海角大神

Karen writes in:

My brother has argued with me that I shouldn鈥檛 make any extra payments on our mortgage because we鈥檙e losing money over the long term by making early payments. He says that with inflation at 3% and our money able to earn 1% at minimum in a savings account and more if we do other things, we鈥檙e losing money by making early payments on our 3.75% mortgage. What do you think?

From a purely financial perspective, your brother does have a good point. However, your brother鈥檚 case has a bunch of implied assumptions that don鈥檛 necessarily apply to your situation.

First, let鈥檚 look at the math of the situation. Let鈥檚 say that you get a raise at work that equals the rate of inflation. Since your mortgage payment stays the same (assuming it鈥檚 a fixed rate mortgage), that means that your mortgage payment will take up a smaller and smaller percentage of your income over time. With the percentages expressed by your brother, your mortgage payment will take up only about a third as much of your income by percentage during the last year of your mortgage compared to the first year of your mortgage.

Want real numbers? Let鈥檚 say your monthly mortgage payment is $1,000 and you bring home $30,000 a year. Right now, you鈥檙e paying $12,000 a year in mortgage payments, which is 40% of your take-home pay. Each year, though, you鈥檙e getting a 3% raise. After ten years, you鈥檙e making a little over $40,000 a year, dropping your mortgage payments down to only 30% of your take-home pay. After twenty years, you鈥檙e bringing home around $54,000 per year, dropping your mortgage payments down to about 22% of your take-home pay. During the last year of your mortgage, you鈥檙e bringing home $72,800 per year, making your mortgage payments around 16% of your take-home pay.

The argument against early payments is that at the point where mortgage payments make up 40% of your take-home pay, it doesn鈥檛 make sense to pay even more just so that you eliminate payments at a later date where the payment is only taking up 16% of your take-home pay.

That鈥檚 a pretty powerful argument. It forgets a few things, though.

First, it assumes your income steadily increases at the rate of inflation or better. The truth of the matter is that and, in many industries, wages are actually seeing negative growth.

Most Americans can鈥檛 rely on the idea that their wages will routinely go up. That鈥檚 just not reality for the majority of people out there. Yes, there are people who are smart and work hard and have an entrepreneurial bent and a big pile of transferable skills who can keep increasing their wages, but that鈥檚 not something you can plan on unless you鈥檙e exhibiting confidence bordering on arrogance.

Second, it assumes that you can earn a sizeable steady return from a small investment. If you have $500,000 sitting in the bank, you can probably find some ways to invest it that can earn a nice return on that money, better than the 4% or so return you might get from other things. It鈥檚 much harder to do that with $1,000 in the bank.

Most Americans do not have the capital on hand to buy a rental property. Many Americans struggle to have an emergency fund. With an extra mortgage payment, a person can get a steady 3.75% return (in the mortgage example above) from every single dollar they pay ahead on their mortgage.

Third, it assumes an inflation rate. The Consumer Price Index, which is likely the best tool for estimating inflation, and is usually around 1.5 to 2%. Some people debate whether CPI is a good measure of inflation and some argue for other rates, but CPI is a pretty solid benchmark for inflation.

Inflation does vary over time, but we鈥檙e currently in a period of very low inflation. Most inflation-based arguments rely on an inflation rate of at least 3% for people to make financial moves based on the inflation rate.

Finally, it assumes inflexibility. If you鈥檙e in a position where inflation is at 5% and savings accounts are paying a 6% return, it makes a lot of sense to put money into a savings account and make minimum payments on a 3.75% mortgage. On the other hand, when we鈥檙e in the position we鈥檙e at now, with savings accounts paying 1% and inflation somewhere around 2%, you鈥檙e going to want different solutions. Just because you choose to make early payments now doesn鈥檛 mean you can鈥檛 choose to do something differently later on.

In the end, the decision to make early mortgage payments or invest in something else is a minor point compared to the real issue. As long as you are spending less than you earn, you鈥檙e getting ahead. If you鈥檙e spending $100 less than you鈥檙e earning each month, you blow away any investment returns you might get on that $100 by instead figuring out how to spend $150 less than you earn each month. Spending less than you earn is the real key to financial success, regardless of how you invest it.