No one likes to be in debt, and for most homeowners, their mortgage is the biggest debt burden they will ever have. While this can be an important psychological step in paying off your mortgage, it may not be the best financial decision in the long run, especially if you are doing it instead of paying off low balance, higher interest debt. Michael Roberts, William H. Lawrence professor of finance at the Wharton School of Business at the University of Pennsylvania, explained why spending that money on other goals might be a better strategy. Our conversation has been edited for length and clarity.
Should people pay off their mortgages sooner if they can? Why or why not?
Much depends on how your mortgage and other expenses fit into the larger context of your budget and it depends on your risk tolerance and the level of risk you are willing to accept. Beyond that, there are a number of pros and cons associated with prepaying a mortgage.
It is becoming a lot less clear, especially in the very low interest rate environment we find ourselves in. Consider the pros and cons.
On the benefit side, you are going to pay future interest charges, you are going to reduce future monthly expenses. You will also increase your future debt capacity which is fancy language as you will be able to borrow more easily in the future as you will not carry as much weight on you. If you are in the PMI (private mortgage insurance) camp, you will get rid of it sooner. It alleviates psychological loads, because some people are stressed.
But there are a host of downsides that people don’t think about. If you pay off your mortgage early, you won’t save that money. Depending on how much you will earn on your savings, you could lose a lot of money. For the past 14 years it was obvious to me not to pay off my mortgage, because I made more investing in the stock market than paying off my 4.5% mortgage, but this is the best choice, because lucky that the market is doing well.
The good thing is that, unlike a house, savings are liquid. If I need money, I can sell stocks, liquidate an ETF, whatever it is. If I don’t sell a home, I’m going to have to take out a home equity line of credit or a reverse mortgage or a second mortgage. The monthly payments actually impose a certain discipline on some people.
If you have other higher interest rate debt, prepaying a mortgage makes absolutely no sense because you have to get rid of that higher interest rate debt first. If all of your equity is tied up in your home, there is less diversification there.
What are the advantages of keeping your mortgage for the entire term?
To expand on some of the things we’ve covered, packing all your money in your house can be really problematic when you need it. The illiquidity of your real estate assets tends not to be appreciated. Depending on your tax status, you also benefit from an interest shield. By paying off your mortgage faster, you lose this deduction.
Keep in mind that the average return on the stock market has been 11%, mortgage rates have been below that for 30 years, it seems like a no-brainer: if I invest money in the stock market for 20 or 30 years ago, I’ll have a lot more money than if I had paid off my mortgage earlier. This is not the way to think. That’s more, how much can I lose if I don’t pay off my mortgage sooner? If things don’t go well, you’ll lose money on prepaying your mortgage.
You have to have that best outside investment. Yes, you are taking some risk by not paying off the mortgage and investing in something that is not a guaranteed risk-free rate of return. The question is: what risk? From what I’ve reviewed, this is a low risk for people who have extra cash they don’t need to take care of food, utilities, and other essentials. .
Why do people pay off their mortgages sooner and what are some other strategies to achieve these goals?
Much of the rationale for prepaying the mortgage itself is, the cost of the mortgage is higher than the return on any risk-free investment. Yields on AAA-rated treasury bills or municipal bonds are all well below 3, 4, or 5 percent. The other reason, I believe, is psychological: to avoid having to make this important monthly payment. I use my grandmother as an example. My grandmother grew up during the Great Depression and made it a rule never to go into debt. This decision was very heartwarming, psychological and financial, but I also think that this decision limits your financial potential.
This is where people’s tolerance for risk comes in. The most obvious thing is to say that you are just saving money and your savings increase. If you want to invest in something risky like the stock market, they can grow, but they can also contract. Over sufficiently long horizons, the probability of these contractions decreases, it is a fact, but the size of these contractions increases.
I own and these are issues that I am struggling with. What alleviated my worries is that I am on firewood, I have enough savings to cover a few months of my mortgage and any other expenses that may arise. At the end of the day, it’s: do you want the money in the house or the savings account? That’s it. I live in the suburbs of Philadelphia. It’s not San Francisco, Palo Alto, LA, where my house appreciates 8% every year. Do I want all my wealth and savings to be tied up where they are growing at a low rate and it’s really illiquid? Compared to a savings account where I can withdraw it at any time and practically at no cost. I took the risk with these riskier investments it’s a good bet.
It is certainly a unique period in the mortgage market. I bought a house in 2004 and my mortgage broker, who was a good friend, told me at the time that it was the best time to buy because mortgage rates can’t go below 5% .
It’s very easy to get lost in all the pros and cons and arguments, but at the end of the day, it’s just where do you want your money: in the house or in a savings account, and which one pays the most. ?