I have had a lot of discussion with people on the subject of making extra mortgage payments. I have my own opinion (let's just agree to call it that.) I have gained this opinion through education and experience. In the end, I feel that making extra mortgage payments is a mistake. Here's why.
When is your home safe?
Following the philosophy I have developed, the answer is when it is in one of two states of existence:
-Paid in full
-Mortgaged to the max
If your house is paid in full, about the only entity that can possible take it away from you is the town if you do not pay your property taxes. Therefore, your house is safe when it is paid off. Most people get this right away and say, "That's why I want to pay extra towards it and pay it off sooner."
Why would mortgaged to the max be the other one? That doesn't seem to make a lot of sense, and it's one of the things that people struggle with. There's a plain and simple way to explain this. If something happened to you and you became unable to continue your mortgage payments, what would happen? Foreclosure. How much equity is left after a foreclosure? The banks concerns stop at what you owe them. If you only owe $100,000 on your $300,000 house, you're leaving $200,000 at risk.
Liquidity
When opportunity knocks, will you be ready? How fast can you take the money out of your home? The last time I tried, it took about 30 days. But wait, what if I had a bad year last year and my income could not support it? Oh yeah, I'd be out of luck.
This kind of goes hand-in-hand with the keeping your house mortgaged to the max concept. If something happened to you, at least you'd have access to the cash you need. If you had kept your money in a 401k (for example), you can get your money out of your 401k no matter what your personal circumstance. What about the 10% penalty? You only pay penalty on the amount you withdraw. Using the $300,000 home example from before, what if you had to refinance your entire mortgage just to take out $50,000? Add up the closing costs and the points and you're probably pretty close to even to the 10% penalty on your 401k withdrawal.
Accounting 101
Have you ever seen this formula?
Assets = Liabilities + Equity
Another way of putting this is:
Equity = Assets - Liabilities
Which of the two situations below would you rather have?
Stay Conservative
Invest The Money
Assets
Assets
Home
$ 300,000
Home
$ 300,000
401k
$ -
401k
$ 140,000
Total Assets
$ 300,000
Total Assets
$ 440,000
Liabilities
Liabilities
Mortgage
$ 100,000
Mortgage
$ 240,000
Car Loan
$ 10,000
Car Loan
$ 10,000
Total Liabilities
$ 110,000
Total Liabilities
$ 250,000
Total Equity
$ 190,000
Total Equity
$ 190,000
You see, they both have the same net worth. One has better liquidity and manages more assets, while the other is more conservative. This is why I said at the beginning that it was my opinion. It's up to each of us as individuals to know what our threshold for risk is.
Arbitrage
Now let's talk about arbitrage. Simply put, arbitrage occurs when someone acquires something at one value and resells it at another. Let's continue with the earlier example. Here we have 2 people, starting today in the same place. They both have homes worth $300,000 and take out 20 year mortgages at 6.5% for $100,000 on the same day.
Scenario 1: Standard 20 Year Amortization
In this scenario, the first person (let's call him Bob) decides he does not want the risk of investing and stress of a mortgage. He pays his mortgage over 20 years exactly s required.
Bob starts with $200,000 in equity. Each year, he pays a little less interest and a little more towards principal. On his interest, he gets a write-off, so we indicate his tax credits, too. Notice how his net worth grows as he pays off his mortgage. It's working well for him.
Year
Interest
Tax Credit
Principal
Balance
Net Worth
1
$6,425.77
$1,606.44
$2,521.11
$97,478.89
$202,521.11
2
$6,256.93
$1,564.23
$2,689.95
$94,788.94
$205,211.06
3
$6,076.78
$1,519.20
$2,870.10
$91,918.84
$208,081.16
4
$5,884.56
$1,471.14
$3,062.32
$88,856.53
$211,143.47
5
$5,679.47
$1,419.87
$3,267.41
$85,589.12
$214,410.88
6
$5,460.65
$1,365.16
$3,486.23
$82,102.89
$217,897.11
7
$5,227.17
$1,306.79
$3,719.71
$78,383.18
$221,616.82
8
$4,978.05
$1,244.51
$3,968.82
$74,414.36
$225,585.64
9
$4,712.25
$1,178.06
$4,234.62
$70,179.73
$229,820.27
10
$4,428.65
$1,107.16
$4,518.23
$65,661.51
$234,338.49
11
$4,126.06
$1,031.52
$4,820.82
$60,840.69
$239,159.31
12
$3,803.20
$950.80
$5,143.68
$55,697.01
$244,302.99
13
$3,458.72
$864.68
$5,488.16
$50,208.85
$249,791.15
14
$3,091.17
$772.79
$5,855.71
$44,353.14
$255,646.86
15
$2,699.00
$674.75
$6,247.88
$38,105.26
$261,894.74
16
$2,280.57
$570.14
$6,666.31
$31,438.95
$268,561.05
17
$1,834.11
$458.53
$7,112.77
$24,326.18
$275,673.82
18
$1,357.76
$339.44
$7,589.12
$16,737.06
$283,262.94
19
$849.50
$212.38
$8,097.38
$8,639.68
$291,360.32
20
$307.20
$76.80
$8,639.68
$0.00
$300,000.00
$78,937.57
$19,734.39
Scenario 2: Interest only loan investing instead of principal payments for 20 years
Jamie also bought her house for the same price at the same time. She also started with $200,000 in equity. Instead of paying towards principal, she invests in a tax-deferred vehicle which has a rate of return EQUAL TO the cost of borrowing from her mortgage (6.5% in this example). Her
arbitrage
only comes from the fact that the investment is tax defered and the interest expense is a tax write-off. In the chart below, there are 2 additional columns: Invested and Value. Since Jamie is not making principal payments, those amounts which would have been principal are instead invested. Invested shows the amount invested each year and Value shows the value of the
investment
account, assuming 6.5% annual ROI.
Year
Interest
Tax Credit
Principal
Balance
Invested
Value
Net Worth
1
$6,500.00
$1,625.00
$0.00
$100,000.00
$2,521.11
$2,521.11
$202,521.11
2
$6,500.00
$1,625.00
$0.00
$100,000.00
$2,689.95
$5,549.78
$205,549.78
3
$6,500.00
$1,625.00
$0.00
$100,000.00
$2,870.10
$8,967.17
$208,967.17
4
$6,500.00
$1,625.00
$0.00
$100,000.00
$3,062.32
$12,811.41
$212,811.41
5
$6,500.00
$1,625.00
$0.00
$100,000.00
$3,267.41
$17,123.94
$217,123.94
6
$6,500.00
$1,625.00
$0.00
$100,000.00
$3,486.23
$21,949.83
$221,949.83
7
$6,500.00
$1,625.00
$0.00
$100,000.00
$3,719.71
$27,338.06
$227,338.06
8
$6,500.00
$1,625.00
$0.00
$100,000.00
$3,968.82
$33,341.83
$233,341.83
9
$6,500.00
$1,625.00
$0.00
$100,000.00
$4,234.62
$40,018.92
$240,018.92
10
$6,500.00
$1,625.00
$0.00
$100,000.00
$4,518.23
$47,432.06
$247,432.06
11
$6,500.00
$1,625.00
$0.00
$100,000.00
$4,820.82
$55,649.32
$255,649.32
12
$6,500.00
$1,625.00
$0.00
$100,000.00
$5,143.68
$64,744.55
$264,744.55
13
$6,500.00
$1,625.00
$0.00
$100,000.00
$5,488.16
$74,797.83
$274,797.83
14
$6,500.00
$1,625.00
$0.00
$100,000.00
$5,855.71
$85,896.02
$285,896.02
15
$6,500.00
$1,625.00
$0.00
$100,000.00
$6,247.88
$98,133.26
$298,133.26
16
$6,500.00
$1,625.00
$0.00
$100,000.00
$6,666.31
$111,611.54
$311,611.54
17
$6,500.00
$1,625.00
$0.00
$100,000.00
$7,112.77
$126,441.39
$326,441.39
18
$6,500.00
$1,625.00
$0.00
$100,000.00
$7,589.12
$142,742.49
$342,742.49
19
$6,500.00
$1,625.00
$0.00
$100,000.00
$8,097.38
$160,644.46
$360,644.46
20
$6,500.00
$1,625.00
$0.00
$100,000.00
$8,639.68
$180,287.61
$380,287.61
$130,000.00
$32,500.00
Growing Wealth
In the end story looks like this.
Conservative Approach
Investment Approach
Costs
Costs
Principal
$100,000.00
Investments
$ 100,000.00
Interest
$78,937.57
Interest
$ 130,000.00
Tax Credits
$19,734.39
Tax Credits
$32,500.00
Total Costs
$159,203.18
Total Costs
$197,500.00
Assets
Assets
Home Equity
$ 300,000.00
Home Equity
$ 200,000.00
Investments
$ -
Investments
$180,287.61
Total Net Worth
$ 300,000.00
Total Net Worth
$ 380,287.61
Realized Gain
$ 140,796.82
Realized Gain
$ 182,787.61
As you can see, Jamie was able to outpace Bob by almost $42,000 (nearly 30%). Guess what? Even after the 20 years are over, Jamie’s money is still growing. Why? Because she invested it long term.
Being Real
There are many different scenarios. Of course, this did not include ups and downs in the market value of Bob and Jamie's home. These scenarios were really meant to show that if you had the same thing going on with your home, how the 2 different approaches would yield you different results.
Another variable is the fact that this is based on 20 years. If you go out 30, it's even more apparent. Then there's the fact that the investment growth rate is equal to the lending rate on the mortgage. If you get that 8% return your financial advisor is always telling you about, then you'll have an even wider spread. You can slice this many, many different ways.
To be successful at this type of plan requires good money management skills. Most people do not save money very well. If you are of the type of person to fret over how much money you owe, or lack the self discipline to know how to control your spending, then pay your mortgage first. If you can learn how to take control of these issues, you can grow your wealth more quickly. You now have the information. The decision is yours.
Cheers
Stacey Brown is a real estate broker, not a financial advisor. The information in this article is informational only. Any risks you take will be based on your own decisions. Stacey Brown & ILM Realty, LLC will not be held responsible for any gains or losses you may incur.
14 Comments on Why You May Want To Stop Making Extra Mortgage Payments
Stacey - Great Post! I love your analysis. I was an accountant before I entered real estate business. I stopped making extra payments on my mortgage because the bank's account receivable dept. did not know how to apply my extra payments. It just sat on a suspense account at the bank and it took them months to correct it so I just stopped doing it.
Wow...lots of numbers but the fact remains that your house is only safe when it's PAID IN FULL! =) It's a concept that we have a great deal of trouble with in America! If your house is paid in full and properly insured, you have only the government and the HOA to contend with to take it away from you. Even in the case of catastrophic accident, you can't be forced out of your home. If you house was paid in full, how long would it take to have the government take it away from you for back taxes? HOw about 2-3 years. If you get behind on your mortgage payment? That's more like 90 days to 6 months!
Your scenario also does not factor in RISK. How many percentage points is RISK worth? If you are investing in good mutual funds, that would still be RISK. How much would you have to mitigate RISK on a paid off house? That would be zero risk.
An interest only loan? That's one of the most terrible products that the mortgage industry ever brought us! Super high risk based on property values that were over valued at the time of the introduction of the interest only loan! OUCH!
Wow...just can not agree with this concept. Too much risk and most of it is coming home to roost right now in our country.
Thanks for the comments. All throughout the blog, I try to point out that the difference really is a matter of each person;s threshold for risk and it's up to the people who follow this to invest the difference and not spend it. As far as interest only being risky, well, it's certainly more risky than a 30 year fixed. Risk is up to each indiviual and this was my opinion.
If it were truly about responsibility, Ethan, why is the government having to bail out so many in the so called "HOUSING CRISIS"?
Here is an interesting exercise to go with this one too...how much could a person invest if they did not have a house payment every month? Well, I know I could put away an extra $18K a year. How fast does that grow?
You've got a great topic going Stacey, no offense meant in my disagreement with the opinion. You are not the only one that feels that way and I'm certainly not the only one that feels like I do (we may be some of the only ones vocal enough to say it though!) =)
Stacey, absolutely great post, I have to admit it was a lot to absorb at 10:00 at night but my brain was still working!
I agree with you about people having to take a long hard look at how much risk they are willing to take on but your points about why making extra payment is not good is valid. I never considered looking at things the way you have and now I will be re-examining my thoughts on my mortgage. As of right now I think that instead of sending in any extra money towards the principal of my loan, I will probably take the money and invest it instead leaving my mortgage payments alone.
In a perfect world...but wait! It isn't a perfect world, and the hypothetical is just that - hypothetical.
The wealthiest people I've known in my 35+ years guiding clients - and my practice allowed me to deal with many - all paid their debts, including their mortgages, as quickly as they could. That you can leverage equity into wealth using debt as your foundation, without significant risk and probable failure, is pure myth.
There are principles and practices that support the use of true arbitrage in a personal economy. The situations that allow that are, however, restricted to those who have already accumulated significant wealth. These practices are risky and are not appropriate for the typical middle and upper middle income families or even for those with higher incomes who have not yet accumulated wealth enough to last a lifetime. They are never appropriate when based on income and not on assets.
Also, arbitrage does not imply the use of debt. True arbitrage involves the buying and selling of financial instruments of known but disparate value to varying buyers using cash or other capital, not debt. Buy a stake in the resdential property on Main Street knowing that it is being rezoned to commercial in the near future. Buy the distressed house on Elm Street for the amount due on the motgage to save the owner from foreclosure and resell it at current market price. Use cash or have your buyer waiting in the wings.
There are tested and proven strategies for managing mortgage debt. None of them involve keeping a property mortgaged to the max. I describe one of them in my book Money for Life...in good times and bad. George Clason's classic The Richest Man in Babylon deals with the topic in some detail also.
This is opinion backed by two centuries of practice in America and millennia of proven principles, and not on hypotheticals and abstract theories developed in the late 20th century to justify the sale of mortgages and "investments" - both of which carry significant risk.
No offense intended. My mission is to help America rediscover the principles and practices of our Financial Founding Fathers (i'd a used Mothers but it doesn't alliterate)
Good points. I tried to explain that this is a matter of opinion and it definitely is not for everyone. The hardest part is the dicipline to invest and not to spend. Thanks for this great point of view.
Stacey Brown, REALTOR®
I have had a lot of discussion with people on the subject of making extra mortgage payments. I have my own opinion (let's just agree to call it that.) I have gained this opinion through education and experience. In the end, I feel that making extra mortgage payments is a mistake. Here's why.
As you can see, Jamie was able to outpace Bob by almost $42,000 (nearly 30%). Guess what? Even after the 20 years are over, Jamie’s money is still growing. Why? Because she invested it long term. 
;)
;)
Stacey - Great Post! I love your analysis. I was an accountant before I entered real estate business. I stopped making extra payments on my mortgage because the bank's account receivable dept. did not know how to apply my extra payments. It just sat on a suspense account at the bank and it took them months to correct it so I just stopped doing it.