- Posted by NateKragness on September 25, 2009
Many households send in additional payments on their mortgage from time to time, but does this make prudent financial sense? When you pay down your mortgage balance, you decrease the future interest you will pay on your loan by a certain amount. But, you also lose the ability to invest the money you send in on other investments. In other words, if you send $500 to your mortgage company every month, that's $500 you can't be investing elsewhere. So, the opportunity cost of making extra payments towards your mortgage is that you can't invest that money somewhere else. Thus, it only makes sense to pay down your mortgage balance if you can't get a better return elsewhere.
For example, suppose you have a 30-year interest-only mortgage of $300,000 at 6.0% -- this means you would be paying $1,500 per month in interest on the loan. Now, suppose you receive an unexpected windfall of $10,000 and are faced with the decision of what to do wiith it. If you pay it towards your mortgage, you will reduce your balance by $10,000, which at 6% interest would save you $18,000 over the course of the loan. At first glance, it doesn't seem like a bad idea -- after all, it's probably more than a bank will pay you to keep your money in a savings account. But, since you are most likely getting a tax deduction on your mortgage interest, this means that you are essentially increasing your tax liability by paying down your mortgage interest. When taxes are working against your investment, it slows down your asset growth. Because of these tax ramifications, if you're in the 25% tax bracket, you would only be earning 4.5% interest by paying down your 6% loan; it turns out that $10,000 investment would only save $13,500 over the course of the loan. That's not a great return, and it's an illiquid investment as well -- while you will save money on your mortgage payment every month, you won't be able to get that $10,000 back. If I'm giving up money that I can't touch for thirty years, I want a better return than 4.5%. The opportunity cost is too great to invest in paying down my mortgage.
So, where can we re-direct that money to get a better return? Consider that the historical rate of the S&P 500, which roughly approximates the general returns of the stock market, hovers at just above 9% annually. If you invest that same $10,000 into the stock market, and earned average returns over 30 years, your investment would be worth about $27,000. Regardless of your tax bracket, that's still a lot more money than you would get by making an extra mortgage payment. And, you gain the benefit of liquidity: you have the option to sell off some or all of your assets at any. So, unless you have a very high interest rate on your mortgage, it's generally better to invest your money somewhere that has the potential for higher returns. If you make a 4.5% investment when you could be earning 9%, the opportunity cost of the equation implies that you're actually losing money by picking the relatively lower return.
Of course, there are situations when paying down the mortgage makes emotional sense, and that can be reason enough to abandon financial prudence. Having a general peace of mind about your financial situation is far more important than maximizing every possibly investment decision that you make, and if making extra principle payments improves your sanity, by all means, aggressively pay down your mortgage debt. There is no quantifiable price tag you can place on having peace of mind. For me, this comes from knowing that I'm making the most prudent decisions about my financial future, so I personally avoid paying down my low-interest mortgages, and instead let my money work in more aggressive investment vehicles. As much as I hate debt, mortgage or otherwise, if the opportunity cost of paying down those debts is simply too high, it behooves me to invest my money elsewhere, at higher returns, while continuing to make the minimum payments on my low-interest money.