This article was written for Consumerism Commentary by Adfecto, a mid-20s guy with a masters degree in engineering. He aspires to be wealthy and writes frequently for his own blog, Adfecto Abundantia.
When I purchased a home it was not a lifetime commitment. I view a person’s choice of housing first as a financial decision and second as a lifestyle decision. A house gives you place to live and the added bonus of potential price appreciation and tax deductions on mortgage interest. If it is cheaper to rent then by all means that is the way to go. Owning your own home can also give you a tangible increase in your standard of living, but personally that is considered a distant second when compared to the financial benefits. What I find interesting is that so many people tend to make emotional decisions about the home rather than rational ones.
Frequently, when home owners find themselves with a little extra cash at the end of every month, the idea of paying off the mortgage is often brought up. Is early payment the right way to use the money? Should the money be invested instead? Is my real motivation to build wealth or to play it safe?
The first step in analyzing this decision is to compare the interest rate on the mortgage to expected investment returns. Historically the S&P 500 with dividends reinvested has returned 10.43% annualized from January 1926 to December 2007, and the current rate for a fixed 30 year mortgage is about 5.76% according to www.bankrate.com. Based on this simple comparison it is plain to see that in the long run you will build more wealth by investing than by prepaying your mortgage.
If you want to further hone this comparison of rates, next you can consider not just the entire history of the stock market, but also every 30 year rolling period of stock market data. Since 1953 the S&P 500 has returned at least 9.34% over every 30 year period which is again well above the interest rate for a 30 year mortgage. Plowing your money into prepaying your mortgage has a huge opportunity cost that will hurt your ability to build wealth.
Why then would people consider prepaying their mortgage? Most people consider their home as a safe investment, and paying off a mortgage as a guaranteed return. A certain piece of mind comes from owing the bank less money. There is a big problem with this argument; there is still a great deal of risk involved with your primary residence!
Some of this risk comes from the fact that the value of real estate is not fixed. It absolutely goes both up and down as many people in Florida, California, and all over the country are now experiencing first hand. Every dollar that is put into a residence is not necessarily money you will get back when you sell.
Additional risk comes from the fact that until your loan is paid in full, the bank still holds the mortgage on the property. The bank will not give you credit for the extra payments made to pay down the debt if you start to struggle further down the line. Even if you are way ahead on your mortgage, a hardship may cause you to miss payments. The bank can foreclose even if you spent years paying down the mortgage balance early.
Investing your free cash into your mortgage is very similar to investing in a bond. It may seem odd, but you are literally investing in a fixed income asset, the mortgage, lent to yourself. The return you get will be equal to the interest you would otherwise pay on your mortgage. One problem that arises is that the bank has first crack at the collateral; your house. Even worse, your mortgage isn’t even a very good deal when compared to the types of bonds; for example, Toyota AAA rated bonds currently pay as much as 7.652%. I bet your mortgage rate isn’t that high.
Furthermore, understanding the nature of your mortgage as a bond brings to light another risk; improper asset allocation. Mortgage prepayment shifts your asset allocation to rest more heavily in fixed income type investments than you might otherwise consider. A 40 year old person should have at least 60% but more likely 80% percent of his/her portfolio in stocks, but add in all of that mortgage prepayment in the bond category and you may find yourself far out of line from you ideal asset allocation.
Another risk related to mortgage prepayment is a lack of diversification. You may think that your mortgage is not very risky because you believe in your own ability to pay. This personal bias can cloud a person from see the true risk factors such as job loss, poor real estate conditions, natural disaster, and a plethora of others. A single unfortunate event can wipe out a large chunk of the equity. A single job loss may bring about a short sale or foreclosure that could wipe out the value of your home. Would you advise someone in your circumstances to invest in individual mortgages? I sure wouldn’t, and neither should you.
Deciding whether or not to prepay a mortgage is another financial and lifestyle choice which depends on several factors, but most of all it is a choice between building wealth (logical) and piece of mind (emotional). People who focus on paying off their mortgage seem to be more in love with their house and the idea of having it paid off than the goal of building wealth. These people are also blind to the risks that come from investing too much of their finances in a single residential structure. I think that for the majority of people the “right” decision would be to keep the mortgage and invest the extra money.
Image credit: Oracio
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Updated January 12, 2012 and originally published February 21, 2008.