In this opinion piece, Wharton finance professor Michael R. Roberts revisits whether homeowners should invest extra money rather than use it to make additional mortgage payments in the current economic environment.
A little over two years ago, I suggested people might want to think twice about paying off their mortgage. Feedback from readers was constructive and thought-provoking. Since then, inflation has ballooned and with it interest rates, which begs the question: How does this new economic environment bode for paying off one’s mortgage? I’d like to tackle that question again and in doing so address some of the arguments I didn’t in my previous article.
Deciding whether to pay off your mortgage early largely comes down to whether your opportunity cost is greater than or less than your mortgage cost. Two years ago, when interest rates on safe investments were near zero, that opportunity cost was lower than most mortgage rates. So, homeowners had to take some risk and a long-term view to justify diverting extra money into savings versus paying down their mortgage.
Well, everyone’s opportunity cost skyrocketed over the last year. In its quest to combat inflation, the Fed’s monetary policy has increased the federal funds rate by 5% since March 2022. Today, in May 2023, we can invest in Treasury bills, all of which earn over 4.5%. Several high yield savings accounts and CDs are offering over 4.5%, as well.
If your mortgage rate is below 4.5%, say 3.0%, then paying down a mortgage early is quite literally turning down extra money and safety. The 3.0% interest expense you’re saving is less valuable than the 4.5% you could be earning even after accounting for taxes. And, the savings accounts, CDs, and T-bills are backed by the U.S. federal government, whereas your equity in real estate is not.
What are the “new” counterarguments, and which hold water?
Argument 1: Paying Off My Mortgage Early Reduces Income Uncertainty
You could lose your job (or be forced into a job with a lower salary) and with it your ability to make mortgage payments. Consequently, you could lose your home. Paying off a mortgage quickly eliminates a significant expense and mitigates this concern.
However, consider two scenarios.
Scenario 1: You use your extra money to pay down your mortgage early and then you lose your job. Unless you want to reenact Game of Thrones for a few months until the sheriff kicks you out, this is a bad idea. Why? You have no savings. You have nothing to pay bills — utility, maintenance, tax, grocery, medical. So, you can enjoy your debt-free home for a few months while you hope for moderate weather, pray nothing breaks, and hone your hunting skills to find food for the family. (Un)fortunately, this won’t last long because the state will eventually evict you and auction off your home because of the taxes you owe.
What about all that home equity? To access it, you have two options. You could take out a reverse mortgage, which will not be on as favorable terms as a first lien mortgage, and which defeats the purpose of paying down the mortgage early. Alternatively, you could sell the home, but this too defeats the purpose of paying down the mortgage early to keep the home. Worse, if you are forced to sell the home, you have to hope it’s a seller’s market, recognize all the expenses associated with selling (agent commission, transfer and title fees, etc.), and not let your financial distress adversely affect your ability to negotiate the sale price.
Scenario 2: You save your money and have cash to tide you over while you look for work or a better job. Better yet, because your savings were earning more interest than the mortgage was costing you, you have even more money than you would have had had you paid down the mortgage early, absent a lucky draw in the local real estate market in which the value of your home went up significantly. Finally, because you have money to make payments on the mortgage, perhaps you can keep the home, or at least not be forced to sell under duress.
The point of this comparison is that the decision to pay down a mortgage quickly isn’t a choice between keeping a home or not keeping a home if you lose your job or experience some other negative income shock. The choice is between locking money up in a risky, illiquid asset by paying down a low interest loan versus saving money in a safe, high interest, liquid investment. It’s hard to argue, on financial grounds, for the former.
“If we’re going to acknowledge the psychological benefit — whatever it may be — of paying down a mortgage early, we also have to acknowledge the financial cost: reduced investment earnings, loss of liquidity, and increased risk.”
Argument 2: Paying Off My Mortgage Early Reduces Interest
Paying down a mortgage quickly reduces the total amount of interest you pay over the life of the loan. This logic is also behind arguments favoring shorter maturity mortgages.
For example, a $500,000 mortgage at 5% over 30 years has monthly payments of approximately $2,684. Over 30 years you’ll pay a total of $966,279 or $466,279 of interest. A 15-year mortgage with the same rate has monthly payments of $3,954 and total interest over the life of the loan equal to $211,714 for an apparent savings of $254,565! This sounds great, but this number, and the calculation behind it, is utterly meaningless unless your savings strategy is literally stuffing cash under the bed.
A dollar of interest 30 years from today is much less costly than a dollar of interest today because of opportunity cost. How much? At a current savings rate of 4.5%, that $1 of interest 30 years from today is worth $0.27 today. Adding money you pay (or receive) at different points in time makes no more sense than adding different currencies. We wouldn’t add 100 U.S. dollars and 100 British pounds and say we have 200 “currency.”
So, homeowners have to recognize the opportunity cost of money. If we save money today at an interest rate greater than our mortgage cost, we’ll have more than enough money to pay for that interest expense in the future.
Argument 3: Paying Off My Mortgage Early Forces Me to Save
Paying down a mortgage forces you to save. If this is the only way you can save, I’m in favor of it. Better to save than not to save. However, in doing so you risk becoming highly underdiversified, and illiquid, with your savings tied up in your house. (Of course, these are potential problems regardless of the reason why you’re paying down the mortgage quickly.)
If we’ve learned anything over the last 15 years it’s that real estate markets can be very volatile, especially at the local level. If most or all your wealth is tied up in your home, you are taking on enormous risk for relatively little return. And, as noted above, if you ever need the money, it’s not easy or cheap to get it out of the house.
So, the justification that paying down a mortgage forces you to save really turns on the argument that there are important psychological benefits to paying down a mortgage.
Argument 4: Paying Off My Mortgage Early Has Psychological Benefits
The idea of not having to make a mortgage payment every month is really appealing to most people, including me. It’s easy to acknowledge the value of reducing stress caused by being indebted, and I’d be the first to do so. However, if we’re going to acknowledge the psychological benefit — whatever it may be — of paying down a mortgage early, we also have to acknowledge the financial cost: reduced investment earnings, loss of liquidity, and increased risk.
Having liquid savings available to weather unexpected negative income shocks (e.g., job loss) and expense shocks (e.g., medical) is arguably as important, if not more so, than being “debt-free” as long as those savings do not come at a significant financial cost.
In a nutshell, for many homeowners with mortgage rates below current interest rates on safe investments, savings come with a significant financial benefit worth considering before diverting extra money to pay down their mortgage.
 Savings accounts are insured by the Federal Deposit Insurance Corporation up to $250,000, though the failure of Silicon Valley Bank suggests that the government may be ready to insure all deposits, including savings accounts and CDs.