3 reasons not to pay off your mortgage early
P.Paying off a mortgage early can free up cash flow and save a lot of money on interest payments. However, investors shouldn’t look at their mortgage in a vacuum. The extra cash on a mortgage can be viewed as part of an overall investment plan.
While there are reasons why paying your mortgage early makes sense in certain cases, many investors are better off paying the minimum every month. Here are three reasons for that.
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1. Real interest rates are currently negative
Inflation drove prices up nearly 7% year over year last month, and it may be some time before inflation hits the Federal Reserve’s target of around 2% again. Several economists predict that inflation will stay above 3% in 2022. Even the Fed’s policymakers have raised their forecast to 2.6% inflation in 2022.
Meanwhile, the average 30-year mortgage rate remains near 3%. Those with good credit or willing to cut the interest rate can get a loan of less than 3%.
With high inflation and mortgage rates near record lows, real rates are likely to remain negative for the next few years. It’s like getting paid to take on debt. Every dollar you borrow for your home can add purchasing power if the rate of inflation is above the interest rate on the loan.
When real rates are negative, you should take on as much low-interest long-term debt as possible (up to your comfort level).
2. You can get better long-term returns elsewhere
When you pay off your mortgage, you are effectively securing a return on your investment roughly equal to the interest rate on the loan. Repaying your mortgage early means that you are effectively using money that you could have put elsewhere for the remaining term of the mortgage – up to 30 years. With interest rates this low, you should be able to get better long-term returns on other investments.
The stock market, for example, should generate returns in the 7 to 8% range over the long term. Morningstar analysts expect a well-diversified equity portfolio to generate an average annual return of 8% in the future.
What is important, however, is that this return is accompanied by greater volatility. The standard deviation of the Morningstar forecast is 17%, which means annual returns will be between -9% and 25% roughly two-thirds of the time. However, in the long run, investors should expect their investment portfolio to outperform their mortgage rates.
The counter-argument here is that most investors would not take out loans on their home to raise investment capital. This is suboptimal from the point of view of an economist, but from the point of view of “I like to sleep at night” it can be optimal. In today’s high home value, low mortgage rate environment, capital is readily available for those willing to take on more debt, but it can be outside of your personal comfort zone.
3. Early payment means an increased risk of return
If you pay off your mortgage early, you will have to stop adding to your investment portfolio today. The effect is that most of your investments are compressed into a smaller time frame – the post-mortgage payout – which increases your risk of a consequence of the risk of return.
The return risk sequence is the potential for a few years in the stock market to have an oversized impact on your investment portfolio. When the stock market has a bad couple of years in a row where you’ve invested most of your money, the impact is significant. If the market goes down for a couple of years and you’ve invested virtually nothing, you have missed out on a significant portion of the returns that the market offers.
Because stocks are more volatile than other assets, the asset class’s real benefit – higher expected returns – is often seen over long periods of time. However, if your investment horizon is shorter, you can expect poor returns for several years at the worst possible time. This risk is mitigated by the more time you invest in the stock market, which means that your investments are spread out for as long as possible.
Debt can be good
Some people are very debt averse, but some debts can improve their financial well-being and provide additional flexibility while reducing the risks of inflation and volatile stock market returns. A home mortgage is a prime example of this type of debt, and the decision to pay it off early should take into account the three considerations above.
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