Choosing to become debt-free could change your life. It feels like freedom; it might help you feel at peace knowing you have become “financially independent.” It's sensible that many people strive to live debt-free, and it's crucial that borrowers with high-interest-rate debt pay off that debt as quickly as possible. However, you often don't need to pay off every debt as quickly as possible. Many people choose to pay down their mortgage at an accelerated rate—but, in fact, it is often best to continue paying your usual mortgage payments and to invest the extra cash. Retiring that debt too soon might actually have the opposite effect you are expecting.
The power of leverage can be quite confusing. If you don’t have a strong understanding of the power leverage can have, purposefully choosing to not pay off a debt probably doesn’t seem very logical. So, let’s make it logical!
For instance; if I offered to give you a $1,000,000 loan at 10% interest to do whatever you wanted with, would you accept? How about a $1,000,000 loan at 3% interest amortized over thirty years? If you reject these loans simply because you feel they would mean taking on too much debt, then you probably categorize every debt as “bad.” But, did you consider what you could use that extra money for?
The S&P 500 is considered to be one of the best representations for the performance of the US stock market—in the last 90 years the S&P 500 has returned 9.8% annually on average. If you took that loan at 3% and invested it all in an index fund that returned the S&P 500 average, over a year you would have accumulated $98,000 dollars in interest while only paying $30,000 in interest on the loan. In effect, you would have used someone else’s money for free to earn $68,000 for yourself—and that is just in the first year! If you got those returns, would you pay back the $1,000,000 loan immediately or would you keep using the money to make you more money?
Obviously, the stock market is not guaranteed to go up and there will always be risk associated with investments, but when thinking about paying off your mortgage at an accelerated rate I would consider thinking about that as an investment as well. Paying off your mortgage quicker will reduce overall interest paid on the loan but this savings very rarely comes close to what investing in other areas could generate.
In essence, don't infer that every debt is bad. If you manage debt properly, you can use it to not only do things like in invest in the stock market but to invest in yourself or your children through education. Using debt properly could help you go to college, or to buy a new car or home.
Good Debt and Bad Debt
Interest rates can help determine whether a debt is good or bad. Right now, the risk-free rate of interest for mortgage is lower than the historic average. This means lenders are willing to let you borrow more money for less. If you obtain a mortgage now that you can pay off on schedule, you won't pay as much in interest as you would have in a rising interest rate environment.
However, a debt with a high interest rate, like credit card debt, is very different! A horse of a different color.
Presently, many credit cards charge high interest rates, often over 17%. Let's say you owe $30,000 on a credit card, and you're being charged interest at 15%—if you paid the typical minimum payment, it would take 37 years to pay it off while paying over $37,000 just in interest. These revolving debts can be useful, but they are very rarely the right way to use debt on anything more than a very short-term timeframe. Credit cards companies charge high interest rates because of the risk associated with that type of loan. However, when you take out a mortgage, you are leveraging the value of the home in a way that gives the lender more security and gives you more money at a much lower interest rate.
When you get the opportunity to receive dollars at a low interest rate, as happens with most mortgages, it doesn’t make much sense to waste that opportunity!
Here are reasons why you might not want to pay off your mortgage:
- Extra Liquidity
Using extra cash to reduce the amount owed on a mortgage faster only converts cash (liquid assets), that could be used for anything, into an asset that you can't sell or exchange for money easily or without a considerable loss in value.
Put differently, paying down your mortgage locks your spare cash in one place – that is the opposite of diversification, a critical, longstanding investment principle. In contrast, you could increase diversification in your portfolio by investing that extra cash in anything else, even to buy a house cheaply and to sell it for a big profit.
An old colleague of mine purchased an expensive home in Florida with cash, completely without legal encumbrances like a mortgage or a lien. But he didn't have windstorm insurance despite living in a hurricane-prone zone. Unfortunately, the worst happened and the home was badly damaged during a hurricane.
There are many ways he could have leveraged his cash better. For example, he could have bought that home with a mortgage as well as several other good-quality rental homes in high-end communities. He would have easily gotten at least 7% return on his money. And in the case of a windstorm damaging his property, his other assets would still have been intact.
- High-Interest Debt
If you're repaying other debts (for example, student loans or credit card debt) with higher interest rates than your mortgage, it is almost always the right idea to put your extra cash toward that debt. This is because it would be very difficult to invest that same cash in a way that would generate better returns than what you are losing in interest on the other debt.
Basically, debts with high interest rates are exponentially more expensive and more costly compared to low interest rate debts so paying those off quickly can save huge amounts of interest in the long run.
- To Boost Retirement Savings
You’ll require a robust retirement account to maintain a normal standard of living upon retirement. So, if yours doesn’t look healthy, it is usually best to boost your retirement account than paying down a mortgage.
Why? You can pay for a home conveniently at a low interest rate, but you can't pay for your living expenses the same way. Without enough savings to pay bills when you retire, you may have to choose the credit card debt option just to survive. If you do, the have then accrued the dangerous, expensive type of debt that we should never hold onto, especially after retiring.
- You Don't Really Pay off Your Home
If you feel it's wise to pay off your mortgage early, think about this:
You don't actually own your home without a mortgage or legal claim. And as a homeowner, you'll always be subject to expenses on the home like repairs, insurance, taxes, and home association fees, even if your mortgage is paid off. This means that even if you are “debt-free” and have your mortgage completely paid off, you could still lose your home to tax liens if you did not budget carefully.
Yes, it can be freeing to have lower monthly bills and to not have to pay a mortgage monthly. You may want to pay down your mortgage so you can settle bills and retire. But know this: there will always be bills anyway. Bills will always remain with or without a mortgage. The best way to go is to create several streams of income via income-producing assets to help you pay your bills when you wish to retire. In this way, you are using your money and your assets to make you more money worth a lot more than the comfort paying down a mortgage might afford.
We have to be careful when taking out debt, considering interest rates and terms. But debit doesn’t have to be a monkey on your back. When used the right way, debt can be your best friend.