There was a lot of good discussion in my lengthy early mortgage payoff post. Now instead of lengthy details, let me try out a quick rule of thumb about early mortgage payoff. Recall from Wikipedia:

A rule of thumb is a principle with broad application that is not intended to be strictly accurate or reliable for every situation. It is an easily learned and easily applied procedure for approximately calculating or recalling some value, or for making some determination.

So roughly applicable to many – but not all – situations.

Early Mortgage Payoff Rule of Thumb

You should time your mortgage payoff date to coincide with the date of retirement, or semi-retirement. Here, I would define retirement or semi-retirement as a time when you’ll be wholly or partially dependent on non-work income like Social Security, pensions, annuity payments, stock dividends, or other investment income. A downshift into a lower-paying second career would count as a semi-retirement.

In my humble opinion, this quick and dirty rule will help you balance the opportunity to invest in potentially higher-returning investments (stock mutual funds, dividend-paying stocks, real estate, high-yield bonds) with pursuing the benefits of having a fully-owned house (less stress, less leverage, lower required monthly expenses, lower required withdrawals from investments and thus lower marginal tax rates).

Example 1. 20s, 30s, 40s with long future career. You love your job and/or want to be doing it for the next 25+ years. In this case you have lots of human capital and a regular stream of income. You also won’t be needed to cash out your retirement assets for a long-time, making it much more likely that your stocks will achieve their higher average returns. Take on the 4% interest rate fixed for 30 years, and over time your salary will rise with inflation while your payment stays the same.

If anything, you could do a DIY biweekly payment plan and pay off your mortgage in under 24 years with less “pain” due to a behavioral trick (works best for those on a biweekly paycheck schedule).

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In the world of personal finance, you can always generate a good debate if you talk about paying off your mortgage early. The argument usually boils down to something like this:

If your interest rate is 4%, then paying extra towards that mortgage will earn you 4%. If you think you can earn more than 4% elsewhere, then don’t pay off your mortgage.

However, when it comes down to if YOU should pay extra towards YOUR mortgage, the above statement is an oversimplication. As Einstein is credited with saying, “Make everything as simple as possible, but not simpler.”

Since I am faced with this decision myself, let’s address the implied assumptions in the sentence above and all the other little details that go into the decision.

Warning: This is a braindump post and thus rather long and detailed…

Assumption #1: Your mortgage interest is 100% tax-deductible.

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What a difference a year makes. In August 2011, I did a mortgage comparison of a 15-year at 3.75% vs. 30-year at 4.75%. Now I’m redoing that same comparison at current market rates of 30 yr @ 3.25% vs. 15 yr @ 2.625%! To be fair, the numbers I used in 2011 were somewhat high.

In any case, the purpose of this comparison to compare the numbers if you wanted to pay down a 30-year mortgage in a 15-year accelerated timeframe, as opposed to just going with the lower interest rate and mandatory higher payment. I’ll be using the mortgage calculators at Dinkytown.

The 30-year at 3.25% would have a monthly payment of $1,305, while the 15-year would have a monthly payment of $2,018. Now, what would happen if we simply paid the $2,018 towards the 30-year mortgage? Using the calculator, we would enter an additional monthly payment of $713. That tells us the 30-year-plus-extra mortgage would be paid off in 15 years and 11 months, requiring 11 additional payments of roughly $2,000 and thus an extra $22,000 of interest in the end. However, the 30-year does allow me the flexibility to reduce my payment by about $700 a month if things get tight. Is the higher cost worth the extra flexibility?

I thought so when I got my first mortgage, but changed my mind once I figured that if I were to hit so hard that I couldn’t make the 15-year mortgage, I probably wouldn’t want to keep paying the 30-year either and would just sell the house and move somewhere cheaper and smaller. I viewed the potential payoff of going with the 15-year mortgage as being to retire one full year earlier.

Lots of people see the low interest rate for the 30-year mortgage and want to use that money to invest in the stock market. That may work out well if you actually invest your money as planned, I don’t know. I personally have enough invested in the stock market as it is, I don’t really want the extra leverage of essentially investing on margin with borrowed money. There is also a chance that the mortgage interest deduction may get capped or phased out over the next several years. That’s a lot of unknowns. I do know a top rate for a long-term certificate of deposit is the 10-year CD from Discover Bank with a yield of 1.90% APY. Meanwhile, the yield on a 30-year Treasury is 2.79%.

In the end, I don’t think there necessarily is a right or wrong answer. There are even more small nuances that went into my decision process, I’ll try and gather those thoughts for next week.

In case you haven’t been paying attention, mortgage rates are still dropping to new lows. Here’s a chart of the historical mortgage rate averages since I bought my house in late 2007, courtesy of HSH.com. It includes the 30-year fixed, 15-year fixed, and the 5/1 30-year adjustable.

From looking up some quotes (see below), 30-year fixed rates are ~3.125% now (~3.5% with no closing costs), and 15-year fixed rates are ~2.5% (~2.875% with no closing costs). Can you honestly say that you would have expected this 10 years ago? Another example of the difficulty of predicting the future.

If you haven’t refinanced in a while, it is definitely worth a try to see how much you could save a month. But what are you going to do with that savings? Buy more stuff that you don’t need? Buy more house that you don’t need? Why not consider refinancing into a 15-year mortgage and have that house paid off much sooner? From this CNN Money article using recent average rates:

Homeowners current paying off 30-year loans with rates of 4% spend about $1,098 a month in mortgage payments on a $200,000 balance, paying a total interest cost of $143,739. Refinancing at 2.63% for 15 years would cost them about $250 a month more, but they would wind up paying just $42,250 in total interest and their payments would end years earlier. Refinancing into another 30-year loan at 3.31% would cost homeowners only $877 a month, saving $221 from the existing loan.

If were to give advice to my future kids, it would be to determine home affordability only using the 15-year mortgage. Just forget the 30-year exists. You’ll be forced to budget properly and if you buy a house at age 30 you’ll be mortgage-free by 45! I think they would thank me in the end. I can still tell them their old man paid his off at 35, of course. 😉

Compare with rate quotes from:

• Provident Funding
• Quicken Loans
• Cashcall Mortgage

I hear that Costco provides a mortgage refinance referral service now as well – any real-world experience with them from readers?

Recent mortgage refinance articles:

• Common Mortgage Refinance Myths
• How To Maximize Your Appraisal During A Mortgage Refinance
• Provident Funding Mortgage Refinance Review

…because it looks like I’m getting another one. After seeing repeated news articles titled “Mortgage rate set record lows”, I’m now looking at refinancing to a 15-year fixed mortgage for 3% with all lender closing costs covered. I’ve seen multiple quotes for under 3% and getting under or close to zero in net fees.

Here’s a chart of the historical mortgage rate averages, courtesy of HSH.com. It includes the 30-year fixed, 15-year fixed, and the 5/1 30-year adjustable. Since I bought my home less than 5 years ago, 30-year fixed mortgage rates have ranged from a high of 7% to just above 4% today.

Even though I stopped trying to predict mortgage rates a while ago, I still find it hard to believe that I started with an interest rate of over 6% and now could be paying under 3% with a no-cost refi.

Alternative investments
If I successfully close on this loan, I don’t know if I’ll be aggressively paying it down as much as before. It’s important to note that the risk levels are not the same for the options below, but the interest rate environment is finally tipping to the point that I’d consider investing instead of paying off 3% debt.

• I could buy super-safe US Treasury bonds, with yields at ~2.2% for a 15-year maturity. Interest on Treasury bonds are exempt from state income taxes.
• I could buy a municipal bond fund like the Vanguard Intermediate-Term Tax-Exempt Fund (VWIUX), which invests in investment-grade municipal bonds. The fund holdings have a duration of about 5 years and yields nearly 2% federally tax-exempt. If you’re in the highest tax bracket, that would be an effective yield of ~3%.
• If I lived in California, I could buy shares of the Vanguard California Long-Term Tax-Exempt Fund (VCITX) with 2.60% yield that is exempt from both federal and state income taxes, with a duration of 6.4 years. That could be an effective yield of well over 4%.
• I could take on more risk and buy shares of mature, dividend-paying companies. The Vanguard Equity Income Fund (VEIRX) has a current dividend yield of nearly 3%.

I’m going through a local mortgage broker, but you can find similar rates over at Amerisave. If the “all lender fees and points” is negative, that means the credit they give you is more than all closing costs including appraisals and title insurance. (Anyone use them before?) Compare that with rate quotes from and Quicken Loans.