Interest rates, though ticking up a bit recently, have been stuck at exceptionally low levels for years. Some of the key indicators are close to or even below zero, after accounting for inflation. While savings accounts never pay very much, the zero that you’re currently earning quite possibly has you looking at alternative places to stash your cash. Let’s discuss one option: paying down your mortgage.
The psychological burden that debt places on many people can be immense, but making the best financial decision might involve overcoming that barrier. To see why, we need to consider the alternatives. The main theme is that debt, and the interest it accumulates, is just a negative investment and a negative return. If your mortgage is 3% (not an unreasonable rate the last few years), then your mortgage is earning you -3%. Conversely, paying it off early would save you exactly that same 3%! Not bad, right?
Well, maybe not. There’s a couple things to consider before sending a big old check to your mortgage holder. First, think of the interest rate. If paying off debt just saves you the interest rate, then you can save more with a bigger interest rate. For instance, a credit card with a 20% interest rate would be a good place to start! Paying that balance off would earn you 20% returns, far better than safe alternatives.
On the other hand, your mortgage likely clocks in at a much lower rate. Because your mortgage is secured by your house or condo, the bank is willing to give you a much lower rate. Why? Well, if you don’t repay, they can just take your house, making mortgages low-risk for banks, and giving you a nice low interest rate in the process. This is especially true in the last few years, as low interest rates meant that many have refinanced into very low-rate mortgages. So instead of earning 20%, paying off your mortgage will only earn you a couple percent at best.
The second aspect to consider is that the interest rate on your debt isn’t the final story of your mortgage. Because of generous federal subsidies (over $100 billion per year, which is more than most budget items), the interest you pay on your mortgage is tax-deductible. Simply put, if you owe $100,000 and are paying 5% interest on your mortgage, then you get to subtract $5,000 from your income when you pay your taxes! If you’re in a 20% income tax bracket, then this saves you $1,000 per year. Because of this, your 5% mortgage is actually only a 4% mortgage!
While the specific amount will depend on your income bracket and your mortgage rate, it’s quite likely that the mortgage tax deduction is reducing the actual interest rate you face. And, as discussed before, it’s best to pay down debts with high interest rates. This means that since you’d be giving up a big tax break paying down your mortgage is an even worse deal.
If paying off your mortgage isn’t the best plan, then what might be? Investing in an index fund, a mutual fund, or certain bonds might be a better bet. Even choosing a fairly low-risk fund is likely to beat a 4-5% mortgage rate, even after taxes. Another consideration has to do with diversification. It’s always good to diversify, which just means to buy a lot of different assets instead of a single big one that might go bad.
Because your house is such a big asset, you should be in no rush to pay back the mortgage on it. Let the bank take the risk! You should diversify your holding by making investments that are well-balanced and that aren’t related to the local housing market.
Finally, I should add a caveat–there might be times when paying extra towards your mortgage is a good plan. If you’re looking to refinance to a lower interest rate mortgage (always a good idea), for instance, your bank might only agree if you’re willing to pay down the principal a bit. In that case, it might be a good plan to do it if the interest rate is going to be a lot lower. This might be true if you purchased at the height of the boom and haven’t been able to refinance since. But in most other cases, don’t do it! There are better investments out there that will pay off in the long and even the short run.
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