Why paying off your mortgage faster isn't always the best move
This article will look at the idea of why paying off your mortgage faster isn’t always the best move through the lens of ‘Opportunity Cost.’ Before leaning into paying down any debt as aggressively as possible, it’s worth stepping back and examining the ‘big-picture’ situation.
The advice to get out, and stay out of debt is given by hundreds of advisers and thousands of articles online. The advice isn’t ‘wrong’, but it might be incomplete. Financial life is like real life - it’s complicated.
Opportunity cost is an expression from economics. It means the “cost” of a decision is the next best option.
Being fixated on using your incoming cash flow to paying down a mortgage can blind you to other things you could be using that money for. Paying off your mortgage faster can be psychologically pleasing, but it can come at the expense of other moves that are a bit more financially savvy.
The obvious example is Bad Debt. Mortgages tend to be regarded as good debt because often the value of your home increases over the long term. Setting aside market corrections and economic slumps, over all the trend in vast sections of the country’s real estate prices are upwards over a long time horizon. You spent money on something that increases in value.
Bad debt means spending money on things that decrease in value.
There’s also a good chance you’re paying higher interest too.
It’s a given you should pay down credit card debt before looking at anything else. For any of your other debts, they can be prioritized in order of highest interest to lowest interest rate. This is better strategy than simply paying off your mortgage faster to increasing your overall cash flow and long term net worth.
While looking at interest rates of various forms of debt, one might forget that when mortgage interest rates are low, the chances of finding investment options with a good yield are higher.
If the average return is larger than the mortgage rate, every dollar you invest gives you a net-positive result over simply throwing it on the mortgage. Add to that, their are tax benefits of using an IRA to invest that dollar.
You’d be losing money by paying off your mortgage faster.
Granted, results in investing are not guaranteed. But remember we’re talking about long time horizons here. With the increasing popularity in index fund investing and robo investors, it’s not that far fetched to be able select a portfolio that over time will work in your favor and that will require very little work on your part to maintain.
Imagine a scenario where a person is so adamant about paying down their mortgage that they’re left with minimal cash housed in the bank. Then a week later that person loses their job and is unemployed for an indefinite period of time. Was paying off your mortgage faster yesterday worth the jeopardy your mortgage is in today?
The emergency fund is called that because predictable things happen at unpredictable times.
Cars break down, jobs get lost, children need braces, or any number of other unexpected expenses. It’s insurance against those things happening at a time when you are financially at your weakest. The suggestion of three-to-five months savings is a guideline. Maybe you’ll need less, maybe more.
Insurance - particularly health insurance - becomes more important as we move through life.
Unexpected medical expenses build up enormously fast. “Not getting sick” isn’t a plan, nor is “Don’t let the house burn down.” A responsible person needs to look at potential risks and mitigate them as much as possible. Don’t take risks with your health or your property just because you don’t like owing the bank money.
Connected to the above point of investing, your retirement planning should be considered. If you neglect your retirement accounts, you may end up having to get a reverse mortgage to fund your retirement anyways.
If your employer has a 401(k) matching plan, you should be taking full advantage of that - otherwise it’s money left on the table. Both the traditional and the Roth IRA have tax advantages to consider.
To expand on the above example, if you found an investment with higher returns than your mortgage's interest rate, purchasing that investment through a Roth IRA would allow those earning to grow tax free. Improving the compounding effect further.
You’ll lose tax benefits
The IRS allows you deduct interest paid on home equity up to $100,000 for married couples filing together and $50,000 for married couples filing separately. Paying off your mortgage faster means you pay down the principle faster and ergo have less interest expense you can deduct at tax season.
Granted, the tax deduction most likely won’t outstrip the amount you would save on interest.
Because of the ways mortgages are structured, you pay more interest at the beginning of the loan and progressively less every month. Ergo the tax benefit helps you more at the beginning of the loan than it does down the road.
However, this should be taken into consideration of the bigger picture plan. Getting a bigger tax return for a few years can be used in tandem with other strategies to maximize your net worth in the long run. It depends on your income / federal tax bracket, as well as individual state income tax. Check with your accountant on this one.
Sacrificing things like vacations or eating out is a personal choice. Being aggressively frugal does have it’s drawbacks along with it’s advantages.
But it’s worth looking at things through the lens of what you want the end result to be, and what tools you have to get you there. Examining the whole picture through the lens of ‘Opportunity Cost’, you might find yourself changing your mind about the efficacy of paying off your mortgage faster at the expense of the other places you could be utilizing your money.