Breaking one of the personal finance commandments.
I have spent a lot of time learning about personal finance, and there are some common steps in the advice given: clear your high interest debts, build an emergency fund, save for retirement and then pay off your mortgage. And when you do pay off your mortgage, you unlock a new level of financial superiority. Or at least, that’s how it seems.
It’s a huge badge of honor in the personal finance community to be mortgage free. It’s an impressive achievement and the idea of it is very alluring, but this clouds the facts. Overpaying your mortgage isn’t the best path to financial success, and doing so could mean missing out on a considerable amount of wealth.
Why People Do It
I want to be clear that there’s no judgement of those who overpay their mortgage. I get it. In fact, we used to overpay on our mortgage. It’s a basic human need to have shelter and security, so the idea of having a home and knowing it’s yours and no-one can take it off you speaks on an instinctual level as humans.
Another common argument for overpaying is that you shouldn’t invest your money while you have debt. The way this is often framed is to ask the following question: Would you take out a mortgage and invest that money in the stock market? Most people would say no, and so the point is made that investing rather than putting that money against your mortgage is essentially the same thing.
Both of the above examples touch on the emotional side of money. We’re generally risk averse, and overpaying a mortgage is a low-risk way to better our financial situation and give ourselves a sense of security.
At a purely financial level, overpaying your mortgage can save you a substantial amount of money on interest, and reduce the term of your loan. As an example, let’s take a mortgage of $300,000 at 3.5% interest on a 30 year term. Paying as little as $200 a month extra could save you $42,000 in interest and have your mortgage paid off six years earlier.
It’s not a bad thing to overpay your mortgage — you can save a lot of money! But if you look at the situation rationally then really it’s a false sense of security, and you’re not making the best decision with your money.
Symptom, Not The Cause
One of the reasons I don’t feel pressure to overpay our mortgage is that the repayments take up a proportionally low amount of our household salary. Our mortgage payments equate to 8.5% of our gross pay — compare this to the general rule of thumb of 28%, which is what’s used to determine mortgage affordability in the US.
Our low mortgage payment isn’t by accident — we purposefully sought out a home that was as cheap as possible (while still meeting our needs) so that we could keep the cost of this down.
For those who have much larger payments, I can see that their mortgage must seem like a huge weight on their shoulders, and overpayments help that pressure ever so slightly. But this treats the symptom, not the cause. There’s an issue that we’re over-leveraged in our mortgage, but that fact shouldn’t be used to justify overpaying. If we do, it’s one poor financial decision (overpaying your mortgage) to make ourselves feel better about another poor financial decision (taking out a mortgage that’s too large). If that’s the reason you want to overpay then perhaps you should reflect on the size of your mortgage.
Running The Numbers
The alternative to overpaying your mortgage is to take that money and invest it. The argument here is that the returns made from investing that money far outweigh the savings made from putting that money towards your mortgage.
Let’s continue on with the example above. Instead of overpaying my mortgage, I’m going to put that $200 a month into a low-cost tracker index fund. Using the historical rate of return, we’ll use 7% for the calculation. After 30 years, that $200 a month would be worth $245,000 — compare that to the $42,000 interest savings on the mortgage. That’s over $200,000 difference from just a few hundred a month.
There are other factors that need to be taken into account like inflation and taxes, but the general point remains the same — investing that money has far greater returns than overpaying your mortgage.
Putting the difference in returns aside, there are other fundamental financial principles being ignored when we overpay on our mortgages.
The first is diversification. Any financial strategy, especially one for those who are risk averse, is built on diversification. That is, your wealth being held in a number of assets; stocks, bonds, property and cash. When you overpay your mortgage, what you’re doing is putting all of your eggs in one basket. You’re tying your entire financial future to not only one type of asset, but in this case one specific asset — your house. That’s the equivalent of putting all your money into stocks, and only buying stocks for one company.
While property is historically a stable asset, all it would take is a housing crash or a change in your employment status to destablize your entire future. If you were to invest instead of overpaying, property would still be a large proportion of your assets, but you’d be building up other avenues of wealth at the same time and spreading the risk.
Another fundamental in finance is the power of compound interest. And this power is only unleashed with time. For those who choose to overpay their mortgage, the strategy is often to focus on the mortgage first, and then when that’s cleared, put all their energy and money towards investments. But a mortgage takes a considerable amount of time to pay off, even with overpaying, eating into the precious time needed to harness the power of compound interest.
Let’s once again go back to the example figures I shared above. We have two people — Person A, and Person B. Both have a $300,000 mortgage at 3.5% for 30 years. The monthly repayment is $1348. Each has an additional $200 available to help their financial status.
Person A paid their mortgage off in 30 years as planned, while investing $200 a month in a low-cost index fund at 7%. After the mortgage was paid off, they continue to invest the $200 plus the mortgage payment amount for another 10 years. At the end of the 40 years they have:
A fully paid off house (which they paid $485,000 for, including interest)
And $763,000 in their investments.
Person B used the extra $200 to overpay their mortgage, which meant their mortgage was paid off in 24 years. They were then able to invest both the mortgage payment amount and the additional $200 for 16 years in a low-cost index fund at 7%. At the end of the 40 years, they have:
A fully paid off house (which they paid $443,000 for, including interest)
And $548,000 in their investments
So at the end of the 40 years, despite Person B paying less for the house, and having an extra 6 years and an additional $40,000 to invest, they still ended up with $215,000 less than Person A.
In fact, if Person A decided to only invest the $200 a month for the 40 years, and didn’t add in the mortgage repayment amount at all, they’d still have $528,000, and would have invested $200,000 less than person B. This is because after that length of time the wealth comes from the compounding interest, not from the capital being put in.
The one thing you can’t buy is time, and that’s the opportunity you’re giving up on if you overpay on your mortgage. Time for your investments to grow and compound over time and reach their full potential.
The last fundamental is liquidity. Liquidity refers to how easily an asset could be converted to cash. Let’s put aside the difference in returns for a minute and think about what happens with the money when you overpay.
Whether you overpay on your mortgage or put the money in savings, you still ‘have’ the money, and your net worth is the same. The key difference is that the money put against your mortgage becomes locked in, whereas the money in your savings can be fully accessible.
The money from overpayments is only available if you were to sell the house, or were to remortgage the property. If for some reason you needed the money, your only options would be to sell the house or to re-mortgage the property. Thinking back to the reasons why people might overpay — security and stability — it seems like this could be much better achieved by putting those funds to use elsewhere.
When I Would Change My Mind
All of the above is based on my opinions, and most importantly my current financial circumstances. When I sat down to write this article, I thought about whether there would be an instance where I’d change my opinion on the matter.
The only circumstance I think where I would consider overpaying my mortgage over investing would be if we experienced a similar situation to the 1980s where interest rates soared to the mid to high teens. In this case, the returns from investing wouldn’t outweigh the savings from overpaying, and so I’d prioritize paying off the high interest debt of the mortgage. But that would only be after I had a considerable amount of cash savings set aside so I had liquid assets to see me through what would be a tumultuous economic time.
Despite the facts of it all, money is still a very personal subject and one where emotions guide decisions as much as, or more so, than the actual numbers. It’s a lot to ask for someone to put aside the strong emotional side of this sort of decision. All I ask is that you don’t just jump on the person finance bandwagon; look at your options, and the pros and cons of each, before deciding what’s best for you.