You've probably been told time and time again that you should pay down your mortgage as quickly as possible. And while it may seem like the responsible thing to do, you may be better off keeping that money invested in something that will earn you more interest.
Here's a closer look at why paying down your mortgage may not be the best financial decision:
Your mortgage is probably your lowest-interest debt
If you have other debts with higher interest rates—such as credit card debt—it may make more sense to focus on paying those down first. There are two advantages to doing this. One is that you can prioritize your highest interest debts and in doing so pay off those debts that are costing you the most in overall and monthly terms. A second advantage is something called the snowball method. Since most mortgages last for 25-30 years, this is usually the biggest debt that someone will carry and the one that will take the longest to pay off. If you had a mortgage for $500k and a car loan of $30k, you may want to save up and knock down some of that debt. You could put that additional $30k into your mortgage and bring down your monthly mortgage cost slightly. Or you could wipe out your car loan completely. Depending on the difference in interest rates, paying off your car loan may be the smarter move in terms of saving more money over time. Let's say your mortgage rate is 5% per year over 25 years and your car loan charges you 8% per year. Here's how those two debt repayments stack up:
Mortgage lump sum payment $30k
$500k @ 5% = $2,908.02/month
$500k - $30k = $470k
$470k @ 5% = $2,733.54/month
So on a monthly basis, the cost savings for paying down your mortgage is:
$2,908.02/M - $2,733.54/M = $174.48/M
Car loan repayment of $30k
$30k @ 8% = $6,498 Total interest on a 60 month term
Monthly payment = $608/M
So, you can easily see that by paying off your higher interest car loan you end of saving yourself $608 per month versus only $174.48 per month by paying down your mortgage. In simple terms this puts you ahead by an extra $433.52/M
Difference in savings = $608/M - $174.48/M = $433.52/M
Now with that car loan out of the way, you have an additional $608/M you can start throwing at paying down your mortgage even faster than before. The main idea with the snowball method is that you knock out your smaller debts and use the extra money saved to pay off your bigger debts. In this case, you are also following the avalanche approach which focuses on paying down your highest interest payment first. Both approaches have their benefits. The snowball approach is handy for giving you that psychological win of knocking out your smaller debts faster. The avalanche approach is more financially efficient since it focuses on paying off higher interest debt first. In a lot of cases, your mortgage is going to be your bigger loan and have a lower interest rate, often making your other debts preferred candidates to knock down first.
You could miss out on potential investment opportunities.
If you have the opportunity to invest your money in something that has the potential to earn more than your mortgage interest rate, you may want to do that instead. You could end up making more money in the long run this way. Let's say for example that you have a locked in fixed mortgage for the next few years at only 2%. Today's cashable GIC's are paying as high as 4.75%. So that means you have an opportunity to make a guaranteed 2.75% more on your money by putting it in a cashable GIC than by using it to pay down your mortgage. Additionally, if you are comfortable with taking on some risk you could make even more money by investing in the stock market or another rental property. By some measures, the US stock market has averaged a 7% return on investment per year over many decades. If you invested $100k in the stock market with a 7% annual return on investment that would be $7000 per year, or almost $600 per month compounding with each additional year you're invested! With rental properties it's possible to make even more money when you factor in three areas of potential: rental income, appreciation, and equity. Some rental properties can net you upwards of 10% per year! And although you can't quickly and easily liquidate a rental property back into cash, the upside of an investment property is the fact that you get to leverage more than you have. So if you invest $100k as a down payment on a $500k property you can now benefit from the appreciation of a $500k asset with only 20% down.
You may not have enough saved for an emergency fund
Although it's good to pay down debts, you don't want to put yourself in a vulnerable situation if an unexpected emergency arises. Before you start putting extra money towards your mortgage, be sure you have an emergency fund saved up. This will help you cover unexpected expenses if they come up suddenly. Although this isn't actually a reason in and of itself not to work on paying down your mortgage early, it is a caution that if you are pursuing this goal you should make sure you maintain a rainy day fund just in case the unexpected happens.
Weigh all the pros and cons before making a decision
Paying down your mortgage early isn't always the best financial decision. Be sure to weigh all the pros and cons before you make a move. As with most important decisions the costs and benefits of paying down your mortgage are going to be extremely personal based on your own unique circumstances. For some people this might be the highest and best use of their savings, for others maybe not.
While the conventional wisdom of paying down your mortgage as quickly as possible may seem responsible, it may not always be the best financial decision for everyone. Several factors need to be considered before deciding whether to prioritize mortgage payments or explore other investment opportunities:
Focus on higher-interest debts: If you have other debts with higher interest rates, such as credit card debt, it may be more prudent to prioritize paying those down first. Utilizing the snowball method can help you knock out smaller debts and free up funds to tackle larger debts later. Typically, consumer debt has a higher rate of interest than a mortgage.
Potential investment opportunities: If you have the chance to invest your money in assets that can earn higher returns than your mortgage interest rate, it might be more advantageous to explore those options. Investments like cashable GICs, stocks, or rental properties could potentially provide greater long-term gains.
Emergency fund: Before committing extra funds to paying down your mortgage, ensure you have an adequate emergency fund in place to cover unexpected expenses. Maintaining financial security is essential, even when working toward paying off debts.
Ultimately, the decision to pay down your mortgage early should be carefully evaluated based on your individual financial situation and goals. While it may make sense for some individuals, others might benefit more from pursuing different investment strategies or addressing higher-interest debts first. Weighing all the pros and cons will enable you to make an informed decision that aligns with your unique circumstances and objectives. Remember to seek professional financial advice if needed to make the best choice for your financial future.
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I am a Victoria-based local realtor with eXp Realty. My commitment to honesty, integrity, loyalty, and hard work have been essential pillars for me because they drive a high standard of excellent service for my clients. Helping you realize your dream is my goal!
I service Vancouver Island, but my focus is on Victoria, Sooke, Saanich, Malahat, Shawnigan Lake, Cobble Hill, Duncan, and the rest of the Cowichan Valley.