Prepaying a mortgage loan can free up cash and save a lot of money on interest payments. But investors shouldn’t be looking at their mortgages in a vacuum. Putting extra money into a mortgage can be seen as part of an overall investment plan.
While there are reasons why prepaying your mortgage makes sense in some cases, many investors are better off paying the minimum each month. Here are three reasons why.
1. Real interest rates are negative right now
Inflation pushed prices up almost 7% year-on-year last month, and it may still be some time before inflation returns to the Federal Reserve’s target of around 2% . Several economists believe that inflation will remain above 3% throughout 2022. Even Fed policymakers have raised their forecasts to 2.6% inflation in 2022.
At the same time, average mortgage rates over 30 years remain close to 3%. Those who have good credit or are willing to redeem the rate can get a loan for less than 3%.
With high inflation and mortgage interest rates nearing record lows, the real interest rate for the next few years could very well remain negative. It’s a bit like getting paid to go into debt. Every dollar you borrow against your home can increase your purchasing power if the inflation rate stays higher than the loan interest rate.
When real interest rates are negative, you should take on as much long-term, low-interest debt as possible (up to your comfort level).
2. You can get better long-term returns elsewhere
When you pay off your mortgage, you actually get a return on your investment roughly equal to the interest rate on the loan. Paying off your mortgage early means that you are effectively using cash that you could have invested elsewhere for the remaining term of the mortgage, up to 30 years. With rates so low, you should be able to find better long-term returns with other investments.
The stock market, for example, is expected to produce returns in the range of 7% to 8% over the long term. Morningstar analysts expect a well-diversified equity portfolio to produce an average annual return of 8% going forward.
But above all, this return is accompanied by greater volatility. The standard deviation of Morningstar’s forecast is 17%, which means that annual returns will vary between -9% and 25% about two-thirds of the time. Over the long term, however, investors should expect their investment portfolio to exceed their mortgage rate.
The counter-argument here is that most investors would not borrow against their home in order to raise investment capital. This is suboptimal from an economist’s point of view, but it may be optimal from a “I like to sleep at night” point of view. In today’s environment of high real estate values and low mortgage rates, capital is readily available for those looking to take on more debt, but it can be found outside your personal comfort zone.
3. Paying off early means increased streak of return risk
Paying off your mortgage sooner means giving up adding more to your investment portfolio today. The effect is that most of your investments are compressed into a shorter time frame – the post-mortgage repayment – which increases your exposure to return streak risk.
Return sequence risk is the potential for a few years in the stock market to have a disproportionate impact on your investment portfolio. If the stock market has had a few bad years in a row after you’ve invested most of your money, the impact is significant. Likewise, if the market collapses for a few years and you have hardly invested anything, you will have missed out on a significant portion of the returns offered by the market.
Since stocks are more volatile than other assets, the real advantage of the asset class – higher expected returns – is often seen over long periods of time. But if you have a shorter investment horizon, you could face several years of poor performance at the most inopportune time. This risk is mitigated with more time invested in the stock market, which means spreading your investments over as much time as possible.
Debt can be good
Some people are very averse to debt, but some debt can improve your financial well-being and provide additional flexibility while lowering the risks posed by inflation and volatile stock market returns. A real estate mortgage is a prime example of this type of debt, and the decision to pay it off sooner should take into account the three considerations above.