Meridian Blog

We’ve been receiving a lot of questions about paying off mortgages or using cash to buy real estate…Nathan covered the question of whether to purchase a home with cash (or use cash for a larger down payment) in his Meridian Market Minute, so this blog post is about using cash or investments to pay off (or pay down) an existing mortgage.

Since COVID, the combination of the reduced ability to spend money in 2020, rounds of stimulus checks, rising wages, and rising investments has led to Americans having fairly healthy bank balances and excess cash on hand. 

Should I Pay Off My Mortgage?

With a few rough years in the stock market in recent memory, people are looking for ways to deploy their cash in a smart and safe manner.  So, we’ve been answering a lot of questions about whether paying off a mortgage is a smart financial move.  And, as it is with most financial questions, the answer is “it depends”. 😊

If you were one of the fortunate folks who bought a home or refinanced between 2010 and 2021, you most likely have a mortgage rate under 5%.  If you were super lucky, you bought or refinanced in late 2020 to early 2021, you might even have a rate in the 2-3% range.  

For context, here are recent returns of CDs, bonds, stocks, and a balanced portfolio from September 2023 to June 2024:

Should I Pay Off a Mortgage or Invest?

With Treasury bonds and CD rates close to 5%, corporate bonds paying 6% interest, and stocks earning 29% over the last year…it’s hard to recommend selling those assets to pay off a mortgage that is costly less than 4% interest annually.  Basically, a 4% rate on a $200,000 mortgage balance costs about $8,000 in interest annually.  But, keeping $200,000 in a 5% CD over the same 12-month period will pay you $10,000 in interest.  So, you pay the bank $8,000 of interest on the mortgage and they pay you $10,000 interest on the CD.  You come out ahead by $2,000.

How do banks make money?

This is flipping the script…banks make money doing this exact math.  In usual economic environments, banks take in deposits from their customers and pay a very low amount of interest on them (i.e. savings account interest at 2%).  Then, the bank makes loans with their deposits at rates higher than the amounts they are paying on the deposit accounts (i.e. mortgages at 5-6%).  The bank keeps the interest rate margin…usually around 3-4% spread between what they are paying in interest to deposit customers and what they are collecting from the loan customers.  Pretty neat system. 😊

Finally, for the first time in a while, you have the chance to be the bank…and keep the spread!  If you have a mortgage in the 2-3% range, you can earn more interest than you are paying by simply keeping your money invested.  

If you are risk averse, just buying CDs and bonds will yield you 5-6% interest annually—so you get to keep the spread between that interest rate and the rate of your mortgage. 

Keeping the Spread

If you are willing to accept a little risk, then a balanced portfolio has earned about 10% over the past year.  So, if your $200,000 mortgage had an interest rate of 3%, then it cost you about $6,000 of interest to the bank.  BUT, your invested portfolio returned $20,000 to you…and you keep the spread of $14,000.  You become the bank, earning the margin.

While the math usually points towards keeping a lower rate mortgage at the current time, as Sarah Irving pointed out in her excellent blog, one size never fits all…there are many other considerations to the decision to prepay a mortgage.

Different Financial Scenarios (and Personal Preferences)

If cash flow concerns are critical, then paying off the mortgage to remove the monthly obligation may make more sense.  If the psychological freedom of being debt-free is the most important factor, that can outweigh the math.  If the mortgage interest rate is closer to the line of estimated reasonable investment returns (like Nathan said in his video, mortgage rates close to 6-7%…), then it may not be worth the investment risk to try to outpace that interest rate cost. Every person’s goals are different!

One other comment on the decision to use investments or cash to pay off a low-rate mortgage…there may be a compromise between paying off the full balance of the mortgage versus using just a part of your cash/portfolio to reduce your monthly payment.  Some mortgage companies will allow you to make a large principal payment and then recast your mortgage. Unlike refinancing, recasting does not involve taking out a new loan or changing the interest rate or loan term, which is a huge benefit when trying to hang on to an ultra-low mortgage rate!!

How to Recast Your Mortgage

Here’s how it typically works:

1. Call your mortgage company to verify they offer a recast.  Some will, some won’t! verify the next steps with them…many will quote you the new mortgage payment based on the lump sum payment that you plan to make.
2. Make a Lump Sum Payment.  Pay a significant amount toward the principal balance of your mortgage.
3. You then request a recast from your lender. 
4. The lender will recalculate your monthly payments based on the new, lower principal balance, while keeping the same interest rate and loan term.

While some lenders may charge a fee for recasting, it’s often less than the costs associated with refinancing. There may also be conditions or minimum payment requirements to qualify for recasting.  But generally, recasting can be a good option if you want to lower your monthly payments without changing your loan’s terms or incurring the costs associated with refinancing.

Too much to think about? Milo thinks so…we can help you think through your decision!

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