Nobody likes being in debt, and for most homeowners, mortgages are the biggest debt burden. While paying off your mortgage can be an important psychological milestone, it may not be the best financial decision in the long run, especially if you do it instead of paying off debt with a lower balance and higher interest. Michael Roberts, William H. Lawrence professor of finance at the Wharton School of Business at the University of Pennsylvania, explained why investing that money in other goals might be a better strategy. Our conversation has been edited for clarity.
Should people pay off their mortgages ahead of time if they can? Why or why not?
It really depends a lot on how your mortgage and other expenses fit into the broader context of your budget, as well as your risk tolerance and what kind of risk you are willing to take. In addition, there are a number of pros and cons associated with early repayment of a mortgage.
This becomes much less clear, especially in the context of the really low interest we find ourselves in. Let’s think about the pros and cons.
On the other hand, you are going to pay off future interest expenses and cut down on future monthly expenses. You will also increase the capacity of future debt, which is a fancy expression as it will be easier for you to borrow in the future because you will not have that much hanging over you. If you are in PMI (private mortgage insurance), you will get rid of it sooner. This reduces the psychological burden because some people are under stress.
But there are a lot of downsides that people don’t think about. If you pay your mortgage ahead of schedule, you will not saving this money. Depending on what you earn from your savings, you may be throwing away a lot of money. Over the past 14 years, it has come as no surprise to me not to pay off my mortgage because I have made more investing in the stock market than I paid my 4.5% on my mortgage, but this is the best choice at its best because I got lucky that the market did well.
The nice thing is that, unlike at home, savings are liquid. If I need cash, I can sell the stock, liquidate the ETF, whatever it is. If I don’t sell the house, I’ll have to rent equity line of credit or several reverse mortgage or a mortgage in the second pledge. The monthly payments actually impose some discipline on some people.
If you have other debt with higher interest rates, paying off your mortgage early makes absolutely no sense because you need to get rid of the higher interest debt first. If all your capital is tied to your home, there will be less diversification.
What are the benefits of keeping the mortgage for the entire term?
To elaborate on some of the things we’ve touched on, it can be said that keeping all your money at home can be really problematic when you need it. The illiquidity of your home asset is usually underestimated. Depending on your tax status, you also get interest protection. By paying off your mortgage faster, you lose this deduction.
Be aware that the average stock market return was 11 percent. mortgage rates have been below that level for 30 years, it sounds like an easy task: if I just put my money in the stock market for 20 or 30 years, I’ll have a ton of money more than if I paid off my mortgage earlier. You can’t think about it like that. Moreover, how much can I lose if I didn’t pay off my mortgage ahead of schedule? If things go wrong, you will lose a little money compared to paying off your mortgage early.
You must have the best outside investment. Yes, you are taking some risk by not paying off your mortgage and investing in something that doesn’t guarantee a risk-free rate of return. The question arises: how big is the risk? From what I’ve seen, there is a low risk for people who have money to spare that they don’t need to take care of food, utilities and other necessities.
Why do people pay off their mortgages ahead of schedule and what are other strategies to achieve these goals?
The main reason for paying a mortgage ahead of schedule is that, strictly speaking, the cost of the mortgage is higher than the return on any risk-free investment. The yield on Treasury bonds or AAA-rated municipal bonds is well below 3, 4, or 5 percent. Another reason, I believe, is psychological: getting rid of the need to make that significant monthly payment. I am using my grandmother as an example. My grandmother grew up during the Great Depression and made it a rule to never borrow. This decision was a huge comfort, psychological and financial, but I also think that this decision limits your financial potential.
This is where people’s risk tolerance comes into play. The most obvious thing is to say that you are just saving money and watching your savings grow. If you are going to invest in something risky, such as the stock market, it may rise, but it may also shrink. Over a long enough horizon, the likelihood of these reductions decreases, it is a fact, but the size of these reductions increases.
I am a homeowner and I am trying to solve these problems. What alleviates my fears is knock on wood, I enough savings take care of several months of my mortgage and any other expenses that may arise. After all, this is: do you want the money to be at home or in a savings account? That’s all. I live in the suburbs of Philadelphia. This is not San Francisco, Palo Alto, Los Angeles, where is my home appreciates 8 percent annually. Do I want all my wealth and savings to be tied up where they grow at a slow rate and are truly illiquid? Compared to a savings account where I can pull it out anytime for virtually no cost. I took the risk with this more risky investment, which is a good bet.
This is definitely a unique time for the mortgage market. I bought a house in 2004 and my mortgage broker, who was a good friend of mine, said at the time that this was the best time to buy because mortgage rates cannot go below 5 percent.
It’s really easy to get lost in all the pros and cons and arguments, but at the end of the day, this is exactly where you want your money: in a house or in a savings account, and which one earns the most?