This post is part 6 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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In previous installments of this series, we considered your mortgage money as if it were “in a vacuum.”  When inflation or equity payments were considered, we didn’t consider what you might do with your money otherwise.  We just compared the returns on your investment essentially to what you’d have if you just kept the money as cash.

Of course, most people don’t do that.  At a minimum, if you don’t overpay on your mortgage, you might put the money into a money market account or something.  For the past few years, those tend to earn less than 1% interest or so, but that’s still better than 0%.

As mentioned in previous posts, there are some “no-brainer” situations where putting your money elsewhere is a better investment than putting it into your mortgage.  If you have credit card debt or other loans with very high interest rates, definitely pay those off first.  If your employer gives you a “match” for your retirement, be sure to take advantage of that to the greatest degree possible, because getting an immediate 100% or 50% return or whatever is better than any other guaranteed investment out there (including your mortgage).

But let’s say you’re already paid off high-interest loans and credit cards, and you’re getting your employer match.  You have an emergency fund and adequate insurance.  Should you begin pumping money into your mortgage?

The “guaranteed” return of a mortgage

You’ll often hear people in favor of paying down your mortgage talk about how they are “guaranteed” a return on their investment.  That’s true.

Basically, you can compare your mortgage to an investment in a stock or bond or whatever.  Let’s say you get a $1,000 bonus from work for something, and you’re trying to figure out what to do with it.  Let’s say you decide you’re either going to use it to pay down your mortgage, or you’re going to invest it in something else.  What return would you need to get from your investment to make it worthwhile?

The answer seems rather simple in the abstract.  You’d need to get the same annual return on your investment as you pay in mortgage interest.  So, if you put that $1,000 into a 30-year mortgage with an interest rate of 4%, you’ll theoretically end up with exactly the same amount of money as if you had invested that money into a stock that earned a 4% annual return until the end of the 30-year mortgage term.  (There are further complications to this simplified example, which we’ll discuss below.)

If your mortgage interest rate is high for whatever reason, and you haven’t been able to refinance, it may be doubtful that you could get as good of a return elsewhere.  If you’re paying 6% or 7% interest or more, you might as well take that return.  Yes, you might be able to do better in the stock market overall, but it’s risky and not guaranteed.  Your mortgage return is guaranteed, though.

One immediate caveat to this “guaranteed” return, though.  It’s only the same as that an equivalent investment assuming that you wait for the entire length of the mortgage term.  In other words, if you have a 30-year mortgage at 4%, putting additional money into the mortgage is like investing in a CD that matures at the end of those 30 years.  It doesn’t even matter if you pay the mortgage off early by overpaying.  That money is essentially “locked in” for the entire 30-year loan term at 4%, at least when you compare it to other investments.  If you sell your house after only 10 years of ownership on a 30-year loan, any overpayments may not have given you an effective 4% return.  It’s hard to say exactly what kind of return you did get without considering how much you can sell the house for after 10 years and how much that extra equity affected your rate of return for the sale.  (As we explored in the last segment of this series, additional equity actually decreases your effective return in some cases.)

But let’s be absolutely clear about what people mean when they say they get a “guaranteed return” equal to their interest rate on their mortgage.  What they mean is that you have two choices with what to do with your money over a 30-year period.  Say your mortgage payment is $500 per month.  You have $600 per month to use for mortgage and investment.  You could make that extra $100 payment each month, or you could invest that $100 in some investment with the same annual return as your interest rate (say 4%).  If you pay off your mortgage early by overpayment, you need to continue to make investments of $600/month now in some account at 4% annual yield.  After 30 years of paying $600/month, you’d end up with the same amount overall by overpaying your mortgage and then investing $600/month later as you would if you paid your $500 regular payment for the entire 30 years and simultaneously made $100 investments each month.

These two things only come out equal if you always make the $600/month mortgage/investment payment for 30 years, regardless of whether you pay off the mortgage early.  If you instead take a snapshot after 10 years, for example, the guy who was investing his $100 per month will have a lot more money in his investment account than the person who had just been throwing it into a mortgage.  Of course, the person who overpaid the mortgage has greater equity, but it’s all a trade-off.  The person will the large investment account in 10 years might need that liquid cash for some reason, and he’ll be able to use it immediately, whereas the person with equity would need to apply for a home-equity loan (usually at a higher interest rate) or sell the house to get that equity back out.

It’s only if you wait the full 30-year term that the “guaranteed” mortgage overpayment equals the external investment.

In other words, treat mortgage overpayments as if you were putting your money into a 30-year CD.  Unless you wait the full term, you might not see that return.  If you want to “withdraw early,” you’ll need to take a home-equity loan or sell the house, either of which could carry financial penalities (higher interest rates, cost of marketing and selling house, having to sell a house in a bad market at a lower price, etc.).

So, yes, the return is “guaranteed,” but the “fine print” on that guarantee is important to consider.

Calculating the real interest/return rate on your mortgage

When you want to compare potential returns on investments, you also need to take into account the effective interest rate on your mortgage, i.e., what you really are paying once you take various factors into account.

For one thing, be sure you understand the difference between the interest rate your bank tells you about the mortgage, versus your actual annual rate.  What I mean here is the difference between what’s sometimes called APR (Annual Percentage Rate) and the interest rate usually stated.  For example, if your bank gives you a 4% interest rate on your mortgage, the interest is usually “compounded” at each payment.  If you pay monthly, at the end of each month they will need to charge you 1/12th of that 4% interest, which they usually do by just dividing 4/12 = 0.333% interest per month.  That seems fair, but it makes it difficult to compare the rate to investment returns or even interest in your bank account.  There, the interest truly is “compounded,” that is you “earn interest on your interest.”  In a loan situation, you are also effectively “paying interest on your interest” compounded backwards, which is why your mortgage payments early on are mostly interest, but toward the end of your loan, they are mostly principal.

This is a hard concept to grasp, so if it doesn’t quite make sense, don’t worry about it.  From a practical standpoint, what you need to know is how your loan interest rate compares to a rate on another investment.  To figure that you, you would need to use a formula.  First, divide your “annual interest rate” (the bank rate) by the number of times the interest is added on each year (usually for each payment, so 12 for monthly payments).  As we saw above, for a 4% rate, that’s a 0.333% interest rate per month.  Now, you covert that percentage into a decimal (divide by 100): 0.333% = 0.00333.  Add that to 1: 1+0.00333 = 1.00333.  Multiply it by itself for however many interest periods per year, in this case 12: 1.00333 * 1.00333 * etc. 12 times, or 1.00333^12 = 1.04074.  Now subtract 1 again, and convert back to a percentage: 0.04074 = 4.074% interest.

In this case, 4.074% is pretty close to 4%, so the difference is not huge.  For larger interest rates, it may make a bigger difference.  (For example, for a 15% bank rate, you’d actually end up paying higher than 16% interest annually if it were compounded monthly.  We haven’t seen mortgage rates like that since the early 1980s, but this is relevant for credit card interest rates.)  In any case, that’s what you should compare to your annual yield on your stock or bond or money market account investments.

The more complicated issue is taxes.  While the conversion to an effective interest rate from your bank rate may make your “guaranteed” mortgage return look slightly better, for many people the tax advantages of paying a mortgage may make that annual return look significantly worse.  It depends a lot on your ability to deduct mortgage interest and your tax rate, but you might be saving a percentage point or more on your supposed mortgage interest rate.  On paper, you may be looking at 4% interest, but once you take tax advantages into account, you’re really only paying about 3% or less interest.  These sorts of issues would best be addressed with a tax expert or financial planner, unless you’re really good with percentages and doing your own taxes.

Nevertheless, again, you should use your effective interest rate (taking taxes, compounding, etc.) into account when comparing your return to other investments.  A 4% investment guaranteed for 30 years is quite different from a 3% investment for 30 years.  (For a $1000 initial investment, at 4% interest it would come to $3,243 after 30 years; for 3% interest, it would only be $2,427.)  And just because you can’t find a better guaranteed investment right now, you need to consider whether it’s a good investment to lock your money into an effective 30-year CD at 3% interest.  For some conservative investors, that might look like a reasonable idea.  For young people trying to invest for retirement, who have time to swing a bit with ups and downs of the market, a locked-in 3% interest rate for 30 years may not be that desirable.

Remember that you also need to compare your effective mortgage rate with your effective investment rate for other investment accounts.  Again, that will depend on taxes, fees, etc.  Your stock may have gained 10% per year on average for the past 5 years, but what is your actual return after capital gains, fees to your broker or investment service, etc.?  If you’re looking at retirement investments that can grow tax-free (like Roth IRAs), your annual rate of return is pretty much your real rate of return, but otherwise, you may need to do some computing to figure out what you’re earning elsewhere vs. investing in your mortgage.

Viewing your mortgage as part of your investment portfolio

In the previous post of this series, we saw how short-term ownership of your house can be considered to be an investment, and how having excess equity actually can drag down your rate of return in some circumstances.  That is not saying that ownership or equity is bad, but rather that you need to consider the “balance” of your portfolio of investments.

Most people understand the basic idea that you shouldn’t invest 100% of your money in some risky stocks.  Most advisors would say to have a balanced portfolio including some stocks (or mutual funds containing diverse stocks), some bonds or other lower risk investments, some cash or money market accounts, etc.

Your mortgage is an investment.  You already are invested in real estate by buying a home, and that comes with certain liabilities.  But your mortgage should almost be considered a separate entity from the house itself in terms of investment.  Once you have the mortgage, you can choose to invest your money in various ways.  You could overpay your mortgage (and effectively earn a few guaranteed percentage points on the equivalent of a long-term CD).  You could invest your money in retirement or stocks or bonds or a savings account for an emergency fund.  No matter what, you should always have enough money in the bank or equity in your home so you don’t end up “underwater” in your loan (i.e., owing more than your house is worth and unable to sell).  So, don’t go around putting money in risky stocks until you have an investment (or equity) cushion in case your home value depreciates a bit.

But even for your house, there are different ways to invest.  If you plan to sell your house in the next few years, adding equity won’t matter very much in terms of getting you a better deal on your sale.  You might be better off taking excess cash and investing in some minor improvements to your property, which could raise the sale price a lot.  Many household repairs and improvements can give you an immediate return on your investment if you want to sell your house — often even doubling or tripling the money you put in when it comes time to sell.  A 100% or 200% return on some home improvement in the next couple years will beat out anything you’re going to get by overpaying your mortgage in the short term.  You should consult with a real estate agent if you’re considering this type of monetary investment, just to be sure you’re going to do something that will increase your perceived property value significantly in your area.

Summary

By buying a home, you have already made a significant investment in residential real estate.  For many people, this is a huge portion of their overall investment portfolio.  By overpaying a mortgage, you are choosing to put even more money into that particular investment now, rather than other things that could round out your overall financial picture.  Aside from comparing investment returns and yields, it often comes down to priorities too: do you want a well-rounded portfolio now, or would you prefer to own your home first and then build up other aspects of your portfolio?

In previous posts, we’ve identified other priorities that are essential to invest in before overpaying on your mortgage, like paying off high-interest debt, getting adequate insurance, and preparing for the future by having money available for emergency funds and retirement.  There are very few circumstances where overpaying your mortgage should take priority over these sorts of things.

But once you have these other major concerns addressed in your financial health, the next step is considering your investment portfolio as a whole.  Investing in a mortgage gets you a guaranteed return for the long-term.  But it also locks more of your money into an investment in a particular piece of property in a particular area.

I am definitely NOT encouraging anyone to go out and buy a bunch of risky stocks instead of paying into their mortgage.  But having some riskier investments in your portfolio can help enhance your returns over time.  When you’re thinking about how much money you have saved elsewhere, how much is in various types of investments, and how much you have to invest further each month, you should consider whether it’s a good idea to put your money into the equivalent of a 30-year CD at your mortgage interest rate.  If you’d do that with a CD at that rate at a bank if you had the extra cash, you should invest in your mortgage.  But if you’d hesitate to lock that money into a long-term CD, perhaps you should also consider other options before overpaying your mortgage.

Go to part 7: When you should pay down your mortgage

Disclaimer: This is not intended to be professional financial advice, nor does it apply to all people in all situations.  It’s a good idea to consult a professional financial advisor before making any major changes in your finance management, because individual circumstances will often affect the choice of strategy.