Should You Make Early Mortgage Payments?

When making any financial decision you need to be able to see both sides before you act. This could be for an investment, a savings decision, debt payoff or even how you allocate your monthly budget. The reason it makes sense to look at alternatives is because we have a tendency to gather facts that support our own conclusion but don’t seek out the other side of the argument. This is called our confirmation bias.

Economics textbooks often discuss opportunity cost. Opportunity cost is simply measuring your decisions in terms of the next best choice. You could consider it the lost benefit of the second or third option that you considered but ultimately chose not to take. Thinking in terms of opportunity cost allows you to seek out all of the facts to make more informed decisions with your money.

A question that comes up often in the context of opportunity cost is whether or not to make early mortgage payments as soon as you are able.

There are two schools of thought on the subject of paying off your mortgage early. In one camp we have those people who assume that it’s a great idea to carry a mortgage payment because you get benefits such as leverage, interest tax breaks and the ability earn higher rates of return in other investments. This group is obviously against paying off your mortgage early.

In the other camp are those that absolutely hate debt in any form and make it their sole mission in life to pay off every cent as soon as they possibly can. A mortgage payment fits the bill here so this group makes it a priority to pay it off as quickly as possible.  With this option you are getting a guaranteed return on your investment in the form of your mortgage interest rate.

If you are trying to make a decision on what to do with your savings and it comes down to these two choices which one should you choose? Both can be beneficial in the long run.

Paying off your mortgage frees up cash flow in the future and gives you the added bonus of lowering lifetime interest payments. Investing in other markets (stocks, commodities, bonds, etc.) gives you the opportunity for diversification, better rates of return and the ability to let compound interest work in your favor.

So if you choose to pay off your mortgage early and only focus your finances on that goal, your opportunity cost is lost returns elsewhere. And if you choose to invest in other markets then your opportunity cost is peace of mind as well as higher mortgage interest payments over the long–term.

Luckily for you it doesn’t have to be black and white. There should be room in your financial plan for both options. This is the kind of decision where the numbers matter but shouldn’t be the final determinant. The objective here will be to give yourself the highest odds of success. You have to prioritize.

You first priority should be to save enough for retirement to be in range for your long-term goals. Your extra mortgage payments should not be eating into these goals. This is especially true if you get a 401(k) match from your employer. That equates to a 100% return on your money and there is no way you can get that kind of return by paying down your mortgage with rates around 4%.

Let’s assume that you are already saving enough to get the company match but still have a little extra leftover each month and want to know if you should pay down your mortgage or increase your contributions.

If you have to pick one place to park your cash I would suggest retirement contributions as opposed to completely paying off your mortgage early (I consider early to be in less than 10 years). Housing doesn’t always work out as a long-term investment. It can be illiquid if you need to sell quickly and pull out your cash. Plus you are making the age old mistake of putting all of your eggs in one basket. By choosing to forgo retirement contributions in favor of accelerating your mortgage payments you are making the decision that your home is your biggest investment.

This is equivalent to putting all of your retirement funds in your company’s stock. Ask the former employees at Bear Stearns and Lehman Brothers how that worked out.

By setting up a diversified investment plan you have the ability to make changes over time to your risk profile, rebalance (buy & sell) and possibly pull the cash out in an extreme situation. That might not be the case with your housing investment.

That being said, there are many benefits to owning a home, so investment performance and diversification over the years probably won’t be your biggest reason for making the purchase. You build up equity over time and get to pick the neighborhood and school district that you live in. There is no landlord so all of the decisions on what to do with the interior and exterior of the property are yours. If you time it right you can have your mortgage paid off before you retire (or earlier) which gives you a ton of flexibility.

There is also a huge level of psychic income involved with home ownership. Psychic income is the intangible benefit you receive above and beyond the price or value of a purchase. The greater the psychic income expected the more someone will spend on a purchase. With your home the sense of community and pride come into play when you make that purchase and it’s hard to put a price on those things.

An example of psychic income would be the cost of a bride’s wedding dress versus a regular off-the-rack dress from the mall. Brides don’t mind paying a substantially higher cost for a wedding dress because of the importance of the occasion and the benefit they get from looking their best on their wedding day (husbands and the bride’s father might not feel the same way, but their opinion doesn’t really matter here).

However, we all know that a woman is not going to make an expensive wedding dress the only piece of clothing in her wardrobe. She will have a diversified closet full of other clothes and each of them can be used for different occasions. The same should ring true for your diversified investment portfolio.

If you are satisfied with your retirement contributions, start by increasing your monthly mortgage payments by $50 to $100 as a start. Then as you age and increase your earnings power you can continue to add to that amount. You can slowly build equity and lower interest costs in the same way that you will add to your retirement savings over time.

If you are one of the people that hates debt with a passion just remember that having a mortgage payment does offer you some benefits.  According to the book The Millionaire Next Door about 60% of the millionaires they studied carried a mortgage.  While they could afford to pay it off in the short-term they choose not to.  I don’t think this necessarily means they were solely looking for better rates of return on their investments.  It offers you flexibility by not having all of your wealth tied up in your home.

Financial goals don’t have to be mutually exclusive. No one will be there to hold a gun to your head and force you to make one choice over another. Having a diversified investment plan will help you reach your long-term goals. And owning a home can be very satisfying just like having a beautiful dress on your wedding day. Just don’t let the benefits cloud your long-term decision-making ability and make your home your only investment.

There should be room in your financial plan to accomplish both goals. And reaching retirement age with the combination of a good-sized investment portfolio with no mortgage payment will give you the option of worrying about much easier decisions.

If you are taking the time to work out the numbers for these kinds of decisions and using that thought process to make your long-term financial plans then you are already light years ahead of the average household, no matter what choice you make in the end.

 

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