Updated July 27, 2021
Have you ever asked “is it a good idea to pay off your mortgage early” or “how can I pay off my mortgage early” or is this the debate for you?
There is a debt free revolution that spans many blogs and tips from financial gurus (like Dave Ramsey) that says you should achieve this debt free goal and pay off all your debt, including your mortgage. But should you do it?
When it comes to credit cards with a high interest rate, pay them off absolutely, but mortgages are more nuanced in your age and investment horizon.
If you’re retired and don’t have decades of track ahead of you and are looking for conservative investments, go ahead. Paying off a mortgage means a risk-free repayment of your mortgage interest rate and will release one of your largest bills when you have paid it off.
However, for the rest, they should keep that mortgage debt and reverse the difference.
Mortgage rates are minimal
Recently, I just refinanced and got a 30 year fixed rate mortgage of 2.65%. 2.65%! For 30 years! Check local rates.
I couldn’t believe how low that rate was. I can’t think of any other type of loan that allows you to borrow hundreds of thousands of dollars for this misery.
And the terms of the loan are fixed during the life of the loan. There is no margin for appeal if the value of the home is low and the lender cannot recover it when it is favorable to them. It is a very low risk financing where you can use the excess capital in other areas of your life.
Will the mortgage rate reverse at some point in the next 30 years? Maybe, but why not block these rates while you can?
Inflation eats away at the value of debt every year. High inflationary environments eliminate this debt faster, but even a little inflation causes the value to fall sharply over long periods of time.
Here is the value of the dollar for 100 years:
And, for a more recent look, over a 20-year period, the dollar has lost about 40% of its value due to inflation.
In other words, over the life of a mortgage, the value of the debt will be worth about half or less of what it was when you originated it.
And if you’ve read my article on inflation, I don’t understand the “transitional” argument and expect a higher-than-normal level of inflation for the next two years.
Another way to think about it is if your mortgage is 3% and inflation is 3%, you basically get the mortgage loan for free (assuming your hikes keep pace with inflation, of course).
Mortgage interest is tax deductible
Another factor is that if you detail the deductions, up to $ 750,000 in mortgage debt is tax deductible. So, if your family is between 25% tax, your 3% rate will actually go up to 2.25%, which will make the loan even cheaper.
Again, lower than the cost of inflation.
However, only 11% of applicants detail these days, so this tax cut is often exaggerated by real estate agents during the sale process. But if you live in the state with a high income tax and expensive housing, there is some savings.
Opportunity cost: mortgage or investment?
A key piece of this puzzle is what you do with the money you would have spent paying off the mortgage. If you keep it in cash, this clearly doesn’t help you that much (although you would have a lot of liquidity, which can have its own benefits for emergencies or investment prospects).
It doesn’t help either if you end up taking advantage of toy and junk predators.
But the assumption is that you will invest the money with which you will pay off your mortgage on an asset that returns a rate higher than the effective rate you are paying on the loan. They could be stocks or real estate or another class of assets.
This is one of the main reasons why real estate investors do so well over long periods of time. They leverage and capture increased property value, while the level of their debt decreases in value. Then, after a few years of asset appreciation, they perform a cash refinance and buy more properties, resetting the clock and doing it again.
Again, you need to compare rates of return in post-tax terms.
If you are between 25% tax and have a 3% mortgage and invest in an 8% S&P 500 index fund (long-term average), the appropriate rates to compare are 2.25% at 6% if detailed or 3% to 6% if you don’t. Therefore, by not paying your mortgage and investing in the stock market, you get 3-3.75% more per annum.
Because the standard term of the mortgage is 30 years, the appropriate investment horizon to consider is also 30 years. People generally don’t live in the same house for 30 years, but they generally live in a home, so that, as long as they continue to obtain similar levels of mortgage rates, they may consider time horizons of more than 30 years comparable.
Therefore, to find out whether it is better to repay the mortgage or invest, the key point here is that each period of more than 20 years of investment produced a positive return and the average return was 8-9%. The worst 30-year return in S&P 500 history in 100 years was 3.6%, which was even better than current mortgage rates.
Of course, past results are no guarantee of future results, but this is strong evidence that a 30-year stock retention period will outweigh the investment of paying the 3% mortgage.
A home is usually the largest asset you have. If you only focus on paying off your mortgage, you are concentrating all of your assets on a single asset that has no investment diversification.
Your city could face a long-term negative consequence from the local economy, a nuclear power plant could bring down pollution in the area, or some other black swan could ruin the value of your home, and then all those additional years of making money to pay off your mortgage. it would not have been for nothing.
So, should you pay a mortgage with 401,000 euros? Definitely not! You don’t want the only resource you have to be your home.
If you keep a mortgage contributing more to your 401k, you have a valuable default option in the future if you need it.
So say you lost your job and suddenly the money runs out. But wait, you’ve made 12 months of extra payments on your mortgage, so you’re ready for next year, right?
Your payments are still due on time, regardless of the number of additional payments you have made. The principal is reduced, but the term does not change (until you reach this last payment).
So even if you’ve poured $ 30,000 more into extra payments on your mortgage balance, all you’ve done is reduce the risk for your mortgage lender. Just after you have filed the foreclosure proceedings, they will jump in the air and click on your heels because you have reduced the relationship between the value and the loan and they are guaranteed that you will not lose the loan.
The above reason is why you should have emergency cash.
Some people say you should have 3 months to spend, others say 6 months and others just say you use your credit cards for emergencies. Well, you can’t put your mortgage on a credit card.
No one really agrees on how much to save, as it is personalized for each person. If you are in a high-demand industry, you may have a smaller pillow than others.
When should I try to pay the mortgage early?
If you are already an elderly person and do not have the clue of a 20 or 30 year investment horizon to exceed the mortgage rate in the stock market or other investments, paying off your mortgage is a conservative investment.
Another reason is whether he refuses to invest in the stock market or invest in real estate or any other class of assets that exceeds his mortgage rate because he is very risk averse. That’s all right! Everyone’s risk tolerance is different.
In either scenario, you will still need to set aside some emergency money that can cover your mortgage payments and living expenses in case you lose your primary income stream.
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