financial planner Stephen Zelcer
Should you accelerate payments towards your mortgage (or any other debt)?

Should you accelerate payments towards your mortgage (or any other debt)?

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 additional payments of principle each month, on top of the regular monthly mortgage payment.

Is that a good move?

It depends.
Debt has a cost. You have to pay back what you borrowed (the principle), but you also need to pay interest. So, the cost of debt is the interest. If you reduce your principle, you will reduce your loss of interest. If you do not reduce the principle, the debt will cost you more interest.
To say it differently, every dollar you use to pay off your debt is providing you a financial benefit in the form of avoiding the cost of interest. This financial benefit is your RATE OF RETURN on paying down your debt.
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. In this case your financial benefit is obvious – it’s the $10 gain, which is a 10% rate of return.

Scenario 2: You BORROW $100 with an annual interest rate of 10%. After a year you will owe the original $100 plus $10. By paying $100 towards this debt your financial benefit is less obvious, but nonetheless the benefit is the $10 in interest you avoided. So, paying the $100 yielded you a $10 value – that’s also a 10% rate of return!
Thus we see, paying off debt provides a quantifiable rate of return.

What is the rate of return you get by paying down 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 compared 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. 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 (for those who itemize their deductions).
You get a dual investment benefit.
By “dual investment benefit” I mean you now have two assets appreciating – the Real Estate that you purchased with the mortgage, and your cash which, instead of being used to accelerate payments on your mortgage, you could invest elsewhere.

Your real estate can appreciate, and your cash can appreciate. That’s a dual investment benefit!

I realize that you would 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 have two appreciating assets. If just one of those assets outpaces the mortgage, you are coming out ahead of the game. (If both assets outpace the mortgage, you are seriously accelerating the growth of your net worth!)

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. You now have two assets appreciating – the Real Estate that you purchased with the mortgage, and your cash which you could invest elsewhere.

As always, I wish you much success!
Stephen

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