Wharton finance professor Michael R. Roberts reexamines whether, in the current financial climate, homeowners would be better off investing their excess money rather than using it to pay down their mortgage.
In this opinion piece, Wharton finance professor Michael R. Roberts reexamines whether, in the current financial climate, homeowners would be better off investing their excess money rather than using it to pay down their mortgage.
A little more than two years ago, I made the suggestion that people should reconsider paying off their mortgage. Feedback from readers was constructive and thought-provoking. Since then, interest rates have skyrocketed along with inflation, raising the question, “How does this new economic environment bode for paying off one’s mortgage?” I’d like to revisit the topic and address some of the points I didn’t cover in my earlier piece.
Whether your opportunity cost is higher or lower than your mortgage cost will determine whether you should pay off your mortgage early. That opportunity cost was less than the majority of mortgage rates two years ago, when interest rates on safe investments were almost zero. Therefore, in order to defend allocating additional funds to savings rather than mortgage repayment, homeowners had to assume some risk and adopt a long-term perspective.
Well, everyone’s opportunity cost skyrocketed over the last year. The Federal Reserve’s monetary policy has raised the federal funds rate by 5% since March 202022 in an effort to combat inflation. Today, in May 2023, we can invest in Treasury bills, all of which earn over 4. 5%. Several high yield savings accounts and CDs are offering over 4. 5%, as well.
If your mortgage rate is below 4. 5%, say 3. 0%, then paying down a mortgage early is quite literally turning down extra money and safety. The 3. 0% interest expense you’re saving is less valuable than the 4. 5% you could be earning even after accounting for taxes. And, the savings accounts, CDs, and T-bills are backed by the U. S. federal government, whereas your equity in real estate is not. [1].
A mortgage is a big financial commitment, and many homeowners wonder whether it’s better to pay it off at the beginning or end of the year. There’s no one-size-fits-all answer, as the best approach depends on your individual circumstances. However, by considering the pros and cons of each option, you can make an informed decision that’s right for you.
Advantages of Paying Off Your Mortgage at the Beginning of the Year
- Lower interest payments: By paying off your mortgage early, you’ll save money on interest payments. This is especially beneficial if you have a high-interest rate.
- Faster payoff: Paying off your mortgage early means you’ll be debt-free sooner. This can give you peace of mind and free up your monthly cash flow for other expenses or investments.
- Tax benefits: In some cases, you may be able to deduct mortgage interest payments from your taxes. However, this benefit is phased out for higher-income earners.
Advantages of Paying Off Your Mortgage at the End of the Year
- Maximize tax deductions: If you itemize your deductions on your tax return, you can deduct the mortgage interest you paid during the year. This can save you money on your taxes.
- More flexibility: If you’re unsure about your financial situation, waiting until the end of the year to pay off your mortgage can give you more flexibility. This way, you can make extra payments if you have extra cash, but you’re not obligated to do so.
- Potential investment opportunities: If you have other investment opportunities that offer a higher return than your mortgage interest rate, it may make sense to invest your money instead of paying off your mortgage early.
Considerations
- Prepayment penalties: Some mortgages have prepayment penalties, which means you’ll have to pay a fee if you pay off your mortgage early. Be sure to check your mortgage agreement before making any decisions.
- Opportunity cost: Paying off your mortgage early means you’re giving up the opportunity to invest your money elsewhere. Consider whether you could earn a higher return on your investment than you’re paying in interest on your mortgage.
- Emergency fund: It’s important to have an emergency fund in case of unexpected expenses. Before you pay off your mortgage early, make sure you have enough money saved to cover any potential emergencies.
Tips
- Make extra payments: Even if you can’t pay off your mortgage early, making extra payments can save you money on interest and help you pay off your mortgage faster.
- Refinance your mortgage: If you have a high-interest rate, refinancing your mortgage to a lower rate can save you money on interest payments.
- Talk to a financial advisor: A financial advisor can help you create a financial plan that includes your mortgage and other financial goals.
The best time to pay off your mortgage depends on your individual circumstances. You can choose the best course of action for you by weighing the advantages and disadvantages of each option. For advice if you’re unclear of what to do, speak with a financial advisor.
Frequently Asked Questions
Q: Is it better to pay off my mortgage early or invest my money?
A: It depends on your individual circumstances. Paying off your mortgage early might make sense if it has a high interest rate. However, it might make more sense to invest your money if you have access to other investment opportunities that provide a higher return.
Q: How much money do I need to save to pay off my mortgage early?
A: The amount of money you need to save to pay off your mortgage early depends on your mortgage balance, interest rate, and the amount of time you have left on your mortgage term You can use a mortgage calculator to estimate how much money you need to save
Q: What are the tax benefits of paying off my mortgage early?
A: In some cases, you may be able to deduct mortgage interest payments from your taxes. However, this benefit is phased out for higher-income earners
Q: What are the risks of paying off my mortgage early?
A: There are a few risks to consider when paying off your mortgage early. First, you may have to pay a prepayment penalty. Second, you may give up the opportunity to invest your money elsewhere. Third, you may not have enough money saved to cover unexpected expenses.
Q: Should I talk to a financial advisor about paying off my mortgage early?
A financial advisor should be consulted before making any decisions regarding early mortgage payoff. You can set financial goals and include your mortgage in a financial plan that is created with the assistance of a financial advisor.
Argument 1: Paying Off My Mortgage Early Reduces Income Uncertainty
Your ability to pay your mortgage could be taken away from you if you lose your job or are forced to take a job that pays less. Consequently, you could lose your home. Paying off a mortgage quickly eliminates a significant expense and mitigates this concern.
However, consider two scenarios.
Scenario 1: You utilize your surplus funds to reduce your mortgage early, and as a result, you become unemployed. This is a bad idea, unless you want to live out a scene from Game of Thrones for a few months until the sheriff kicks you out. Why? You have no savings. You have nothing to pay bills — utility, maintenance, tax, grocery, medical. So, you can take advantage of your debt-free house for a few months while you pray for steady weather, practice hunting so you can provide for the family, and hope for moderate weather. Sadly, this won’t last long because you will eventually be forced to leave your home and have it auctioned off by the state due to unpaid taxes.
What about all that home equity? To access it, you have two options. One option would be to obtain a reverse mortgage, but the terms would not be as advantageous as those of a first lien mortgage, and this would negate the benefit of early mortgage payoff. As an alternative, you could sell the house, but doing so would negate the benefit of lowering your mortgage early in order to retain your house. Even worse, should you be compelled to sell your house, you will need to hope that the market is favorable to sellers and understand all of the costs involved in doing so (agent commission, transfer and title fees, etc.). ), and not let your financial distress adversely affect your ability to negotiate the sale price.
Scenario 2: You have money saved up and can use it to get by while you hunt for a job or a better one. Better yet, barring a fortunate break in the local real estate market where your home’s value increased dramatically, you have even more money than you would have if you had paid down the mortgage earlier because your savings were earning more interest than the mortgage was costing you. Lastly, since you can afford your mortgage payments, you might be able to keep your house or at least avoid having to sell it under duress.
The comparison’s main argument is that, in the event of a job loss or other unfavorable income shock, choosing to pay down a mortgage quickly does not mean choosing to stay in your current residence or not. The decision is to pay off a low-interest loan and lock money away in a risky, illiquid asset or to save money and invest it in a high-interest, safe, liquid option. It’s hard to argue, on financial grounds, for the former.
Argument 2: Paying Off My Mortgage Early Reduces Interest
The amount of interest you pay overall over the course of the loan is decreased when you pay off a mortgage quickly. This logic is also behind arguments favoring shorter maturity mortgages.
For example, a $500,000 mortgage at 5% over 30 years has monthly payments of approximately $2,684. Over 30 years you’ll pay a total of $966,279 or $466,279 of interest. With monthly payments of $3,954 and total interest of $211,714 over the loan’s life, a 15-year mortgage with the same rate appears to save $254,565. While this sounds impressive, the calculation and figure mean nothing at all unless your savings plan consists of shoving cash under your mattress.
Due to opportunity cost, a dollar of interest in thirty years will be significantly less expensive than a dollar of interest today. How much? At a current savings rate of 4. 5%, that $1 of interest 30 years from today is worth $0. 27 today. It makes no more sense to add money that you pay (or receive) at different times than it does to add different currencies. We wouldn’t add 100 U. S. dollars and 100 British pounds and say we have 200 “currency. ”.
So, homeowners have to recognize the opportunity cost of money. We will have more than enough money in the future to cover the interest expense if we start saving now at an interest rate higher than our mortgage payment.