Should you accelerate payments towards your mortgage?
I see people do this all the time, especially in the pre-retirement group. Many people are uncomfortable having any debt, including their mortgage, and they are driven to enter retirement “debt free.” To rid themselves of debt they make an additional payments of principle each month, on top of the regular monthly mortgage payment.
Is that a good move?
Maybe. Let me explain what I mean.
When you pay off your debt, you are avoiding the loss of interest. By avoiding this loss, you now have more money in your account. Thus, by avoiding a loss you have gain!
Let me illustrate with two similar scenarios:
Scenario 1: You invest $100 into a vehicle that grows at a rate of 10% per year. After a year you will have your original $100 PLUS $10. Those $10 are the money you gained by investing your $100. Obviously.
Scenario 2: You BORROW $100 with an annual interest rate of 10%. After a year you will owe the original $100 plus $10.
If you choose to pay off this debt, it will require you to take $100 out of your pocket and put it towards your debt just so you can keep the $10 in your pocket. Without paying the $100 you will no longer have the $10. So paying the $100 EARNED you $10! Meaning, you got a 10% return on paying off your 10% debt.
You see, paying off debt provides a quantifiable rate of return.
What rate of return can you get on your debt?
The rate of return you earn by avoiding the interest charge is the interest rate that you avoided. If you have debt that charges you 10%, by avoiding that interest charge you got yourself a 10% rate of return. If you have debt that charges you 19.99%, by avoiding that interest charge you got yourself a 19.99% rate of return. If you have debt that charges you only 3%, by avoiding that interest charge you got yourself a 3% rate of return.
With that in mind let’s reword our question: Should you INVEST in your debt or should you INVEST in some other vehicle?
The answer obviously depends on what your debt’s interest rate is, and how does it compare to what you could get elsewhere. Is the rate of return on your debt better than the rate of return you’d get elsewhere?
If your mortgage interest rate is 4%, and you accelerate payments towards your mortgage, you will have earned a 4% return on that accelerated payment (I’m ignoring the lost benefit of a higher tax deduction for the moment. See what I say about that below). That’s better than a checking or savings account which will only grow at a rate of 1% (or less!), and it’s even better than the current G-fund yield of less than 2%. But it’s not as much as the F, C, S & I funds which yielded more than 4% over the past few years.
There are a couple more benefits to not accelerating your mortgage payments:
- You preserve a tax deduction for your mortgage interest.
- You get a dual investment benefit.
Here’s what I mean by “dual investment benefit.” As I mentioned above, if you decided to not accelerate your payments, you would be able to invest that money. That’s first investment. The second investment is the appreciation of your real estate.
You would anyhow get the real estate appreciation even if you did accelerate your mortgage, however once you make that accelerated payment, those monies are “invested” in the real estate and can no longer be invested elsewhere! Had you not accelerated those payments you would have the ability to invest that money, and thus you’d get the “dual investment benefit” of:
- The appreciation of real estate, and
- The appreciation of whatever other investment vehicle you chose
Are you following me? If you are, you’ll notice that this also answers another popular question for pre-retirees (and even younger folks); When buying a new home, is it better to pay cash (ie. use the equity from the sale of your previous home, or use whatever money you have available) and avoid/minimize a mortgage, or is it better to have a mortgage and invest the money elsewhere?
If you’ve been following my thinking, you’ll see that here, too, having the mortgage provides you with:
- The mortgage interest tax deduction.
- The dual investment benefit.
As always, I wish you much success!
Stephen
