I mentioned in an earlier post that while financial freedom will not be a major focus of this blog, it is something we are working toward in order to give us time to do some of the things we want to do, such as working on our homestead. And so today’s post is going to focus on an important part of our finances—our mortgage.

A lot of the FIRE bloggers I have read seem to fall in one of two camps—either they paid off their mortgage before retiring to get the psychological freedom from debt or they plan to keep paying for the full thirty years since they can make more in the stock market than the interest rate on the mortgage. Both sides do tend to acknowledge the other is a valid strategy—a purely rational person would not pay a 4% mortgage early when he can make 5% or so in the stock market, but I don’t know of any purely rational people out there. However, what I haven’t seen acknowledged in blogs much before is a third option that combines the two nicely—namely, refinancing a mortgage to a shorter term for a lower rate. This is the option Mr. BBB and I have pursued for our house. I’ll show the math here for those of you who want to make the rational decision. For those of you who just don’t want any debt hanging over your head, there’s good news for you too—with a ten-year mortgage like we have, you can easily pay off a house before retiring early even if you don’t pay extra each month.

When we first decided to try and pursue this option, we had just over $260,000 left to pay to Chase over the next 27 years. We had a 3.99% interest rate for this balance which was the best we could find for a thirty-year mortgage. This meant we were paying $1240 per month (technically, it was more than that since Chase required us to put money in escrow and our new mortgage company does not but we won’t get into that here). Over the 30-year loan, we would pay $186,321 in interest.

After a good deal of searching, we found a credit union which offered a ten-year fixed-rate mortgage at 3.25%. Most of the major banks only go down to a fifteen-year mortgage which had a correspondingly higher rate, so if you’re interested in doing something similar, check your local credit unions. Just avoid adjustable rate mortgages. You’ll likely end up paying a lot more with them (I suppose you could argue that if you pay off your mortgage during the period where the rate is fixed, you might come out ahead but that wasn’t the case for us given the low fixed rates).

With our new mortgage, we pay $2,541 a month and will end up paying $44,883 in interest. This means we will save $141,438 in interest. But this is not the whole story—otherwise, we would be better off with no mortgage at all, and as I mentioned earlier, that doesn’t make sense from a financial perspective. The reason this doesn’t tell the whole story comes down to what economists call an opportunity cost—in this case, what else that money could have been doing if you weren’t paying the extra toward the mortgage each month. For simplicity’s sake, let’s assume that we invest it in the stock market and get a 5% real return annually (0.417% monthly). So if we had stuck with the 30-year mortgage, we would have paid $1240 to the mortgage in month one and then invested the extra $1301 which would have earned $5.42 in the next month. Then, we would invest another $1301 which would earn $5.42 in the next month. Plus the original $1301 invested would now earn $5.45 (since the $5.42 we made earned money too).

Carrying this pattern through, we earn $46,788 over ten years. Certainly, that’s nothing to sneeze at, but it still means we save nearly $100,000 with the ten-year mortgage. And that’s without accounting for the fact that once we pay off the ten-year mortgage, we will be investing $1240 per month that would otherwise have gone to the thirty-year mortgage. I also did not account for the fact that Chase required us to escrow but the credit union with our mortgage now does not, freeing up even more money to earn, at least for a year.

Some of you might be wondering what happens if you follow this path to its (on the surface at least) logical conclusion. After all, if a shorter timeframe for the mortgage is better, should we keep shortening it? What about a five-year mortgage? In that case, why have a mortgage at all? Turns out, it’s all about interest rates and how much lower you can get them by reducing the term of your mortgage. At some point, it’s no longer worth it because of the cost of not investing the extra money you’re paying each month. For example, even the 30-year mortgage is better financially than just paying for the house outright because though you pay $186,321 in interest, you gain $316,638 in investment returns (again, assuming a 5% real return). And that is why a mortgage often makes sense financially—assuming you can get a fixed rate lower than your expected real rate of return over the 30 years (I wouldn’t accept a rate higher than 5% or so).