Should you pay down your mortgage?
May 30th, 2007 by KenricOne of the main reasons financial advisors give for paying down your mortgage is the forced savings effect. It seems to me that people who need to have “forced savings” are bad with their money anyway. If the only way that they can save money is to lock it up, then they’ve got bigger problems. Once we write that principal paydown check, we change cash into the equity. There’s no way to get the cash out without getting another loan.
I used to think that if our saved money is earning less interest than our home loan rate that we are losing money everyday. If we get 5% from ING and our home loan is at 8%, we are losing 3% daily. The big question is what do we gain by paying down our mortgage? If I had an extra $5,000 in the bank, what do I gain by sending a check to my mortgage company?
The obvious answer is instant principle paydown thereby shifting the principal and interest ratio on subsequent payments. Simple math can easily calculate the thousands of dollars saved in interest over the next 30 years from this simple payment.
As many people live using monthly financial budgets, what does this principle payment check do for them? Your mortgage payment does not decrease due to the paydown. You have not changed any of your monthly financial numbers although your bank account is lighter by $5,000. In fact, I argue that sending in that $5,000 check is detrimental to your financial health. What you have done is you’ve limited your future financial options.
Suppose your home needs repair unexpectedly, a health emergency arises or your car needs a new transmission. If you were paying down your loan as a means to “save” money where do you get the funds for your emergency? You’d probably use credit cards, personal loan or even a HELOC. All of these sources have a higher interest rate than your mortgage loan. Now you are forced to borrow money which you had available at a higher rate. Wouldn’t having that $5,000 in your savings account be much more important than saving that 3% a day?
My opinion is that paying down your mortgage locks up your money and the risk incurred by doing so greatly outweighs its benefits. I do want to mention that this post is directed towards people who tend to use paying down principle as a means of saving money. People who manage their money and keep adequate cash reserves can choose to pay down their mortgages without ill financial affects.
Posted in Finances | 11 Comments »
Stumble it!
This is what I do.
I personally would rather have the $5k sitting in my bank account for something such as an emergency. If I needed to have access to quick cash, I don’t have time to get a refi and pay the thousands associated with that.
Cash on hand.
Self Discipline.
By Clifford on May 30, 2007
Kenric,
I’m glad that you stated that this post was directed at people who do not have cash reserves. Otherwise, paying down the mortgage is a guaranteed return.
This is especially true for us Canadians who do not have the added benefit of mortage interest deductions from our tax bill.
In Canada, paying down the mortgage makes more sense than in the United States, simply because of the tax rules.
By Tyler on May 30, 2007
I completely agree with you. Unless you are pretty close to retirement, I don’t see a reason for paying down your mortgage.
By Shaun on May 30, 2007
I agree with you. Everyone should have cash reserves, in checking, money market, and short term CD type investments. The amount of the reserves depends on your expenses and the stability of your income. More stable incomes (e.g. government employment) and lower expenses require lower reserves.
For people that are financially disciplined and secure, a HELOC on their primary residence can make sense. If an investment opportunity comes along, the HELOC can provide quick capital. If they lose their employment income because of an extended disability or similar catastrophe, the HELOC can carry them beyond their cash reserves.
By Another Investor on May 30, 2007
I’m sort of facing that dilemma for the past 2 years, whether to use the money that is sitting in my saving account earning 2% after tax return to pay down my mortgage for my principle residence at 4.5%. (Mortgage interest on principle residence is not tax deductable in Canada).
And so far I haven’t pay down my mortgage, for the simple reason that I’m a procrastinator. And I sort of justify my action my calling the 2.5% spread as the insurance premium that I need in case of emergency.
By William on May 30, 2007
William, You should be able to get at least 5% in a savings account now.
By Kenric on May 30, 2007
Wow, Kontera sort of went link crazy on this post. Sorry about the intrusion, I need to figure a way to limit their links.
By Kenric on May 30, 2007
William might not be able to get 5% in Canada, not sure what the returns are there for savings accounts.
If my mortgage is 8%, then I’d pay it off. 3% is too much to keep in a savings account. The wild card in all this is that my HELOC currently is 8%, so getting money back out would be at no penalty in times of emergency. If it was 10+%, that might make me think. Then again, I don’t think I’d find myself a home-owner at 8% interest in this market – I’d prefer to rent.
Anyway, my mortgage is around 6%, tax deductable. It’s pretty straight-forward that I can get the best of both worlds, 1) able to invest it at a higher rate and 2) be able to keep the money around in case I need it.
By Lazy Man and Money on May 30, 2007
I’ve gone back back and forth on this over the last few years. I was in the conservative camp of wanting to pay down and eventually off my mortgage. Also, because my mortgage was low enough that paying it off was a reasonable financial goal, I seriously considered it. However, as my real estate investments became more successful I saw I could make far more by investing the money instead of paying down my mortgage and to fully take advantage of the tax advantages of real estate investing. So I’ve changed my view on this.
However, I think paying off your mortgage off at some point early is not a bad goal. I would suggest a different way of paying it off. The problem as you pointed out is that by making additional principal payments, you gain equity but lose the cash that you may need later. Accessing that equity in the future will cost you more money. So instead of making the extra principal payment, invest that money in a high yield savings account or even taking more risk in a mutual fund. Just designate that money for mortgage payoff. If your circumstances change later, and you need that cash it is still there earning interest. Don’t ever pay down the mortgage. Only pay off the mortgage at once when you saved enough to do so if you decide to.
By Allen Young on May 31, 2007
Consider this, if you carry a mortgage you will have higher monthly expense. If you happen to lose your job or become sick/disabled such that you cannot work anymore, how will you be able to pay that mortgage (which may still have 15-20 yrs to go…not to mention most of what’s left of the mortgage is your principal debt).
But if you pay your mortgage off early (within 10-12 yrs) while you are still healthy and have a good paying job, you can get a HELOC and have your equity available for withdrawal at any time.
By ToPayorNotToPay on Jul 20, 2007
Furthermore, upon paying off your mortgage, you now have reduce probably the biggest monthly expense in your life.
Whatever you earn from this point on can be invested and you always have access to your equity (via a HELOC) which is also increasing as time goes by (unless the housing market collapse completely).
By ToPayorNotToPay on Jul 20, 2007