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 Financial Analysis and Exploration of Alternative Strategies
In today’s dynamic economic climate the decision of whether to pay off your mortgage early can be a complex one. This article, drawing insights from Wharton finance professor Michael R. Roberts, delves into the factors to consider and explores alternative strategies to help you make an informed choice.
The Opportunity Cost of Early Mortgage Payment
Opportunity cost is the key question: in the current economic climate, with interest rates on safe investments like Treasury bills exceeding 4 percent, is the potential return on alternative investments greater than the interest rate on your mortgage? Five percent of the time, paying off a mortgage at a lower interest rate might not be the most financially advantageous course of action.
Alternative Strategies for Your Extra Money
Instead of channeling extra funds towards early mortgage payments, consider these alternative strategies:
- Invest in High-Yield Savings Accounts or CDs: With interest rates on these accounts exceeding 4.5%, you can potentially earn a higher return on your money while maintaining liquidity.
- Invest in the Stock Market: While the stock market carries more risk than savings accounts or CDs, it also offers the potential for higher returns. However, this strategy requires careful consideration of your risk tolerance and investment goals.
- Build an Emergency Fund: Having a readily accessible emergency fund can provide peace of mind and financial security in the event of unexpected expenses or income disruptions.
Addressing Counterarguments for Early Mortgage Payment
Counterargument 1: Early Payment Reduces Income Uncertainty
Although paying off your mortgage early can save you a lot of money each month, it also reduces your available cash. Should you lose your job or have your income reduced, it might be difficult for you to pay other bills. Building an emergency fund and exploring alternative income sources can mitigate this risk.
Counterargument 2: Early Payment Reduces Interest
It’s important to take into account the opportunity cost of paying off your mortgage early, even though doing so lowers the total amount of interest paid over the course of the loan. In the event that investing your money elsewhere yields a higher return, the interest you save on your mortgage might not be as substantial.
Counterargument 3: Early Payment Forces Savings
While paying off your mortgage early can encourage saving, it’s essential to diversify your savings and avoid overconcentration in a single asset. Consider building an emergency fund, investing in a variety of assets, and exploring other savings strategies.
Counterargument 4: Early Payment Has Psychological Benefits
The psychological benefits of being debt-free are undeniable. However, it’s crucial to weigh these benefits against the potential financial costs. Consider exploring alternative strategies that can provide both financial security and a sense of accomplishment.
In today’s economy, paying off your mortgage early may not always be the most financially advantageous decision. By carefully considering your financial goals, risk tolerance, and alternative investment options, you can make an informed choice that aligns with your overall financial well-being. Remember, a balanced approach that prioritizes both financial security and psychological well-being is key to navigating the complexities of the current economic landscape.
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.
Should You Pay off Your Mortgage Early? THE TRUTH
FAQ
Is there a downside to paying off mortgage early?
Is it better to pay off mortgage or keep money?
Is it better to be mortgage free?
At what age do most people pay off their mortgage?
Should I pay off my mortgage early?
Each month that you make a mortgage payment, some money is going toward interest — so the fewer payments you have, the less you will pay in interest. Paying off your mortgage early could save you tens of thousands of dollars. (Just make sure to clarify with your lender that all extra payments will just be going toward your principal, not interest.)
Should you pay off your mortgage 4.5 years early?
On a $150,000, 30-year loan with a 6% interest rate, a single extra payment every year will help you pay off your mortgage 4.5 years early, saving 56 months’ worth of payments. 3. Refinance To A Shorter Loan
Should you delay paying off your mortgage?
So all things being equal, it often is wise to pay that off. However, if you urgently need to boost your retirement or emergency funds, or if you have corrosive debt like an unpaid credit card, it can make sense to delay paying off your mortgage. Here’s how to approach it.
Should you pay off your mortgage?
Paying down and getting rid of bad debt is important. Nobody needs to be climbing the financial ladder with that kind of baggage in tow. But if you want to really grow your wealth, paying off your mortgage won’t let you go as far or as quickly as the prudently leveraged property will. Here are some points to ponder: