Approach almost any financial professional with the question, “Should I make extra principal payments on my mortgage?” and the answer is almost always no. You should invest any extra money you have versus paying down debt. Unfortunately, this advice misses the importance of a well-managed balance sheet and ignores the nuance of peoples’ financial circumstances.
First, the standard advice is generally correct. Paying down a mortgage is an investment like any other, except it has a fixed return which is the interest on the loan. Simply put, investing your money in a vehicle that may earn you 3% to 3.25% when you have the potential for much higher returns in the market is not rational. Moreover, equity in a home is illiquid. The house must be sold or a loan must be taken out to access your capital. Conversely, other investments (outside of retirement accounts) can be accessed at any time. So if this advice is so straightforward, what are we missing?
A material conflict of interest
There is a conflict of interest that must be acknowledged when addressing this issue. Most financial advisors are compensated by asset management fees and cannot collect fees on money that has been applied to a mortgage, which may lead them to persuade you to invest the extra money. That said, an advisor who is a fiduciary is legally and ethically obligated to act in their client’s best interests at all times and should provide advice that considers the elements outlined below.
The advice presumes that everyone is underinvested for long term goals like college and retirement. However, many people have maxed out their work retirement plans, direct ample savings to brokerage accounts, Roth IRAs, and 529s and are looking for other investment options. For clients in such a situation, paying down the mortgage is just another savings vehicle and a form of diversification.
Leverage is useful but ultimately paying down liabilities is a sound financial practice. Moreover, while markets tend to produce positive returns over time, nothing is guaranteed. Paying off a liability is a known outcome with a clear financial benefit.
Say what you will about optimization and logic, but money and financial decisions are rife with emotional baggage. A mortgage is often the largest financial obligation a family has and it is carried for decades. Paying extra principal towards a mortgage loan is incredibly motivating for many people, as they can envision a future where they are debt free (the sooner the better). And in practice, the day clients pay off their mortgages is often one of the happiest milestones they reach.
What you should do
- Prioritize your savings strategies. Paying extra toward your mortgage comes after other goals such as maxing out your retirement contributions, saving to a taxable brokerage, funding Roth IRAs, and eliminating consumer debt or student loans. If you cannot hit those targets, consider moving to a biweekly payment schedule with your loan servicer. The program will effectively make an extra loan payment each year without changing your cash flow.
- If you are in a position where you can pay extra toward your mortgage, consider making payments that would put you on track to pay off your loan in 20 years (assuming a 30 year loan). For most people in this situation, it is manageable from cash flow perspective. Contact your loan servicer for information on how much you would need to add to your payment to meet that goal. Very aggressive timelines such as a 10-year payoff will require significant cash flow commitments and suffer from diminishing returns (i.e., the interest saved drops dramatically).
- Refinance to a shorter loan. Depending on the rates moving to a 15- or 20-year loan may make more financial sense than extra principal payments.
Regardless of where you stand financially, take it with a grain of salt when a financial professional says mortgages are good debt and should never be paid off early. As with all decisions, consult your personal financial advisor for questions about your situation.
If you would like to discuss your situation with an advisor who will act as your fiduciary you can contact us here.
This is not a recommendation and is not intended to be taken as a recommendation. This material was prepared for general distribution and is not directed to a specific individual.
LPWM LLC does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers.