Because of the low rates on home mortgages, many financial gurus now suggest that people hold off on paying back their mortgage. Rather than making extra payments, they suggest, you can get a better return by investing elsewhere.
On the surface, that’s a great argument. If you assume that Warren Buffett’s prediction of 7% annual returns over the long haul in the stock market is an accurate one, then it makes sense to put your money into stocks rather than to pay ahead on your mortgage, right?
Not necessarily, and here’s why.
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For starters, there isn’t an investment available right now that locks you in at better than 4% guaranteed. To get a return better than that, you’re going to be investing in stocks or real estate or something else that injects risk into the equation.
How does that risk show its ugly head? In a given year, your returns might be much lower than 4%. In fact, they might be negative.
If you buy stocks only to watch the market become a bear, you’re going to lose money in the short run. If you buy real estate only to watch the local market start to fall (for any number of reasons), you’re going to lose money in the short run.
“Well, that’s the short run,” you might say. “I’m investing for the long run.”
The problem with that philosophy is that unless you’re very wealthy, the ups and downs of your life are quite likely to cause you to tap those investments, often when you least expect it. You lose a job. Your business collapses due to an employee’s mistake. A spouse falls ill. You fall ill. You unexpectedly have a child. Many, many things can happen out of the blue that can force you to tap investments when you least expect, and you’re more likely to have to tap it during a down market (because others are feeling the pinch and try to spread the risk around).
If you put money into the mortgage, it’s going to give you a locked-in-stone annual return equal to your interest rate as long as you still hold that mortgage. If you make an extra $1,000 payment right now, you’re getting a 4% (or whatever your interest rate is) guaranteed return for the lifetime of that mortgage. That money actually appears at the end of the mortgage in the form of having it paid off earlier.
That’s a good conservative investment (assuming you already have the mortgage, of course). It’s better than you’ll get from a savings account or a treasury note right now and there’s very little risk in that extra investment.
Still, purely as an investment, I view paying off a low-interest mortgage early as simply a very conservative option.
The reason I still advocate for it is for another reason entirely: having your home loan paid off does wonders for your cash flow.
Regardless of what you’re doing with your money, when you have a mortgage, you have a large monthly bill that you have to pay. It’s $1,000 or $2,000 (or whatever) that you must come up with, every single month.
Now, as I mentioned above, life happens. You lose a job. Someone gets sick. The lower your monthly bills are, the easier it is to survive this type of situation.
Some might argue that it makes sense to invest your money instead of making extra payments on that mortgage. If you don’t have enough on hand to pay off your mortgage all at once, this makes reasonable sense, as it provides a very liquid emergency fund for you. However, you’re still left with two choices – investing in something with little risk that doesn’t return as much as an extra mortgage payment (like a savings account) or investing in something with substantial risk that should return more over time but may return much less in the short term (like stocks).
There’s also the human factor. If you have a lot of money sitting in the bank, it becomes much easier to talk yourself into spending it if it’s just sitting there. You can tell yourself it’s an emergency fund, but as the balance grows, so does the temptation.
Because of all of these factors, I still consider it a solid idea for most people to make extra payments on their mortgages, even when the interest rate on the mortage is low. This assumes, of course, that you have an emergency fund already in place (to handle most of life’s disasters), that you don’t have any other debts, and that you’re also contributing to your retirement savings at a total rate of at least 10% of your income. If you’re not taking care of those things, make them a priority.
Source: Christian Science Monitor