Editor’s note: This is an update of an article originally posted in May 2012 – our first week of publication. Since most of you missed it, we thought you might enjoy it.
The 30-year mortgage is one of the biggest financial traps out there. There, I said it out loud. Now, let me be clear by saying it again: the 30-year mortgage is one of the biggest financial traps out there! While a 30-year mortgage may seem like a good idea, spending 30 years to pay it off could be one of the biggest financial mistakes of your life.
Before you get all bent out of shape and tell me why I’m wrong, I ask you to please hear me out. First, we have a home mortgage. In fact, we have three mortgages – one for our primary residence and one each for our two rental houses. Without these loans, we would not have been able to afford these properties. So, yes mortgages can be useful tools when they are used correctly. Admittedly, we probably could not afford the houses we bought when we bought them. That was our mistake. However, it has always been our plan to pay these debts off early. Our philosophy is that we will never let the bank make more money off of us than necessary.
What I am about to tell you is probably the best financial advice you will ever get. If you do this, you will free yourself from the bonds of debt slavery much quicker than if you choose another path. It goes against conventional wisdom and probably against the advice of nearly any professional financial advisor out there. However, it could be the key to your financial freedom. Are you ready for this magical bit of advice? Here it comes: pay your mortgage off early.
Mortgage Prepayment Basics
In order to pay-off your mortgage early, you will have to pay over and above your monthly payment. So, if your payment is $1,000/month, you would need to pay more than $1,000/month to your mortgage company. Provided that there are no prepayment penalties, I would argue that this is a great use of your resources. The extra money should go directly to your principle balance, decreasing both your principle balance and the amount of interest that you owe. Keep in mind that the amount of interest that you pay over the lifetime of the loan is front loaded, meaning that for the first 15 years or so on a 30-year mortgage, you are paying more interest than principal. The faster you can knock down that principal balance, the less interest you will be paying the bank – which could save you tens of thousands of dollars during the life of the loan. On a $200,000 loan at 6% interest, just $50/month extra can eliminate 3 years on your loan! Now, that is saving money!
Professional financial advisors would almost never give you this sort of advice. They would argue that you can make more money by investing it in some form of securities. Their typical simple mathematical reasoning for this usually goes as follows:
Your mortgage interest rate is costing you approximately 4% interest on your investment. However, over time, the stock market gives you a rate of return somewhere around 10%. Therefore, if you invest the extra money you have, you would earn 6% more than you would by paying off your mortgage early.
That sounds like a pretty good argument, right? Wrong. While I think that most financial advisors are good people and are genuinely trying to help you make solid financial choices, the simple fact is that their math is wrong. They are neglecting to include three things in their equation – taxes, fees, and risk. You see, you have to pay a capital gains tax on any money earned through an investment. That tax rate is currently 15%, but could either increase or decrease at any moment. Also, each time you invest – make a purchase – through an advisor, there are fairly substantial fees and commissions that you must pay. These vary from company to company, but they all have them. Finally, there is no guarantee that you will make any money on your investment. If you are able to pay off your house in a short amount of time, say 5 to 10 years, chances are very good that you will not actually reach a 10% return on your investment. So, by they time you weigh all of these things into consideration, it is my belief that by investing your money, the results will be close to a wash. However, you will have taken on several more years of putting your house at risk.
Think about it this for a minute. Who does paying off your house benefit besides you? Nobody. That is why most people in the financial field won’t give this advice to you. Nobody makes any money in this endeavor but you. The bank makes less money in interest, brokers and financial advisors make less in fees, and you get to keep more of your hard-earned money. That is great for you, but bad for them.
Live Below Your “Means”
One of the big trends today is moving into a bigger “better” house as your income increases. Lot’s of people will tell you that you can afford this upgrade in lifestyle, that you have the credit to get that $400,000 mortgage that you want. I’m here to tell you that advice is bunk. It is terrible. Why trade one mortgage for another? Why start a new 30-year mortgage at age 40 and become a debt slave to the banks until you turn 70? That doesn’t sound lilke good advice to me.
Of course, prepaying your mortgage is only a good idea if you have no other debt besides the mortgage. If you have credit card balances, car loans, etc., then it is definitely best to pay those off first. Additionally, you should only be prepaying your mortgage if you are also able to save for retirement. If you have a work sponsored 401K or IRA, you should definitely be contributing as much are you are comfortably able to. If you do not have a retirement plan sponsored through your employer or are self-employed, you should set up your own IRA.
So, if you want to live the rest of your life being a slave to debt, go ahead and pay those minimum payments on your mortgage. If you want to have a starter castle that will take 30 years or more to pay off, go right ahead. If you want to have as much home as you can manage to get financing for, by all means go for it. But first, take a minute and imagine a different future for yourself. Look ahead five or ten years and imagine owning your home outright. Imagine what you could do, where you could go, and who you could be if you were not a slave to your mortgage.
If you don’t trust my advice, my challenge is this: Find a person who has paid off their home early and ask them if they regret it. Find one person, anyone, who wishes they hadn’t paid off their home ahead of schedule and I will eat my words. Trust me, you won’t find this person. They don’t exist.