Should You Pay Off Mortgage With Low Interest Rate Early?

If you can pay off your mortgage early, but you have a very low interest rate, should you? Or should you invest your money elsewhere?

Q: I tried to get on your radio show this past weekend, but I called too close to the end. I refinanced two years ago to a 3.625 percent loan. I have lots of equity in my home and have been paying more than double each month since I refinanced.

At this pace, I will pay off the loan on my house in 4 years. Yay! But, should I do this? Could I put that extra money to better use instead of paying off a low rate mortgage? I will want to move out of my home as soon as my kids are gone and the house is too big for us. I’m afraid to sell in this market.

Thanks for all you do!

A: Thanks for your questions. Believe it or not, as low as your interest rate is, you could probably refinance your loan into an even lower rate mortgage. But we’re not advising you to do that. You’re paying so little in interest at the moment that it would be a waste of cash to pay any refinancing costs.

The question of whether you should even prepay a loan this cheap is excellent. Let’s walk through some of the logic.

As you are planning to sell your home in the next couple of years – or within the next seven years, your choice is to decide where to put your money. Your question certainly implies that you want to put your money to work elsewhere than in your home. You still have a balance on your current loan and you pay some interest on that loan. If you decide not to continue paying down your current loan, you’ll have to decide where to put that extra money.

When you decide where to invest, you also have to decide the risk you’ll want to take with that money. You know that by paying down your current mortgage, you will save yourself the interest payments on that loan at a rate of 3.625 percent. So, you’re effectively earning 3.62 percent on every dollar you prepay.

If you elect to put the money in a checking account, you won’t earn any interest on it. Investing in long term bonds at these low interest rates could be risky for you, especially if interest rates start to increase. Putting your money in the stock market – what many people appear to be doing – carries its own risk.

It’s probably true that interest rates will go up over time. While we don’t know when, we sort of know that over the next five or 10 years, interest rates should be higher than they are today, especially when you consider historical trends. After all, it was only in the early 1990’s that mortgage interest rates fell below 7 percent for the first time in more than 25 years.

It would be great if you could borrow a big sum of money today at these low historical rates and wait to invest the cash in a couple of years. We’d all seem like financial geniuses when we’d borrow at 3 or 4 percent interest and then invest that money in years to come at 7 or 8 percent interest. However, in the time interest rates increase, we’d still be paying our current loan and we’d have to find a place to park the money. If you have that place in mind and feel comfortable with it, you can move forward with that plan.

We’d like to remind you that in the late 1990’s people borrowed money left and right with the expectation that they could invest that money in the stock market. When the internet bubble burst, quite a number of investors got burned. Later, they borrowed money and invested in real estate to ride the market up only to then lose money as it crashed down. With that in mind, we caution you to invest wisely and not place all of your money in one investment bucket.

You may not want to sell your home today, but if you sell in five years and the market is where it is today or has improved in your area, you will get the cash out of your house at that time.

At that point, you will have a substantial amount of money and can consider where to put that money given the financial conditions at that time. Good luck.


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One Response to Should You Pay Off Mortgage With Low Interest Rate Early?

  1. chris says:

    If you prepay enough into your mortgage “this” year to knock the final payment off the end of your mortgage, if you take a look at your amortization schedule you’ll notice the interest amount of the final mortgage payment is in the neighborhood of $5. How is it ever advisable to put over a $1000 “today” in for the “win” of saving about $5 come N={1 to 29} years from now?

    Prepaying a mortgage only robs you of the most favorable months of your loan, effectively raising your APR with every month of term truncation, while also charging you an enormous opportunity cost: Whatever income the final month’s prepay money could have earned for YOU is traded to the bank in return for approximately $5. If you have ten years left of your $1200/mo mortgage, that opportunity cost would come to about $700 or $800 on just a 4% CD. The bank makes out like a bandit on your prepaid mortgage and you don’t even know you got robbed.

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