I wrote about Dave Ramsey’s Baby Step 6: Pay Off Home Early about a year ago, and I’d like to revisit the question of “Should you pay off your mortgage early?” in light of today’s economic crisis. In the Dave Ramsey article, I examined both the advantages and disadvantages of paying off your home loan early, but I didn’t give a definitive answer, because I believed, and still believe, that each person will have to decide on their own based on their unique situation.
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Mortgage Prepayment Doesn’t Make Sense In Bad Economy
However, I can now say for certain that I am fully opposed the idea of prepaying your mortgage without paying it off completely because there are several related factors that make this a bad idea. In this discussion, I’ll assume that you’re relatively debt free; otherwise, prepaying your mortgage doesn’t make sense in the first place.
Another note, the point I am making in this article is specific to someone who has a fixed mortgage loan and has a large enough balance that they cannot pay off the loan in the short-term by prepaying — i.e., prepaying to reduce interest expenses. This is a clarification based on the first two comments below.
Unexpected Job Loss
I expect things to get worse over the next 12 months and unemployment rate will continue to rise — yes, despite the economic stimulus package that President Obama just signed into law. As such, I think any extra money that you may have should go toward your emergency fund as opposed to mortgage prepayment.
If you have 3 to 6 months worth of living expenses in your emergency fund before, now is the time to beef it up to 12 months. Why such a big jump all of the sudden? I think the greater margin of safety is needed because it’s now much harder to get a decent job than it was a year ago. Even the most skilled workers could go unemployed in this economy for many months.
Although the interest rates continue to drop, I think high yield savings account is still the best place to keep your money due to liquidity and preservation of principal.
Great Time To Invest
If your emergency fund is already in good shape, then I think investing your extra money in the stock market right now will give you better result in the long-term. Sure the real estate market price is depressed, but the stock market is nearly 50% off its high. So if you are looking for a “buy low” opportunity, this is it. Aside from buying at a deeper discount, I also think that the stock market will recover faster than the real estate market.
I think a Vanguard Target Retirement Fund is a great way to catch the market rebound. It’s simple, low cost, and globally diversified.
There may be other reason why paying off your home mortgage right now doesn’t make sense, but I think these two reasons alone are enough to make a strong case for not doing so. Sure, some of you may say that paying off your mortgage early gives you the best return on investment right now, and that’s probably true. But remember this, prepaying doesn’t buy you any favor with your mortgage lender. If you found yourself unable to pay your mortgage one day, all the money you paid early won’t make any difference.
What’s your thought on paying off your mortgage early? Do you think it makes sense in this economy?
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.
I think I lean a bit more towards the completely debt-free end of the personal finance spectrum. My wife and I paid off our mortgage 8 months after we bought it. However, we only had to borrow 63K on a 85K house (a lovely former “old lady’s house” in the rural South) so it wasn’t as hard to do. We still have 45K in student loans at less than 2% interest. I figured, if we hit hard financial times, it’d be easier to put student loans on hardship deferral than worry about mortgage payments. Our 401k took a beating like… Read more »
Some of us have what’s called a revolving credit mortgage. Not all of it, but some of it. For example, 20% of my mortgage is in a revolving credit account therefore every single month I leave the extra from my account in there. This offsets the mortgage on which I pay interest (therefore pay less) and also doubly acts as my Emergency Fund.
So you might be right, but under my circumstances, I probably won’t change anything in the current climate since my current situation is still right for me now.
Interesting thoughts though 🙂
@Pharmboy and Andy – You both made good cases with different views. When I wrote this, I wasn’t thinking about someone who’s close to paying it off and could pay off the balance (as in Pharmboy’s case), or someone who has other types of mortgages than standard fixed mortgage (as in Andy’s case).
The main point I am trying to make is that if you’re in a fixed mortgage situation and has large enough balance, then prepaying to save money on interest alone doesn’t make sense.
Let me clarify that in the post.
Pinyo, I think you are right here. In fact I would take it a little further. In an uncertain economic environment, with interest rates so low, you can increase your liquidity by refinancing for a lower interest and longer term. This may not actually save you any money (if you have built up equity in your payment a longer term will increase the amount that goes to interest), but your ‘liquidity’ will increase because your payment will go down. The upside is that is provides some additional money to save/invest (presumably at a higher return) and gives you more flexibility… Read more »
Agree. But, it’s still a good long term goal to pay off your home and now is a good time to stategies how and when you can pay off your home. If you find an investment right now – like Gold – that goes up over the next few years, then you can use the increase to once and for all pay off your mortgage. That is my plan.
I think it would make sense to pay down your mortgage if you’ve gotten underwater though. In uncertain times, it’s best to be flexible and having the ability to refinance or sell if you needed/wanted to would add a lot of flexibility in your choices. Otherwise, I’d still say it depends on where you are and where you’re going with your life. As a side note, it sometimes makes sense to prepay a bit of other fixed loans like student or car loans if it pushes off your next due date. That way, if something happened, you have the option… Read more »
I was prepaying my mortgage when it was 5.75% until I refinanced at 4.375%. I don’t think I’ll prepay at the rate I now have. Though I did see an advantage in the refinance because my payoff was less.
You seem to be equating paying down a mortgage with investing in real estate, and comparing that to investing in the stock market. Paying down a mortgage isn’t “investing in real estate” … you already made that investment when you bought the house. Paying down a mortgage is investing in a bond. A bond with a guaranteed rate of return equal to your mortgage rate, and investment safety better than even a US Treasury, and with a rate better than just about any fixed income investment out there … especially when safety is accounted for. When considering investing in a… Read more »
I am a big proponent of paying extra towards the mortgage but I agree with you right now. If you don’t have a sufficient e-fund then that is #1 in this economy.
Usually we send an extra $1,000 to the mortgage balance this time of year, but not this year. I’m keeping all the cash I can until the storm passes.
If you’re deciding between paying extra on your mortgage principal and boosting your emergency fund, I would recommend the emergency fund. You never know when you might lose your job. If you’re deciding between paying extra on your mortgage principal and investing in the stock market, I would suggest the stock market route. The stock market is at an extreme discount. If you have a lump sum that would completely pay off your mortgage, I would go that route as it works like an emergency fund. Not having housing payments is awesome for if you get laid off. Or at… Read more »
I had been putting about 10% extra into our monthly mortgage until about a year ago and quit after reading a book on why this was not smart. I wish I could remember the book and author, but the reasoning did stick and I can really relate now. Lose your job and who is going to loan you money on your home, better yet what if your home is worth 20% less today than it was last year…If you have that extra in cash some where you sure are better able to weather the storm than with the cash in… Read more »
I think we would all sleep better at night if we didn’t have a mortgage payment, but it’s also tempting to put some money to work with the stock market at 6 year lows. What to do? I guess you could split the difference and put 50% towards principal and 50% in an index fund.
I think the idea of beefing up your emergency fund is a good one, although getting to a year’s worth of income would be pretty tough, and perhaps not necessary if your job does not appear to be in jeopardy and you have two incomes in your household. The biggest advantage that I see from paying off your mortgage early is that it would require you to have less income in retirement, and so you will end up being in a lower tax bracket then. And given the huge amount of debt that our “esteemed” members of Congress have just… Read more »
We paid off our mortgage in 2002. We have savings in the credit union that are sizable. We have paid cash for remodeling the home we own and a second professional degree for me. My earning capacity is high as is my partner’s. I won’t get into the debate of the financial wisdom of this but I will tell you that we sleep peacefully knowing that no bank or mortgage company’s melt-down can affect us. We are secure. Friends mocked us for saving in a conservative manner now we are sorry for them as they decry their disappearing retirement accounts.… Read more »
Pinyo, I don’t know of any reasonable personal finance writer who advocates paying down a mortgage prior to saving a comfortable emergency fund. This is not even an argument that needs to be made. However, you made another argument in your original post, and others made it in the comments as well: that one should consider investing in stocks in a taxable account instead of paying down the mortgage. This is tantamount to borrowing on your house to invest in the stock market, and no matter what you think of the current market valuation levels, this is a very dubious… Read more »
It’s simple: over the long-term, any reasonable asset that you can purchase will appreciate in value at a greater rate than inflation; you want to have as large a pool of assets as you can afford the holding costs on (income less expenses, including interest). Therefore, you should be INCREASING your holdings by borrowing more, rather than DECREASING by borrowing less. Carve the current 5 years economic period out (simply by holding a 20+ year horizon) and you will find that this is the timeless ‘secret’ to wealth … I don’t know anybody who has become richer over the long-term… Read more »
Pinyo and AJC,
So, you guys are maxing out your available Home Equity loans to invest in the stock market? Or perhaps you are refinancing your full home value at current low rates and pulling out equity and investing it in the stock market?
Because when you have money that could go toward paying down your mortgage, and you instead invest it in stock in a taxable account … you are essentially doing the same thing.
@J – I can’t speak for AJC. I am too conservative to pull equity out of my home to reinvest; however I don’t prepay my mortgage preferring to use that money to build up emergency fund and investing in retirement plans. I think it’s a bit extreme to equate the two as being the same thing because they aren’t.
For those who have a stable income, and some day would like to be mortgage free, a 15 year fixed rate mortgage can at least provide a realistic goal, while saving thousands on interest payments, compared to a 30 year loan.
Last year I invested $ 400K in annuities and mutual funds. I now have about half that amount of money. (I have another $ 400K in a company pension fund, plus social security) Five years away from retirement with a stable job, I decided to pull most of the money that’s left in those investments and pay off my mortgage. Over the next five years we will put what we had been paying on the mortgage in CDs. Even at 2% interest, that will give us almost 7.5% growth on our money, if you figure the mortgage interest we’re not… Read more »
So, I have a question for all of you – we bought our house in 2007. Too bad, because the market fell so badly after we bought our house, which we shopped and shopped for the best deal for. Our mortgage is at 5.6%. We had the opportunity through our lender to refinance at 4.75% (with closing costs) and decided to take it. But, they did an assessment of the property value and determined that our home has lost 20k (from 385k) in value since we bought it. Our lender said in order to continue to qualify for the 4.75%… Read more »
I am wrestling with this a bit myself. I know I will get a long term higher return if I invested in the stock market, but to help improve our cash flow I am looking to reduce some of our mortgage payments – cash flow is a little tight right now.
How about this: You’re young and healthy and buy a house. You also take out a par whole life policy for the amount you owe. You dump in extra money into the policy as you have it, buying paid up additional insurance. Dividends accrue within the policy tax-free. Depending on the interaction of the dividend scale and the amortization table, some time around year 15-20, you”d have the cash value sufficient to pay off the house completely if you want to. Maybe you don’t want to, though… if your policy is accruing tax free, and your mortgage interest is tax-deductible,… Read more »
I can see the logic in what you’re saying, but for me (someone who has no debt other than a small mortgage), paying off the mortgage in an accelerated fashion is part of my long-range goals, and if i invest the money rather than prepay, I’m just deferring that aspect of my plan. I can’t retire until I pay off the mortgage, and i plan to have it paid off in just 7 more years.
My numbers, by the way, are as follows: balance on my mortgage, $65,000 at 6%. I would rather continue prepaying (with an extra $425 monthly) than shell out $4,000 or so on closing costs to refinance at a lower rate.
My emergency fund has 3 months worth of living expenses, and i’m adding to it with an extra $700 monthly while i still prepay the mortgage AND fully fund my IRA and 401k.
If i had to, i could pay off the full balance of my mortgage now with taxable invested savings (but wouldn’t want to)