If you’re like me you hate debt. The word mortgage literally means ‘death pledge’ in Latin. That doesn’t sound pretty especially since you most likely bought a home for somewhere to live. It should be a positive thing right?
Only if you can afford it.
Getting a mortgage in most cases feels like a huge weight being tied around your neck and then taking the plunge off a cliff into the ocean deep water. It makes sense then why people want to pay it down as quickly as possible, often putting off saving to pay down their mortgage and then focus on saving for retirement after. This is reasonable, no one wants a mortgage in retirement. And there are psychological benefits of being debt-free. But is it the right decision? Here are some reasons why paying down your mortgage early is not always the best idea.
1) The opportunity cost
Every dollar put into your house is a dollar that can be used somewhere else, like investing in the stock market. The opportunity cost is more apparent if you have a lower interest rate on your mortgage because you are not paying as much in interest and can earn a greater return elsewhere. My rule of thumb is if you can get a better return compared to your mortgage interest rate, you should invest in that. If you have other financial goals, weigh the benefits of paying down your mortgage over reaching those goals. I would always recommend having an emergency fund first before making prepayments.
2) Your investments won’t be very diversified
A lot of people are house rich and cash poor. This is troublesome if your house declines in value as this has a big impact on your net worth. Think about the 2008-2009 financial crisis, or living in Alberta between 2015-2019. It is better to spread your investments into different industries, or as I write in my book, Kicking Financial Ass, investing in index funds. Moreover, it is often hard to make mortgage prepayments and to save for retirement at the same time. Better to pick one or the other.
3) Inflation eats into the prepayments
This ties back to your mortgage interest rate. If you live in the U.S. and have a 30-year mortgage, your mortgage payments stay the same for the life of the loan. But inflation, which averages 2% to 3% per year, is making those prepayments worth less each year. Let’s say you make monthly pre-payments of $500 or $6,000 per year. Next year that pre-payment is worth $485 a month or $5,820 over the year, assuming 3% inflation. Of course, you are saving on your mortgage interest at the same time, which at the end of the day, help offset each other. But the fact is that your overall savings rate is being offset by inflation, lowering how much your money is worth by the time your mortgage is paid off in full. This is true with the stock market as well, but the higher return in the market, compounded over time, helps to compensate for the eroding effects of inflation.
4) Return on your investment is lower than the stock market
The average stock market return is 9.7% over the past 100 years* not adjusting for inflation. The average increase in real estate prices is the inflation rate or 2% to 3% per year. This may not seem like much but with the power of compound interest, this can result in the difference of thousands if not millions of dollars. But wait, what about real estate in cities like Toronto, San Francisco, and New York? Yes in some cities real estate can increase by mind-boggling rates, but in most cases, real estate on average increases at the rate of inflation. This means you are better off investing in the stock market.
*Note: Past results do not guarantee future performance.
5) Real estate is not easily sold
Selling your home can be difficult and costly. You need to hire a realtor and depending on market conditions, you could be waiting months and months before selling. If you are experiencing a financial emergency this can be especially devastating. Rather by investing in the stock market, you are able to sell your investments faster, with fewer fees, and have peace of mind that only having financial flexibility can provide.
6) Missing out on tax breaks for mortgage interest
If you live in the U.S., you can claim a tax deduction for mortgage interest as long as your mortgage is on a first or second home and you have $750,000 of mortgage debt or less. This applies to mortgages taken after December 15, 2017; pre-existing mortgages are grandfathered in. You also need to have itemized deductions higher than the standard deduction of $12,000 for singles, or $24,000 for married filing jointly. If you don’t itemize your taxes, your mortgage interest deduction is worth nothing. In many cases, this reduces the value of the home mortgage interest deduction to where it’s pretty much worth nothing.
In Canada, if your property is a rental property, you are allowed to deduct mortgage interest which can result in tax savings. Unlike the U.S., you cannot deduct mortgage interest on your primary property.
7) Paying extra in fees
Depending on the type of mortgage you have, you might only be able to prepay up to a certain amount. Paying any more than the limit results in prepayment penalties.
8) Ongoing costs
Property taxes and insurance still cost you even after your house is paid for and if you own a condo then you have to still worry about condo fees. This is likely thousands of dollars per year which is a shock to some when they thought that no more expenses would be incurred.
9) Your net worth is not increasing
If you are taking the money you have saved and making a payment on your mortgage your net worth hasn’t grown. Essentially this is taking money from your left pocket to your right pocket.
When does it make sense to prepay your mortgage?
This is not to say that prepaying your mortgage is a bad idea. It’s that there are likely better uses for that money. At the end of the day, you are still saving money, which is more than what most people are doing these days. However, there are situations where prepaying your mortgage does make a lot of sense. Here are a few reasons when it can make sense.
1) When the mortgage rate is higher than the market return
This is not unfathomable. Back in the 1981 U.S. mortgage interest rates hit a high of nearly 19%. No-one knows if interest rates will go that high again but never say never. Over the past 20 years, U.S. mortgage rates have fluctuated between 3.65% and 8.05%. The higher that number goes, the more it makes sense to make prepayments.
2) Wanting to have forced savings
If you know you are likely to buy and sell stocks at the wrong time, or that you are likely to spend the money if it’s easy to access, then making prepayments can make sense. It’s about recognizing our strengths and weaknesses and compensating for them.
3) Wanting to have peace of mind of being debt-free
This is going back to paying off that death pledge. Not to mention making prepayments psychologically feels good and can make you more financially confident in your financial decisions. By making prepayments you can pay off your mortgage years faster and one day you can honestly say you are debt-free.
Legal Disclaimer: The views expressed by Mr. Dumont on Money Sensei are solely his and not intended as investment advice nor a guarantee of any financial return. Mr. Dumont is not an investment or tax professional, so the information contained on the blog is not a substitute for professional advice. The contents of this blog are accurate to the best of his knowledge at the time of posting, but rules and laws are ever-changing. Please do your research to confirm that you have the current information.