This post is part 7 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.
This series of posts has attempted to identify reasons why the standard advice that putting extra money into your mortgage may not be the best financial strategy in all circumstances. Nevertheless, there are also plenty of situations where the standard advice is still relevant. In this final article, we’ll consider some reasons to pay down your mortgage.
1. High interest rates. Perhaps you have (or had) bad credit, so you have a terrible interest rate that is far above both the expected rate of inflation and any other safe investment’s annual return. Or maybe you acquired your mortgage during a period when interest rates just happened to be significantly higher than they are now. Refinancing might be an option in the latter case, and it could save you significantly more money than small extra payments on your loan. But if refinancing isn’t an option, and you’re stuck with a high interest rate, by all means pay it down as quickly as you can.
2. Adjustable rate and non-standard mortgages. The assumption throughout this series is that you have a standard 30-year fixed-rate mortgage, though similar advice would apply to other mortgage terms (such as 15-year mortgages or less standard options like 20-year mortgages). Mortgages with terms longer than 30 years–such as the 40-year and even 50-year mortgages that have recently become more popular–can have special pitfalls, but as long as they are fixed interest rate loans (which they often aren’t), the same advice here applies to them.
The other major type of mortgage beyond fixed-rate mortgages are adjustable rate mortgages (ARMs), also known as variable-rate mortgages. The terms of such mortgages must be read very carefully. Know exactly how often and when your interest rate can change, as well as what cap might be in force on the new rate. In general, ARMs are popular among people who want lower payments up-front, but they have a real possibility of ballooning into huge money sinks years down the road. It’s impossible to give general advice to cover all scenarios, but ARMs are generally most suitable to people who plan to sell their home again around the time that their interest rate could go up.
If you plan to own your home in the long term, a fixed-rate mortgage is often a better option, unless you truly can’t afford the payments up-front. One way to hedge your bets with an ARM is to try to overpay your mortgage in the first few years so that your payment is equal to what you would have paid for your normal fixed-rate loan. For many reasonable ARMs, you might accumulate enough equity early on to offset the potential rise in interest rate later. Again, though, every case is different, and modeling such mortgages is significantly more complex.
More exotic mortgages are rarely worth it. If you find yourself agreeing to some bizarre loan terms just to get a monthly payment low enough to afford a house in the short term, you can’t afford the house. It’s that simple. Some mortgages even include options like negative amortization, which means you make payments so small at the start that you aren’t even paying the interest on your loan. Effectively, you accumulate a higher principal over the first period of the loan, which leads to even larger payments later. You’re paying interest on the interest to own a home in the short term. If you somehow got yourself into a mess where you have some exotic mortgage loan, you should probably try to overpay it like crazy while attempting to refinance and get a more reasonable loan terms (even if it requires larger payments). Unfortunately, some of these exotic mortgages by predatory lenders even slap additional monetary penalties on you if you try to prepay.
3. Very low equity. As discussed in previous posts, equity in your home can be a positive or negative aspect of your overall financial portfolio. But a small amount of equity is almost always helpful. Most lenders will require private mortgage insurance (PMI) with less than 20% equity in your home. That can add large payments for additional insurance on top of your interest each year. In many cases, it will make sense to make additional payments early on to get yourself to a high enough equity that you can drop PMI.
4. “Underwater” scenarios. One of the major rationales behind PMI, as mentioned in the previous point, is that low equity owners are at greater risk if they need to sell a home because of inability to make payments. Low equity can also make it difficult for an owner to sell a home even under “normal” circumstances (such as moving for a new job). To close the deal when you sell your home, you may find yourself paying out commissions to real estate agents, last-minute improvements and repairs, and various other fees, particularly in a buyers’ market. These often add up to 10% of the selling price of your home–and perhaps significantly more–especially if your home is in poor repair. If the housing market in your area happens to depreciate, you may be looking at a hit of 20% or more when you try to sell your home. (Here I’m discussing non-speculative real estate purchases outside of real estate “bubbles.” In extreme circumstances, the losses can be much greater.)
Having some equity will allow you to sell your home without coughing up cash to get out of your loan. Whether this actually requires you to overpay your mortgage, however, is a separate issue. You might be willing to tolerate being slightly “underwater” in your loan, for example, if you have a large investment portfolio and emergency fund that would allow you to get out of your loan if you needed to. If you choose to stay with relatively low equity in your home, you should be sure to have a reserve kept in secure, extremely low-risk investments (or cash equivalents), which is large enough to allow you to exit your loan. Saving for this reserve should be a high priority, even you don’t overpay your loan to gain equity.
5. Lack of financial discipline. Many people seem to have difficulty saving money, even when they have excess income. If you are the type of person who lives paycheck-to-paycheck and will spend money if it’s in your bank account, I first would suggest you try to open a separate account and have automatic deductions move money there with each paycheck so you can accumulate a reserve. If you can do that, you should first address the many issues discussed in previous posts: paying down high-interest debt, creating an emergency fund, saving for retirement, and paying for adequate insurance. For many people, it is simply a matter of segregating the funds into a separate account where it isn’t available with easy access from your debit card.
But some people still can’t manage money. If you truly can’t keep a cash reserve somewhere without spending it, I suppose paying into your mortgage is better than frivolous spending. By “locking” your money into your mortgage, you can’t easily access it. However, if an emergency occurs, you may be able to get some equity back out by taking out a home-equity loan or selling your house. It’s not the road I would suggest, but for some folks it might be one of the few ways to “save” anything. If you decide to take this route, however, you should still be sure to pay off higher interest debt first, like credit cards or other types of loans with worse rates.
6. Feeling secure in “owning your own home.” For many people, this reason may trump everything I’ve written in this entire series. There is something nice about being able to say: “I own my home outright.” If this matters significantly to you, the financial benefits I’ve discussed may not be that important. By all means, overpay your mortgage, and feel secure. On the other hand, do be sure to consider advice in previous posts (reiterated in the previous point) about goals that may be more important to your overall financial security. These are critical issues to address before adopting an overpayment strategy.
Despite the pride you may feel in owning your home, do keep in mind that the trends today are toward short-term ownership. Averages vary depending on whom you ask, but the average length of home ownership in the U.S. is about 10 years. Unless you overpay significantly, you will probably not even make it to “total ownership” for a 30-year loan in under 10 years. You may be tempted to say, “Well, but then I can sell my home with greater equity, and that will allow me to trade up more easily.” Yes and no. You might actually be better off having a greater cash reserve when it comes time to sell your home. Many people end up in a situation where they want to buy a new home but have trouble selling the old one, which can become particularly difficult when moving for a new job. With a large cash reserve, you might be able to make a down payment and buy your new home even before selling your old one. If you have to wait to get your equity out of your old home before you can buy the new one, it can be much more complicated.
Nevertheless, debt makes some people anxious. They’d prefer to have a lower balance on the loan, and it may actually allow them to sleep better at night or worry less. If you have that type of personality, overpayment may simply be the best option for you.
Everyone has their own mortgage situation. Everyone has their own tolerance for risk and debt. Everyone has their own views about how to invest money.
In this series, I’ve tried to give fair advice about scenarios where overpayments on your mortgage may not be as useful as you think, and in some cases could actively harm your overall financial situation. In this post, I’ve also noted the most common situations where overpayment should strongly be considered.
My overall piece of advice is: take any “conventional wisdom” with a grain of salt. It does not make you more virtuous or a better person to overpay your mortgage, and from an overall financial perspective, it is rarely in the top few things you should do with excess income. But if your financial situation is already good overall, by all means make yourself feel better and pay that mortgage off early.
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.