of what I was raised to do.
I took a slightly different solution than the one Robin is considering. I wished to rebalance my 401(k) investments, and was very unhappy with the fixed income choices (all of the stock funds are MorningStar 4′s and 5′s, but the fixed income are either poor performers (well behind their peers) or something I didn’t wish to invest in (junk-bond portfolios).
What I did was take out a loan against my 401(k), out of the poor fixed income choices. I then paid off my mortgage. Now, I am paying myself 4%. Yes, there is an opportunity cost, but since this was going to be in the fixed income portion of my balanced 401(k), I think I’m making out better.
By the way, the mortgage will be paid off in five years, with total payments less than what I would have made had I not made the payoff. (The loss of the mortgage interest deduction was a minor consideration, as most of the payments still to be made where principal, rather than interest.)
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Most comments are right.
Personally, I would put half towards the mortgage and keep the other half available. While i’m %100 for being mortgage free, you need money available for emergencies.
You’ll make the biggest impact on the mortgage, the earlier you overpay. By hitting it hard early, you’ll be hitting the interest side like a ton of bricks. The banks always take their money first! Then future payment take out much more principal.
Now the liquid half could go in a Roth, but that would limit to investing $5000 a year. The rest would do better in the market, but since you don’t know when that is, dollar cost averaging would be the best bet. Since, buying anything in a lump sum all at once is market timing, she could invest some monthly over a number of years (5-10?) and that would leave her money in the saving account as a buffer while she does it.
If the person is ultra scared and is planning on keeping the liquid money in a 1% saving account, well, that isn’t making the most of it. Inflation will quickly overtake the %1 return.
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Well we have 2 yrs left on a 15yr mortgage and payoff amount is about $11,000@6% and wife has come into some money from a death and she wants to pay off our home. I agree with her and after it is paid off the 600.00 month will be split into two payments to double a heloc and creadit card payments. heloc could be paid off in 18 months instead of 3 yrs
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I would hold on to the mortgage as you can take a mortgage interest deduction at federal income tax time. That mortgage saves me thousands of dollars per year in money that would otherwise be paid in tax.
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Be careful with that reasoning. The mortgage interest deduction is certainly a piece of the puzzle that you should include when you’re doing the calculation, but it is not a reason to keep paying interest. Assuming you’re paying a marginal tax rate of about 30%, you could treat the mortgage interest deduction as decreasing your interest rate by that 30%. Which means that if you’re currently paying 4.625%, the mortgage interest deduction makes it so that your interest rate is effectively 3.24% . And if you don’t have anything else that you’re itemizing on your taxes, the net effect of the mortgage interest deduction is considerably less than that.
In summary, do not keep paying interest on your mortgage simply because you get a portion of that interest back in April. Run the numbers with all the variables and make your decision from there.
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I agree this more of a psychological …err rather an emotional decision. I would suggest that she do pay *some* additional principal (or all in her case) into the mortgage after:
- setting up an emergency fund (3-6 months of expenses)
- funding retirement accounts (to maximize employer tax and/or employer contributions) which seems like she has done
- having adequate insurance (didn’t mention the family situation but if there are kids term insurance would be a consideration)
If she chose to pay of the mortgage in increments there are online calculators that will help show when the loan will be eventually paid off. Shameless plug…I show how to put one together in Excel on doughmoney.com
But if she’s got all the stuff above taken care of…I’d say pay it off. Putting the money in other investments is not a 100% guarantee. Paying off the mortgage is a guarantee that she does not have to pay 4.25% to the bank.
Plus, nothing beats the peace of mind of being house debt free.
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Pay it off.
My philosophy is to maximize cash flow, not net worth. If you focus on cash flow, the net worth will quickly follow.
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I have 14 yrs left in my 30yr mortgage at ok don’t yell 8.6% Owe 34k on it. I have 100k in savings account earning yeah an awful 1/2 %. It’s slightly underwater. It’s a condo and their going for 30k. My bank offered a lower interest rate of 4.75%. $1300 closing costs. And make it into a 20 yr mortgage. To me that’s going in the wrong direction. Yes the interest is bad but the amount of the loan back 15 yrs ago was a small loan 44k. Should I pay it off? But I believe it will still depreciate in my area. What can info?
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Why don’t you make it a 10 year mortgage with the same interest rate, and closing costs? That would lower your monthly payment and you pay it off quicker, and less interest over time. Just because your existing bank offers you something, does not mean you have to take it. If you cannot pay it off completely, as you will be cash strapped, then do something to lower the rate and payment.
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What about the insurance cover part of this? Not to be morbid but we had a recent health scare which fortunately was ok in the end. We have insurance that is one of us dies the house loan gets paid off by insurance, therefore would it not be better to save the money and should anything bad happen we have both the savings and the house paid off?
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Just curious…can amortized interest and compounded interest be compared equally? Not sure but I thought to compare it (mortgage interest) with other interest rates (savings interest), the interest rate and the compounding frequency must be disclosed.
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