With interest rates on the rise as a result of efforts by the U.S. Federal Reserve to curb inflation, consumers in the market for a new mortgage have seen APRs essentially double over the course of 2022. At the end of October, the average 30-year fixed-rate mortgage was 6.94%. That’s up 3.85 percentage points from a year ago.
If you were one of the lucky ones who got your mortgage or refinanced in 2021 or sooner, then chances are that you were able to lock in at a reasonably low rate. However, this begs the question: Could this low rate be somehow used to your advantage?
Many financial enthusiasts love the idea of paying off their mortgages early because of all the positive benefits it offers: Becoming debt-free, paying less interest, building more equity, needing less money for retirement, etc. While these are all great reasons to make advanced payments against your principal, we are in a unique environment where higher-than-average interest rates could create some lucrative opportunities for people with low-interest loans.
If this describes you, then in this post, we’ll explore five reasons why paying your mortgage off early may not be the best use of your money.
1) Better Investment Opportunities
The first thing to consider is if there could be ways to get a better return on your capital. Whether you’re investing for the future or paying down your debt, the main goal is usually to put yourself in the best possible financial scenario.
Remember that when you pay down fixed-rate debt, it’s almost the equivalent of investing your money and getting the same interest rate. For example, let’s suppose your mortgage carries a 3 percent APR. In this circumstance, putting any extra money down on the principal would be basically like getting a 3 percent return.
In today’s environment, can we do better than 3 percent? Absolutely! Not only have most high-yield savings accounts raised their interest rates to 3 percent or more, but it’s also possible to get CDs, money market accounts, and even U.S. savings bonds (such as series I bonds) that pay more.
If you’re willing to take on a little extra risk, then there are plenty of reputable value stocks, ETFs, and REITs that also pay much higher dividends. Check out some of their historical returns and use Buxfer’s Forecast feature to estimate how much value shares of these assets might be over the next years or even decades.
Obviously, conduct these comparisons using the interest rate of your specific mortgage and whatever investment opportunities are currently available. Chances are that if you bought a home or refinanced your mortgage before 2022, then you should have no problem finding more lucrative investment opportunities.
2) Lower Relative Future Payments
You may not realize this, but in the future, your mortgage may feel much “cheaper” than all of your other expenses. This is because while inflation makes the cost of everything go up over time, the payments of fixed-rate mortgages stay the same. This means that even though your payment doesn’t technically change, it will appear much less relative to all of your other living expenses.
This is a concept that’s related to something called inflation-induced debt destruction. Investors who understand this concept are happy to continue making mortgage payments for as long as possible. Meanwhile, they can use any excess cash flow to build their net worth and prepare for the future.
3) Increased Financial Security
No one ever knows when trouble is going to strike. You might have an appliance that suddenly needs to be replaced, an expensive repair that has to be made to your home, or an unexpected job loss where you may be without a paycheck for the next few months.
To prepare for this and avoid getting into debt, it’s highly recommended by most financial professionals to have an emergency fund on hand. Your emergency fund should be somewhere between 3 to 6 months’ worth of your living expenses. It should also be held in cash and ready to go at a moment’s notice.
Unless you’ve already got a healthy emergency fund built up, then consider allocating money to one instead of putting it towards any extra mortgage principal. You’ll have a much easier time pulling it out of a high-yield savings account than you will be tying it up in your home equity where the only recourse is to apply for a home equity loan or HELOC (both of which make you list your home as collateral).
4) Potential Loss of Equity
Paying down your mortgage is not always a home run in terms of return on investment. Depending on the markets, housing prices can often go down in years when there is low demand from buyers or a high supply of sellers.
Consider what happens if you pay an extra $10,000 against your principal. If you later sell your house for $10,000 less than what it’s worth today, then the net return would essentially be zero.
Though it’s impossible to know for sure what the future holds, there are many people of believe that home prices have risen too quickly over the past two years and may be poised to decrease to more realistic values. If that happens, then again – tying up your principal in home equity would not be the best use of your financial resources. Consider other avenues that may be more liquid or lead to better growth potential.
5) Avoid Prepayment Penalties
Though not all lenders do this, it’s worth noting that paying down your principal may incur prepayment penalties. This is because from the lender’s point of view, paying down the principal eliminates future interest payments. Therefore, they might choose to charge a prepayment penalty to discourage these early payments.
Pick the Direction That’s Right for You
Ultimately, it’s up to you what you decide to do with your money. If becoming debt-free is an absolute priority, or if you bought a house this year and are essentially stuck with a high APR mortgage, then prepayments can make a lot of sense. Otherwise, consider the reasons we’ve discussed here and determine what the best course of action for your money will be.
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