When To Pay Off Your Low-Interest Mortgage

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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.

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Latest posts by Wanderer (see all)

• Does Gen Z Have it Harder Than Millennials? - November 20, 2023
• When To Pay Off Your Low-Interest Mortgage - November 6, 2023
• Reader Case: Can’t Work Because of Health Issues and Worried - October 23, 2023

Note: Winners of last week’s book contest will be announced at the end of this post

A few weeks ago, we posted a reader case Can’t Work Because of Health Issues and Worried, in which our reader had recently become disabled, unable to work, and was worried that their financial situation was going to go into the crapper. As it turns out, no, she was going to be fine, and one of the main reasons is because she made the conscious choice to pay down her debt, first her credit card, and then her mortgage.

She wrote me back after her reader case was up to thank me for featuring her, which was very nice. We always love hearing back from people we’ve helped, but something she said stuck out at me…

You’re given us so much to consider and also.. are the first financial  person who hasn’t gasped when hearing that we decided to pay off our mortgage in such low interest rate times. 

At first, I just thought she talked to some pretty bad advisors, until I started mentioning this around my friends and family and realized they were getting this advice too. It seemed to be such common knowledge that when I started arguing that “No, it totally makes sense to pay off your mortgage even if the interest rate is low,” they would look at me like I had two heads.

So where did this advice come from, and why is it so wrong?

The reason is twofold:

1. Millennials have never seen interest rates rise so rapidly in our lifetime, so much of the advice written for us didn’t take this into account
2. Most financial advice is written for an American audience

There’s a lot of the American financial system that’s confusing beyond belief. Why is their retirement plan called a 401(k) and doesn’t have the word “retirement” in it? Who knows?

But when they call a mortgage fixed-rate, they actually mean it. The interest rate is fixed for the entire duration. It doesn’t change, even if the central bank changes interest rates for everyone else. Fixed rate means fixed rate.

Canadians, on the other hand, call our mortgages fixed-rate, but they’re not. They’re fixed for a portion of the time, usually 5 years, and then they reset to a new interest rate. Americans would never call that a fixed-rate mortgage, they would call that a 5/5 ARM, or Adjustable Rate Mortgage.

And unfortunately, Canadians tend to read advice referencing “fixed-rate mortgages,” and think that it applies to our “fixed-rate mortgages” while in reality they were talking about the American definition.

Let’s demonstrate this by…you guessed it…MATHING SHIT UP!

Actual Fixed Rate

Let’s take a mortgage that you got for an abnormally low interest rate during the pandemic, like 2%. And let’s make that mortgage a cool $1,000,000 to make the math easier.

This mortgage has an amortization period of 25 years, and is fixed-rate. ACTUALLY fixed rate, meaning that the interest rate stays at 2% for the entire 25 years. I plugged this into a mortgage calculator and the monthly payment would be $4,235 per month. According to the summary at the end, after 25 years, you’ll end up paying $1,270,354, so $1,000,000 in principal and $270,354 in interest.

Let’s see what happens if we put in a lump-sum payment after 5 years. Over the first 5 years, this is what the mortgage amortization table looks like this…

At the end of 5 years, you’ve paid $254,071 and have a remaining balance of $837,703. Now, let’s say you dump $100k into the mortgage, reducing your outstanding balance to $737,703. This causes your monthly payment to drop to $3,729. This is what the amortization table looks like for the next 20 years…

At the end of this section, you’ll have paid $894,966.

So in total, this mortgage will have cost you $254,071 (Years 1-5) + $100,000 (your extra payment) + $894,966 (Years 6-25) = $1,249,037.

So that means, this mortgage costs $1,270,354 without any extra payments vs $1,249,037, for a difference of $21,317.

In other words, you ploughed $100,000 early into your mortgage to save $21,317. Not bad, but not exactly earth shattering returns here.

Now let’s see what happens if the interest rate resets upwards, similar to what’s about to happen to all these Canadian mortgages out there.

“Canadian” Fixed-Rate

Let’s start with our base case. Same starting parameters, a $1,000,000 loan with a 25 year amortization, with a starting interest rate of 2%. The first 5 years looks identical to the last example, and at the end you’ll have paid $254,071 with an ending balance of $837,703.

If you do nothing and let the mortgage renew at prevailing interest rates, which are currently hovering around 6%, and it stays like this for the rest of the mortgage, your monthly payment jumps from $4,235 to $5,966, and this is what years 6-25 look like…

At the end, you will have paid $1,431,846. So over the life of the mortgage, the total cost is $254,071 (Years 1-5) + $1,431,846 (Years 6-25) = $1,685,917.

Ok great. Now let’s see what happens if we plough $100,000 into the mortgage at renewal time. Again, this brings down the mortgage balance at year 5 to $737,703.

This has two effects. One, the monthly payment is still going to increase due to the higher interest rate, but not as much. Where before, it jumped from $4,235 to $5,966, now it only goes up to $5,254.

And here’s how years 6-25 look.

At the end of this section of the mortgage, you’ll have paid $1,260,921. So that means over the life of this mortgage, you’ll have paid $254,071 (Years 1-5) + $100,000 (lump-sum payment) + $1,260,921 (Years 6-25) = $1,614,992.

Compared to the original scenario in which you’ve paid $1,685,917, by dumping $100k into the mortgage before it renews at a higher rate, you’ll save $70,979 in interest charges.

So that means that by spending $100k into paying your mortgage before your interest rate jumps, you’ll save over $70k, for an effective return on your investment of 70%!

Why Does This Happen?

This effect is caused by the fact that all the mortgages in this country are about to reset at vastly higher rates, so this creates an interest rate differential at renewal time. It’s this change in interest rates that the rule “Don’t pay off a low interest mortgage” doesn’t take into account, and the bigger the differential between your starting rate and your renewal rate, the bigger this advantage will be.

Because it’s easier to find cash to throw at your mortgage when your interest rate is still low, that’s when you want to be paying it off. You’ll be able to make way more progress quicker before renewal, because after renewal your mortgage monster is going to get a LOT hungrier. Then you’ll get hit with a double-whammy. Your mortgage payment will shoot up, making it harder to save money, which makes it harder to build up cash to pay down the principal.

But if you do it now while your payments are still relatively low, you’ll be able to reduce your balance a lot quicker, so when the mortgage monster’s appetite heats up, it’ll be a smaller monster to tackle.

So what our reader did was the exact right move because she was able to throw so much cash at her mortgage while her interest rate is still low. And unfortunately, the advisors she’s talked to are taking a rule that made sense for mortgages whose interest rates don’t change and mistakenly applying it to mortgages that do.

Conclusion

I ran this simulation using assumptions that I thought were the most relevant, meaning a large mortgage obtained at low interest rates, about to reset much higher. Everyone’s mortgage is different, so I encourage you to play around with the mortgage calculator I used, which is right here. You may find that paying off your mortgage might not make sense after all, or you might find it totally makes sense.

But either way, don’t rely on a rule that was written for a different audience living in a different interest-rate environment and assume it applies to today’s world of rapidly increasing interest rates, because it doesn’t.

We really enjoyed reading through all 100+ entries for JL Collins’ Pathfinders book! I could really see that people understood the point of the question “If you lost all your possessions in a house fire, what is the one thing you’d miss the most?” It was to realize what’s important to you and why we work towards FI.

Most people said photographs of their loved ones. A close second was “nothing”–all material possessions can be replaced, and the third is sentimental items. There were quite a few suck-up answers too about their copies of “The Simple Path to Wealth” and “Quit Like a Millionaire”. HAHA. Well played.

And now, without further ado*drum roll* the winners of JL Collin’s Pathfinders book are:

1. Sarah: “The possession I would miss most is my 6′ tall fig tree that I propagated from a leaf taken from my grandparents’ yard 13 years ago, when they were still alive.”
2. Danika.O: “I would miss my journals, which I’ve kept for decades since I was a teen. And of course, my dog eared copies of Quit Like a Millionaire and the Simple Path to Wealth 😁”
3. Kate: “Most of my things are digitized but I have my grandmother’s hairbrush that I last used when she was semi-conscious on the last day of her life. I quietly brushed her hair and talked with her. I also have my five kid’s first baby curls. Those would be hard to lose.”

Thanks to all of you for entering! If you didn’t win, you can buy a copy of JL Collins’ Pathfinders here.

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