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Should you prepay your mortgage?

Key takeaways

  • Can you afford to prepay your mortgage?
  • What will produce the greatest wealth?
  • When will you need your money?
  • How important is paying off debt to you emotionally?

Owning your home free and clear probably sounds awesome—no more payments to the bank, lower monthly expenses, and the security and pride of knowing you own your house outright. In fact, for some people, paying off the mortgage may seem like a requirement before retirement.

But when it comes to paying off a mortgage early, feelings are just one factor to consider. You should also weigh the financial aspects of the decision. When it comes to dollars and cents, the decision can be complicated: Paying off a mortgage early will help some people financially, and make less sense for others.

How do you know if paying off a mortgage can help you financially?

A key factor is to consider what the money would do if you didn't pay off the loan. Paying off your mortgage is a little bit like investing at a fixed rate of return. Meaning, if you owe $5,000 on a mortgage and pay it down over 3 years at 5% interest, you are going to pay about $500 in interest. If you pay the loan off, you save that $500—that savings is sort of like a "return," and has a similar effect on your net worth.1

But that raises the question, what if the returns from your investment portfolio are different than your loan's interest rate? If you have a higher interest rate than your investment returns, prepaying your mortgage might benefit you long term. But if you were to earn an investment return that outpaces your interest rate, paying off the loan may not make sense.1

Fidelity recently completed an analysis that looked at different mortgage interest rates and hypothetical market performance for a number of different portfolios to see the financial impact of prepaying a mortgage. The study looked at 3 different measures:

  • Plan strength: Did prepaying a loan decrease the risk of running out of money in retirement compared to investing?
  • Volatility: Did prepaying decrease the volatility of the portfolio?
  • Wealth: Was the balance higher at the end of the plan?

"The results show that, in general, more aggressive investors might have been better off continuing to invest," says Mike Rusinak, a director of Fidelity's Financial Solutions group. "More conservative investors, in general, might have been better off prepaying the debt. This is another reason it makes sense to create a holistic financial plan that covers many aspects of your financial life."

This analysis relied on hypothetical market performance and interest rates and assumed the savings were available in cash. There are some important factors to keep in mind about this study. Because tax situations vary so much from one person to another, this analysis did not account for taxes—actual results may be different.

If you needed to sell appreciated stock or withdraw the money from a 401(k) or other tax-deferred account, you would have to pay taxes. That would increase the cost of paying off a loan—meaning even borrowers with lower interest rates might benefit from staying invested. The mortgage interest tax break lowers the cost of a mortgage for those who itemize deductions, which means losing the mortgage interest deduction also reduces the savings if you pay it off. So people who benefit from that deduction might need a higher rate before it makes sense to pay off the loan.

The bottom line is that this analysis can give you a rough idea of the relationship between investment style and the benefits of paying off a mortgage early, but it is important to consider your own situation and consult with an advisor before taking action.

If your investment mix is... (stocks, bonds, cash) Consider paying down debt if your interest rate is more than...
20/50/30 4.750%
30/50/20 4.375%
45/40/15 4.625%
50/40/10 5.000%
60/35/5 5.250%
70/25/5 5.500%
85/15/0 5.750%
100/0/0 6.000%

As of January 2022. Source: Fidelity Investments. The analysis to determine the mortgage rate break points displayed in this chart makes several assumptions. It models a retirement time horizon of 27 years comparing 2 scenarios: 1) no changes are made, and 2) the entirety of the mortgage is paid off using available assets assuming no taxes or penalties incurred in accessing the funds. The analysis does not account for income taxes paid on the withdrawal. Taxes and fees could impact the benefits of either strategy. Using a Monte Carlo framework with proprietary capital market assumptions (which are subject to change) for end of 11/2020, 1000 simulations are run on these scenarios. At the end of each simulation 3 main statistics are reported: 1) incidence of asset exhaustion; 2) portfolio volatility; 3) ending wealth. If at a given interest rate and asset allocation the scenario which pays down the mortgage improves upon the base scenario in all 3 measures it is deemed a reasonable indication to pay down the mortgage given that interest rate and asset allocation. In the base case the mortgage is assumed to be refinanced if rates decline before maturity. Mortgage rates are proxied by the 20-year treasury rate plus a spread. This analysis does not incorporate any taxes or investment fees. For taxpayers who itemize expenses these numbers may not be appropriate, and the required interest rate to consider paying down debt might be higher. Some housing fees, including taxes and insurance, will not change regardless of a mortgage. See disclosure for more information about how these numbers were calculated.

Your investment outlook is just one factor when it comes to paying off your debt. Consider these 4 questions.

1. Can you afford to prepay your mortgage?

Before you pay down your mortgage ahead of schedule, you need to make sure you aren't neglecting other important needs. For instance, if you have high-interest credit cards, higher-interest short-term debt on a car, or a private student loan, you should look at paying off that debt before you consider paying off what may be a lower-interest-rate mortgage.

Also, if you are still working and have not taken full advantage of an IRA or 401(k), those savings options come with significant tax benefits, and maybe even an employer match. The tax benefits and match may make investing in these accounts more appealing than paying off low-interest-rate debt, like a mortgage—particularly if you are concerned you won't have enough funds for retirement.

2. What will produce the greatest wealth?

If your goal is to end up with as much money as possible—for instance, to leave a legacy for charity or your children, paying off your mortgage early may not make the most sense. As shown above, this is particularly true for investors with significant stock holdings, or low-rate mortgages.

3. When will you need your money?

Another key tradeoff between investing and prepaying is flexibility. Generally speaking, it's easier to access money in an investment account than money that's locked up in home equity, and prepaying a mortgage means you'll have more home equity and less money in investment accounts. Tapping into savings in your home equity requires selling your home and moving, setting up a home equity line of credit, or possibly a reverse mortgage. Those options vary in complexity and cost, but in general, the investment account will be easier to access in the event you want or need to spend the money on short notice.

4. How important is paying off debt to you emotionally?

Fidelity research has shown that taking on debt can really weigh on a person’s sense of wellbeing—for some, the burden is even greater than going through a major reorganization at work or other stressful life event. On the other hand, paying off debt can have a big positive impact, even more than a promotion or exercising.

If you are very conservative, the appeal of a predictable return on your money, and the security of knowing that your house is paid up may have value beyond the dollars and cents involved. In that case, prepaying a mortgage may make more sense than the math would imply. Eliminating debt also reduces your monthly income needs, and that is another kind of flexibility.

Case study: prepayment in action

Let's take a look at a hypothetical example. Say Joan is 10 years into a 30-year mortgage with an interest rate of 4%, an outstanding balance close to $275,000, and a monthly payment of about $1,300. She is approaching retirement and trying to decide if she should use her savings to pay off the mortgage before she stops working.

Let's say Joan is a conservative investor—she holds about 20% of her portfolio in stocks, about 50% in bonds, and 30% in cash. If she prepays her mortgage, our estimate indicates she will end up improving her financial condition by reducing the risk of running out of money in retirement by about 5%, and improving her median final balance by about 13%.2

But what if she was a more aggressive investor and held 70% of her portfolio in stocks and 25% in bonds and 5% in cash. According to our estimates, if Joan decides to prepay, she would still reduce her risk of running out of money. But in terms of wealth, the outcome would likely change: Instead of increasing her final balance, prepaying the mortgage would actually hurt her wealth. Because her investments would have grown more than savings from repayment, Joan would see her median final balance decrease by about 5%.

"Prepaying debt sort of functions like buying an annuity: You reduce your risk by creating a guaranteed return equivalent to the interest rate on the mortgage," says Rusinak. "For some investors, that certainty might be compelling, but for others it has the potential to actually reduce wealth."

The bottom line

There can be some real benefits—both financial and emotional—to prepaying your mortgage. You reduce your total interest payments, you reduce your monthly spending needs, and you have the security of a predictable financial benefit and the psychological benefits of knowing you are out of debt.

But you may also want to weigh the benefits of getting rid of debt against the opportunity presented by investing. Prepaying a mortgage may not produce as much total wealth as investing, and it also may make it harder to tap your assets in the event of an emergency, or change in plans. It may be worth considering investing if you are more comfortable with risk, short on retirement savings, value flexibility, or if your main goal is growing your wealth.

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1. Prepaying debt and earning a return on investments are not the same. Prepaying debt removes a monthly liability but may also have tax implications, for instance the loss of the mortgage interest deduction. Debt prepayment limits the liquidity, and may require the borrower to take out a new loan subject to prevailing interest rates. Investment returns are not guaranteed and can be subject to market volatility. The tax treatment of investments varies and could impact total returns. 2. The risk of running out of money is defined as portfolio exhaustion before the target planning date.

Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

Views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.

About the numbers in this story  
The values in this article are based on a Monte Carlo simulation–based approach to estimate potential growth of account balances and the corresponding cash flow from the account. The analysis is based on historical market data to estimate a range of potential outcomes for various hypothetical retirement income portfolios under different market conditions. Monte Carlo simulations are mathematical methods used to estimate the likelihood of a particular outcome based on market performance historical analysis. While over very long periods of time, markets have averages, it is often the case that the market performs both above and below these averages. The Monte Carlo simulations are designed to reflect this historical market volatility.

This analysis used a retirement time horizon of 27 years comparing two scenarios 1) no changes are made 2) the entirety of the mortgage is paid off using assets from a savings account. The analysis does not account for income taxes paid on the withdrawal or investment expenses if the money remains invested. Taxes and fees could impact the benefits of either strategy. Using the Monte Carlo framework with proprietary near-term capital market assumptions, 1000 simulations are run on these scenarios. At the end of each simulation 3 main statistics are reported: 1) incidence of asset exhaustion, i.e. running out of money prior to the end of the planning period; 2) portfolio volatility; 3) ending wealth. If, at a given interest rate and asset allocation, the scenario which pays down the mortgage improves upon the base scenario in all 3 measures it is deemed a reasonable indication to pay down the mortgage given that interest rate and asset allocation. In the base case, the mortgage is refinanced if rates drop. Mortgage rates are proxied by the 20-year treasury rate plus a spread. Again, this analysis does not incorporate any taxes or investment fees. For taxpayers who itemize expenses these numbers may not be appropriate, and the required interest rate to consider paying down debt might be higher. Some housing fees, including taxes and insurance, will not change regardless of a mortgage.

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