This post is part 1 of 7 in a series entitled “When not to pay down your mortgage,” which outlines many scenarios where paying extra on your mortgage isn’t necessarily the best financial strategy.

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Perhaps the least modeled but most important factor in considering mortgage payments is the long-term effect of inflation.  Many financial planners and investment advisors will discuss the merits of putting money in stocks or bonds rather than into a mortgage.  But few will explain why a strategy of paying down a mortgage early must consider inflation to determine whether it makes sense. Let me explain.

The common assumptions about mortgage interest

Let’s assume you’ve paid off your credit cards and any other high interest loans, you have an emergency fund, and you’re getting the maximum matched funds for retirement that your employer may provide.  You still have some money left over each month to save toward something.  Should you put it into your mortgage? The conventional wisdom is—of course you should.

And if you have less than 20% equity or so in your house, perhaps you should.  You might be paying for PMI (private mortgage insurance), which is sometimes costly and can often be waived once you get a certain about of equity.  Or your home value might have decreased, leaving you “underwater” in your loan.  In these cases, gaining some equity quickly is probably a good idea.

But what about people who have either made a 20% down payment or have built up that much equity?  Usually, these borrowers are also convinced of the argument to make additional payments with a simple table showing the total amount of interest you’d pay on the loan under various conditions.

For example, suppose you have a $100,000 loan at 4% (which is not uncommon for current 30-year mortgage rates at the moment).  Your monthly payment is about $477. By paying the standard payment each month, over 30 years you will pay about $172,000 total, including interest.  That appears to be almost double the value of the loan!  (As we will see soon, this number is a bit misleading.) Now, suppose you just overpay your mortgage by $100 each month, making payments of $577.  In that case, you’ll cut off over 8 years from the length of the loan, and your total payments will be about $149,000.  It appears that a small increase in payment will cause you to save almost 1/3 of your interest.  Overpay by even more, and the loan gets paid quicker, which results in even less interest.  If you could afford to double your payment, you’d own your house in only 11 years, and you’d save over 2/3 of your interest on a traditional 30-year mortgage, with a total payment of only a little over $123,000.

Those who study amortization tables—those complex listings of how much you pay in interest and principal each month—will go further in their recommendations.  They will state that the most important time to pay extra on your loan is in the early years, since most of your monthly payment at that time is going to interest, rather than principal. It is certainly true that you pay a lot of interest per month up-front: after 10 years of the loan mentioned above, you’ll only have paid off a little over 20% of the principal, even though you’re 33% through the loan term.  If you do pay extra in the first few years, those payments are generally applied directly toward paying down your principal, and reducing your principal early on is effectively compounding your investment, because principal that is paid-off is principal that you won’t have to pay interest on for the next 20 or 30 years.

At first, paying early seems like an obvious choice.  But we need to model other things that could happen with your money to understand whether there might be better options.

What is inflation?

Almost everyone understands the basic concept of inflation: as the years go by, it costs more to buy the same thing.  Your great-grandmother might have told stories about buying a loaf of bread for a few cents, but now it costs a few dollars.

Your loan principal amount will not change in relation to inflation.  If you have a $100,000 loan, and you don’t even pay any principal, in 30 years it will still be for $100,000.  Meanwhile, your loaf of bread might now cost $20, and your house may have tripled or quadrupled in value.  Paying that same $100,000 in 30 years will seem a lot easier, because everything else costs so much (and, presumably, your salary will have gone up too). Or, to think of it another way, we can adjust the value of dollars over time to take inflation into account.

Let’s go back to that $477 payment on a 30-year mortgage.  Right now, it is $477 in today’s dollars (obviously), and it will feel like $477 dollars when you write out the check each month. But, assuming an annual inflation rate of about 3%—which is close to the average inflation rate for the last century—in 10 years that $477 payment will only seem like $356 in today’s dollars.  By the time we get to 30 years from now, in the era of a twenty dollar loaf of bread, that payment will only seem like $197 in today’s dollars. Assuming your salary roughly increases with inflation—and most people will actually have salary increases over the long term that beat inflation—in 30 years it will probably be a lot less strain on your wallet to pay $477 than it is now.  In fact, it will probably feel like a $197 payment or so, in today’s dollars.

But what does this have to do with mortgage overpayment?

How inflation affects loans

If you make large payments right now, you’re paying them in today’s dollars, which are worth a lot (they can buy more loaves of bread).  If you wait a few decades to make those payments, you’ll be paying them in inflated dollars (which can’t buy as many loaves of bread).  Therefore, payments far in the future should be considered to be significantly less “valuable” in terms of what you can do with the money than payments today.

Let’s take a very simple idea of a loan (without any compound interest or anything like that) to see how this works.

Suppose you have to pay $100 for some item.  The company you owe this to says you can postpone the payment if you pay a 4% (simple interest) charge for each year.  So, rather than paying $100 now, you pay $4, and that gives you the option to pay in another year.  Say you do this for 10 years.  You will have paid $4 each year, or $40 total.  If you finally pay the $100 after 10 years, you’ve paid $140 total. This may seem like a really bad deal, because you’ve paid so much interest.  But suppose that inflation has occurred at 3% over those 10 years.  That means that $1 today will only be worth about 75 cents in its buying power in 10 years.  If you paid the $100 upfront (in 2012 dollars), your money is gone.  If you wait and pay the $100 in 2022 dollars, it will be equivalent (in purchasing power) to paying about $75 in 2012 dollars.

By waiting 10 years to pay, you now only owe three-quarters of what you initially did in terms of the actual value of the dollars you use to make a payment.  You are still paying “$100 dollars,” but those dollars are worth a lot less. Now, since you’ve still paid $40 in interest over the 10 years—actually closer to $35 once inflation is taken into account—this apparent “savings” isn’t free. But it seems like a much better deal once inflation has been taken into account than our initial estimate of $140 in total charges.  Instead, the total charges will be more like $75 + 35 = $110 in constant 2012 dollars.

However, suppose inflation spikes a little more and averages 5% over the 10 years, but our payment agreement still allows us to only pay 4% simple interest.  At the end of 10 years, the $100 principal will now be worth only $61 in 2012 dollars.  If we paid $40 in interest over the 10 years, our loan has actually cost us very little.  In fact, given that those $40 payments were made over time (and are also decreasing in value gradually), we’ve only paid about $33 in interest in 2012 dollars.  In total, we’ve paid $61+33 = $94.

By waiting to pay in the terms of this simple loan, we will actually save money, in 2012 dollars, by waiting to pay.

Wait — sometimes we can save money by paying interest?

This may seem counterintuitive at first: how can you “save money” if you’re actually paying more dollars?  In all of these scenarios, no matter what inflation is, you’re still paying $140 in terms of the actual numbers totaled up.

But, with inflation, those dollars are worth less over time.  If the prices of goods go up faster than the rate your loan charges interest, you’re effectively making money by not paying down your loan. This might be better illustrated if you imagine the exact price for an item as it changes with inflation.

Suppose a loaf of cheap bread costs $2 today.  With $100, you could buy 50 loaves.  Now, let’s imagine 5% inflation over ten years, which is high, but a nice round number.  What can you do with $100 (in actual current dollars) each year?

Year 1: $2/loaf — 50 loaves

Year 2: $2.10/loaf — 47 loaves

Year 3: $2.21/loaf — 45 loaves

Year 4: $2.32/loaf — 43 loaves

Year 5: $2.43/loaf — 41 loaves

Year 6: $2.55/loaf — 39 loaves

Year 7: $2.68/loaf — 37 loaves

Year 8: $2.81/loaf — 35 loaves

Year 9: $2.95/loaf — 33 loaves

Year 10: $3.10/loaf — 32 loaves

If your goal is to feed your family, you can buy a lot more loaves of bread with $100 now than you’ll be able to with $100 in 2022 dollars after a decade.  So, if you make a $100 purchase and pay with cash, you would lose out on 50 loaves of bread today.  But if you paid a small interest charge (which would cost you a loaf or two each year), in 10 years, you’d only lose out on 32 loaves of bread. Whether you save money or lose money on this deal depends on how big the finance charge is.  If you will pay more than “18 loaves worth” in finance charges over 10 years, you will lose money.  But assuming inflation is positive, you’ll never end up paying the $140 = 70 loaves in today’s dollars that you might initially assume.

The crucial point, however, is even more basic.  Most people assume that their salaries will probably go up over time, at least to keep pace with inflation or so.  That means that losing out on $100, or 50 loaves of bread, might be a significant sacrifice in 2012.  But losing out on 32 loaves of bread ten years from now might not be nearly so bad.

(In response to concerns raised elsewhere, I should note here that it is commonly claimed that the inflation factor for mortgages is only relevant if your wages keep up with inflation.  I don’t know why this argument seems to get so much traction.  The reality is that your loan principal will not go up and interest rates won’t change on fixed rate mortgages.  So even if your wages increase at a slower rate than inflation, as long as they increase at all over time, the burden of mortgage payments will decrease within your monthly budget.  If inflation continues to rise faster than your wages, you’re better off having extra liquid reserves to pay your monthly bills as costs rise, rather than have that cash all sunk into a depreciating loan principal.  Keep in mind that the alternative to paying down your mortgage shouldn’t be to go out and spend everything you make every month: it should be to save that money elsewhere, where you can apply it as needed when you don’t get that raise or bonus you expected and prices are rising, or when you lose that job, etc.)

Factoring inflation into a complex mortgage calculation

Now that we have a sense of the effects of inflation, let’s go back to that 4% 30-year $100,000 mortgage which we thought would cost $172,000 in total payments over the years.

Assuming an average 3% inflation rate (which, again, has been typical for the past century), what would our total payments really be like, in current 2012 dollars? It turns out that we’ll actually only pay about $114,000 in today’s dollars by the end of the loan.  We’re still going to lose money to interest, since the inflation rate is less than the mortgage interest rate, but it’s nowhere near as bad as that $172,000 number which actually appears on your loan statement.

Now, let’s reconsider those overpayment strategies.  Before, it seemed like we would save significant amounts, but those numbers just don’t look as rosy once inflation is factored in. If we overpay by $100, we’ll still pay off the mortgage 8 years early, and in today’s dollars, we will have paid a total of $111,000.  If we double our payments, we pay off the mortgage in 11 years, and in today’s dollars, we’ll have paid about $106,000.

Now the differences don’t look as extreme, do they?  Yes, by overpaying you get to pay off the mortgage earlier.  But you’re really not saving much in constant dollars at all, assuming moderate inflation over the next 30 years. By overpaying, you’re not paying as much interest, but you’re paying down the loan early using “expensive” dollars, i.e., dollars that could buy more loaves of bread than they will be able to in 30 years.  If inflation rates increase suddenly, as seems possible given the volatile nature of fuel prices in recent years, the differences between payment strategies becomes negligible.

In fact, suppose we have a fuel crisis as happened in the 1970s, when inflation skyrocketed to over 10% at times.  In that case, there’s a serious advantage to holding onto that mortgage debt as long as possible.  Why?  Because when inflation rates are greater than your mortgage rate, you’re actually going to end up paying less in the long run on your loan (including interest charges) than you would if you paid for the house in full up-front.

That may seem counterintuitive, but we’ve already seen it in the 5% inflation scenario above for the simple loan above.  Or to take a rather extreme case, if loaves of bread suddenly cost $100 due to sudden inflation, a $477 mortgage payment is going to seem like nothing.  Moreover, you would probably be happy to have extra money in the bank to help pay for food, rather than locked in loan principal that is now worth a lot less.  It’s incredibly unlikely to see such extreme inflation within a decade or two, but on a smaller scale your dollars are very likely to have a gradual decrease in value.

Summary

If your mortgage rate is near the inflation rate, you’ll get little benefit in constant dollars by overpaying.  In fact, you’ll probably just be hurting yourself in the short term, since you’ll be churning out large payments in the next few years when your income is likely smaller than it will be in the future.  (Again, we’re making standard assumptions for most people who have at least 20% equity or so in their homes.)  Let inflation gradually eat away at the value of the principal over the long term, unless you really, really feel the need to pay off the mortgage sooner.

If by chance your mortgage rate actually ends up being less than inflation over the next few years, you definitely want to hold back on the payments, since the value of your principal will be falling precipitously in constant dollars.  Also, remember to factor in things like tax benefits, as in a mortgage interest deduction, which means your effective interest rate might be as much as 1% or more lower than your bank rate (once you factor in the tax deduction).

Only if inflation is much lower than your mortgage rate does it actually give you a significant advantage to overpay.  Given how low mortgage rates are now, unless we enter a deflationary period (which again seems unlikely given recent trends in fuel, food, and other essential prices), overpaying your mortgage is rarely going to be a significant advantage once inflation is taken into account.

That’s not to say that you should never pay down your mortgage early.  But if you’re thinking of your payments as possible investments that could be applied to other things in the present day, you might save or invest that money somewhere else or use it to buy something you really need.  (This inflation argument should not be taken as a license to go on a spending spree or to take an expensive vacation: you should still save that money where you can.)

Yes, those total interest charges often look scary on your loan statement.   However, if inflation continues at roughly the pace it has for many decades, in the long run your mortgage costs nowhere near as much as you might think.

Go to part 2: Other high-interest debt

Disclaimer: This is not intended to be financial advice for all people in all situations.  It’s a good idea to consult a professional financial advisor before making any major changes in your finance strategies, because individual circumstances will often affect the choice of strategy.