Although it may be tempting to pay off all your debt early if you are able, there are benefits to not paying off your mortgage early. This is an unpopular opinion, but for many people, there are ways to better allocate the money than paying extra on your mortgage.
How Mortgages Work
A mortgage is a special kind of loan created especially for real estate. A lender (bank, savings and loan, insurance company or individual) loans money to a borrower, often for an extended length of time. Fifteen- or 30-year mortgages are common, but other terms can be arranged.
The lender and borrower agree the property is collateral for the loan. A car loan is like this, too; if you miss a few payments your car can be repossessed. With a mortgage, this is called foreclosure – the lender obtains title to the real estate and can sell it to recover any unpaid loan balance.
From a lender’s standpoint, this is a very safe loan. The borrower makes monthly payments of principal and interest. If they default, the lender can sell the property to be repaid. A detailed process of appraisals, credit applications, and requirements for taxes and insurance protect the lender.
This is good for the borrower, too. The main benefit is low interest rates. Rates are lower than you’d get for a bank loan or credit card loan, and often lower than a car loan.
So with a mortgage, both parties benefit – the lender gets a solid long-term return with very low risks, and the borrower gets money to buy a house with a good interest rate and favorable monthly terms. (For related reading, see: Understanding the Mortgage Payment Structure.)
Use Your Money for Other Expenses
Because this situation is a win-win for everyone involved, it is surprising when people are in such a hurry to pay it off. Personally, if someone will loan me a lot of money for a very low price, I’ll use it for as long as I can.
There are three main points to consider before putting all of your extra money toward your mortgage payments:
- Flexibility: Money paid toward the mortgage is not available for other uses. Some people will send an extra amount to the mortgage lender each month even while they are carrying a balance on credit cards or ignoring a family emergency fund. Extra monthly payments reduce financial flexibility, which can be valuable.
- Foreclosure risks: People fear foreclosure even though it is a remote possibility. Let’s say you have an extra $15,000 you could pay against the mortgage principal. It would be better to hold it in the bank than put it toward your mortgage. If you do this, you’ll have months of payments set aside as you look for work. Cash and other investments reduce foreclosure risk. Yes, you’ll pay some interest on the mortgage, but the extra security and comfort is worth it. (For related reading, see: Saving Your Home From Foreclosure.)
- Opportunity costs: You can use the extra money you have in a better way. Whether that is more education or a fruitful business or investment idea.
How to Better Allocate Your Extra Payment Money
If you're still not convinced, let’s look at some numbers.
To keep things simple, let’s assume a house purchase of $125,000. We’ll put 20% down and finance the remaining $100,000 with a 30-year mortgage. At. 3.7% interest, monthly payments will be $460.28 for principal and interest. If you stay in this house and make all 360 payments, you will have paid $65,700 in interest to the lender. That sounds like a lot of money, and most people focus on that number. Any extra payment each month reduces the principal and, therefore, total interest.
If you send an extra $100 each month, you’ll pay off the loan in less than 22 years and save $20,249.86 in interest. No wonder people send that extra check each month, right? But that is only part of the picture. It’s the easy part, which is why people fixate on it. We’re going to dig a bit deeper.
In 21 years and eight months, you’ve spent $26,000 in extra principal payments to save $20,249 in mortgage interest. What if you invested that $100 each month instead? If you sent that same $100 a month off to a bond fund earning 4% each year, it would have grown to a healthy $42,461 after 260 payments. In a balanced fund (half stocks, half bonds) growing at just 6%, it would have blossomed to $54,995.70. In a growth fund (all stocks) compounding at 8%, it would have become a bountiful $72,256.67.
None of these are guaranteed, of course, but each of them is a decent estimate over 20 or more years and is better than spending $26,000 to save $20,249 in mortgage interest. Even if you don't earn a penny investing, you will still have $26,000 instead of saving $20,249!
In addition, you’ve increased flexibility and decreased foreclosure risks. You’re in complete control when you choose to invest your money. You can decide how much to invest each month, start or stop at will, or – especially if growth exceeds expectations – empty your entire investment account to pay off the mortgage.
Although it is common to want to pay off debt as early as possible, you should evaluate your financial situation and determine if it is better for you to invest your money instead of putting extra payments toward your mortgage.
(For more from this author, see: Investing Requires a Different Way of Thinking.)