Don’t pay down your mortgage!

Why paying down your mortgage isn’t always the best choice

“Should I pay down my debt?”

Ask this question to any financial professional and you will likely get a positive response. Absolutely, yes, it is never a bad idea to pay off/pay down debt. It is such common sense wisdom that you would probably get the same response from your mom and dad, sibling, coworker, and so on. I would even guess most children know it isn’t a good idea to borrow something from a friend and keep it for too long. And for good reason. Paying off debt is a successful plan of attack for nearly everyone.

So there you have it, the standard common sense answer…. But instead, here is your “it depends” answer:

All debt isn’t the same.

Built into the timeless wisdom of “pay your debts” is a hidden assumption that we need to look at closer. Yes, as mentioned above, paying off all of your debts is likely a good idea for anyone. However, this good idea can be more or less beneficial to your financial situation depending on what type of debt you’re looking at. When it comes to debt, there are nearly limitless examples of ways you can borrow money. Let’s break down a few of the most common examples, starting with the worst.

1. Payday and Cash Advance loans: High interest, short term loans that are secured only with a future ability to pay. Often associated with very high interest rates (subject to state law).

2. High interest Consumer Debt: Credit cards, store cards, and other lines of credit with very high interest rates. Often associated with some form of loyalty program, cash back, or other card-holder perks to encourage use of the card and increased spending.

3. Introductory/promotional rate consumer date: This Jekyll and Hyde debt, while similar to credit card debt, does have a beneficial characteristic. It typically features lower or 0% introductory periods that, if used properly, can be a beneficial way to finance a necessary purchase. However, any benefit of a low intro offer is quickly overtaken by high interest and penalties if payments are missed or the balance is not paid off in time.

4. Auto loans: This is where most financial professionals will begin considering “acceptable” types of debt. Since transportation is necessary for most people, auto loans can be a good choice for consumers not able to pay for a car in cash. While some auto loan terms and rates can be harmful, most auto loans have reasonable interest rates and terms since they are secured with the auto purchased.

5. Student loans: Another type of “acceptable” debt, student loans carry lower interest rates than consumer debt because they are backed by a presumed future income based on the education received. Further, many of them are secured by the federal government making them a relatively safe investment for the lender. An added benefit to student loans is the deductibility of interest paid on your tax return (subject to income limits).

6. Mortgages: Of our list, mortgages are the most “beneficial” type of debt. Traditional types of mortgages carry reasonable interest rates and are secured by the home or property purchased. As with student loans, interest paid on mortgages is deductible on your tax return (limits apply). More importantly, mortgages are the most common debt associated with something that will likely appreciate in value; your home.

There are so many types of debt and different characteristics to each one that applying the same wisdom to each seems absurd. Yes, aggressively paying off the first 3 or 4 examples listed above will always make sense, but this isn’t the case with more beneficial types of debt. This is where the “it depends” answer begins.

Your home and your mortgage:

When it comes to your mortgage, there are a few factors affecting the health or harm of the debt. They are:

1. Equity: This is how much of your home you actually own (your home value minus your loan balance). As your home value increases and mortgage decreases, your equity (or ownership) in the home will grow.

2. Term/type: The most common terms provided for mortgages are 30 and 15 year fixed rate mortgages. These types of loans guarantee the same rate for the entire length of the note. Adjustable Rate Mortgages (ARMs) keep your rate level for a introductory period (3-7 years) and then adjust annually along with federal interest rates.

3. Interest rate: Simply, the amount of interest charged on your mortgage balance annually.

When you should pay down your mortgage.

Before discussing reasons why you shouldn’t pay down your mortgage, there are many times that you should consider doing so. Besides the common sense wisdom of paying down debt, there are a few unique scenarios in which you may find yourself in:

1. Negative Equity aka “underwater”: If you owe more on your home than it is worth, you should consider paying extra towards the mortgage at least until you have positive equity in your home. Positive equity affords you freedom to sell your home without owing money to the lender at closing. It can also help make low interest home equity loans available should you wish to make expensive repairs or improvements to your home.

2. Adjustable Rate (ARM) mortgages: ARMs typically have lower interest rates associated with the introductory period. If you have an ARM it is generally a good idea to pay more towards your mortgage for two reasons.

1) When rates are low, more of your extra payment is going towards your principal and will help make future higher rates less harmful.

2) When rates are high, paying down your debt is a good idea just like other type of higher interest rate debt.

3. Higher interest rates: Most importantly, how much is the debt costing you. If you secured a fixed rate mortgage in the last 20 years, most likely you have a very reasonable interest rate below 5% or better. If you have a rate higher than 6-7% I would consider paying down your mortgage. This can be viewed as a “guaranteed return” on your extra payment. For example, at a 6% interest rate an extra $100 payment this month will provide $6/year in savings. While that may not sound like a lot, over many months and along with the magic of compounding those extra payments can make a large difference. In fact, the higher the interest rate, the greater the difference it can make.

4. You’re close to retirement: If you’re close to retirement, your mortgage payment might be a barrier to achieving your goal. This isn’t a math or interest rate issue; it is a cash flow issue. Perhaps you have 7 years left on your mortgage but you would like to retire in 5 or 6 years. In this scenario, paying down your mortgage achieves two goals:

1) You save money on interest and pay off your mortgage sooner.

2) Once your home is paid off, that mortgage payment is removed from your cash flow (along with the extra payment you were adding). Eliminating that large fixed expense could possibly be the difference maker in achieving your goal of retiring sooner than your mortgage would otherwise allow.

Why you shouldn’t pay down your mortgage.

If you have a low interest (5% or lower) fixed rate mortgage and currently have positive equity in your home, here are the reasons you should consider not paying down your mortgage, what to do instead, and how it can benefit you.

1. Establish/increase liquid savings: If you don’t have 3 months of expenses saved in an emergency fund, this should be your first priority over paying down your mortgage. While most savings accounts won’t offer much of a return above your mortgage rate, the difference in having money in an emergency fund is liquidity. That is, the ability to access your money when you need it. Once you pay extra money to a mortgage lender, that’s it, you can’t ask for it back. In fact, even if you pay $10,000 extra towards you mortgage this month your lender will still be there next month asking for the minimum payment. While extra money towards your mortgage increases equity in your home, that equity acts as a vault for the money invested. That is, it takes some effort (and more borrowing) to get that money out should you need it. However, if your extra funds are placed in a savings account or money market, you can access that money whenever you need it (which, by the way, can help avoid the higher interest consumer debt mentioned above).

2. Invest instead: According to Investopedia, over the last 57 years, the stock market has provided a return of over 10% annually based on the S&P 500. By investing any extra cash into an index fund or ETF instead of your mortgage, you are choosing to receive a higher rate of return on your investment over time. For instance, if you have a $500,000 mortgage with a rate of 3% and the stock market averages a return of 10% over the next 30 years, here is the difference of an extra $100 a month towards your mortgage vs investing:

1) paying $100/month towards your mortgage: You will pay off your mortgage 2.2 years early and save $53,943.30 over the life of the loan.

2) investing $100/month in a S&P 500 index fund: You won’t save any money on your mortgage or pay it off any sooner, but in 30 years you will have a mortgage balance of $0 and a portfolio balance of $226,048.79.

Why such a large difference? The over $170,000 difference in strategies lies in the difference between the interest rates. That 7% difference between paying down your mortgage and investing in the stock market, over time, compounds to a large difference. If you’re concerned with losing a tax benefit, remember the interest paid on your mortgage will still be deductible, and if you choose to invest the extra money in a tax deferred retirement account (401k) then you receive a tax break on your extra investment, too. It is important to note that, while the stock market produces 10% on average, future returns will vary and you will likely lose money in some years. This is a long term strategy and will pay off over decades. Stay patient!

3. Your home value doesn’t care how much you owe on it: Your home value is important. There are debates on whether a home is technically an investment or not, but either way the value of your home matters. It matters to your freedom to move, ability to borrow against it, and as a legacy to your heirs.

Once you purchase your home, it is important to realize that the value of your home only depends on what someone is willing to pay for it. It doesn’t matter how much you paid for it. It doesn’t matter what type of mortgage or rate you got, or even if you rolled equity from a previous home. Most importantly, it doesn’t matter how much you owe on it. Your home value is and will always be what someone else (i.e. the “market”) is willing to pay for it.

Why is this important? Let’s revisit the example I provided above. You buy a home worth $500,000 and decide to execute option 1 and pay down the mortgage or option 2 and invest the extra payment instead. We saw the dramatic effect the difference in strategies have, but we ignored one important part: your home value. On average, home values have increased 4% annually over the past thirty years (according to credit karma). That means that, regardless of your choice to pay down your mortgage or invest, your $500,000 home will likely be worth $1.2 million dollars (don’t get too excited, that barely beats inflation). The point is, your home will be worth whatever it’s worth regardless of how fast or slow you pay it down. On the other hand, savings accounts, brokerage accounts, and investments are DIRECTLY related to how much you invest. Given the choice, put your money to work for you.