August 25, 2023:
In this quick article, we want to talk about when it makes sense to make early mortgage payments.
This article was inspired by a Twitter post we saw by someone who is making extra payments on a 3% mortgage, and the surprising (to us) positive response it got from many other readers. The replies made clear that a lot of people believe paying down their mortgage early is always the right thing to do. They view it as some kind of universal truth, regardless of the numbers involved.
But as with many financial issues, the answer can’t be boiled down to a rule of thumb. The real answer to whether it’s a good idea to pay down a mortgage, or any debt, is “it depends.”
One of the main ways that banks make money is to pay out a low rate of interest to depositors and then turn around and lend it to borrowers at a higher rate. They pocket the difference and it’s easy money! That opportunity isn’t usually available to the average citizen, but right now, many homeowners are in the position to flip the script and be the ones to pocket some risk-free money.
Many of us took out fixed-rate mortgages at around 3% or lower a couple years ago when such rates were at all-time lows. That opportunity is gone, because current 30 year fixed rates have risen to around 7.5%. And for the same reason that mortgage rates are high, we’re looking at savings rates that are the highest they’ve been since 2008. Government-guaranteed money markets, CDs, and T-Bills are all paying 5% or more, and we’re still sitting on our low-rate fixed mortgages. This dynamic gives many regular people the ability to effectively “play bank” and earn a guaranteed rate of interest on savings that is higher than the rate they borrowed at.
Sorry Twitter people, but that is free money!
A penny saved is a penny earned: to pay down your mortgage early, put it in cash
For those who really want to get their house paid off early, putting the money into some form of savings is still the way to go at this time. Let’s say you have a low-rate mortgage mortgage, and that it’s your goal to pay it down early. In this example we’ll assume the rate is 3%, and that it’s a fixed-rate mortgage, as most of them are.
If you have some extra cash, you could make an extra mortgage payment and reduce the balance on your 3% loan. That would be the equivalent of earning 3% on that money because “a penny saved is a penny earned.” But why do that when you could earn over 5% on that same money without taking any risk?
For as long as the rate on your cash is higher than your mortgage rate, you can pay the loan down faster in the end by keeping your money in cash and letting it build up at the higher rate. If the cash rate ever drops below the mortgage rate, you can take your pile of money and make a one-time extra payment on your loan at that point. That would get you further ahead of schedule than if you had been paying extra all along the way. If the rate never does fall below your mortgage rate, you can just keep growing your cash pile until you have enough to pay down the entire mortgage all at once — this way, it’ll be paid off months or years earlier than if you’d have been paying extra towards the house as you went along.
Added bonus — you get paid to be more liquid
Even if the mortgage rate and the proposed savings rates were the same, it still wouldn’t make sense to put the extra dollars towards the mortgage because you can’t go get them back at that low rate if you need or want them for something else. Putting those dollars into any of the above referenced options is better because you have access to the money at an effective cost of 3% vs. trying to take it back out of the house with a line of credit or a second loan. If it were needed to back out of the house today, the interest expense would be around 8%.
All of that said…
There are a few valid reasons you might not want to keep your extra savings in cash:
- If we’re talking about very small extra payments, you might just decide it’s not worth the extra money to deal with a savings account (or money market/T-Bills/etc).
- If you are afraid you might raid your savings account and want to make sure that doesn’t happen, directly paying down the mortgage might be a better bet.
- Taxes are a wash if you are itemizing, but if you are taking the standard deduction, the benefits of this strategy may be smaller (or disappear entirely) depending on the rate differential and your tax bracket.
For years, it didn’t matter much where one’s cash was because almost all banks and money markets paid nothing, or next to nothing. While most local banks still have very low rates on their savings and checking accounts, many online banks and brokerage firms offer savings accounts, money markets, CDs, and T-Bills around 5%. So if you have any substantial cash savings, definitely make sure you’re getting a good rate.
We understand that some people just like the feeling of having a paid-off house, but that feeling needs to be combated by logic in times like these. When the rate one can earn on savings is higher than the rate of a loan, the loan becomes “good debt,” and that is something to embrace.