Debt is bad. That is what we have all been led to believe. But not all debts are created equal.
On a high level, there are two types of debt, secured and unsecured.
Unsecured debts, like personal loans and credit cards, are debts not backed by any physical asset and are simply an obligation of the borrower to repay the loan. Failure to repay can result in additional fees, damage to your credit record, and possibly bankruptcy. Because unsecured debt is not backed by a physical asset, interest rates are typically higher to compensate the lender for the additional risk.
Secured debts, such as a car loan or mortgage, are loans backed by a physical asset like a car or home. Failure to repay the agreed upon loan could result in repossession of the asset and because the loans are tied to a physical asset and are thus less risky for the lender, interest rates are typically lower than unsecured debts.
Regardless of the type of debt, shouldn’t we work to pay them off as soon as possible?
Not necessarily. Similar to student loans where forgiveness may be a better option than total repayment, one can make the argument that paying off your mortgage may be financially detrimental to your long-term goals.
Types of Mortgages
Mortgages typically offer two different types of interest schedules, fixed rate and adjustable rate.
Adjustable Rate Mortgages (ARM)
Adjustable rate mortgages are typically 30-year loans, with a beginning low introductory interest rate that is usually lower than the average mortgage interest rate that will stay the same for a certain period of time. Once this fixed-rate period ends, the interest rate will adjust up or down based on an index.
For example, a common type of ARM is a 7/1 loan. The first number (7) tells you how the long fixed introductory rate will last, and the second number (1) tells you how often the interest can change after this introductory period. So for a 7/1 ARM, the interest rate remains fixed for 7 years but after this 7 year period your interest rate can either increase or decrease every year depending on the index to which it is tied.
Adjustable rate mortgages can be a good option for those who maybe don’t have plans to remain in their current home past the introductory fixed period and are looking for a lower rate, but the uncertainty of where interest rates will be in 7 years and how this will affect your mortgage payment is off putting to many.
A fixed-rate mortgage, as the name implies, has the same interest rate throughout the life of the loan. Your monthly principal & interest payment will not change (though your total payment may increase depending on if you escrow your taxes & insurance). Fixed rate mortgages are the most popular type of mortgage due to the predictability and certainty of payments.
Fixed-rate mortgages come in many different term lengths, from 10-year, 15-year, 20-year, and 30-year, which is the most common.
This article will focus on the 30-year fixed rate mortgage as it is the most common, but may also help make the case for why even if you can afford to use a 15-year mortgage with a lower interest rate but higher monthly payments, the flexibility of a 30-year outweighs the lower interest of a 15-year fixed mortgage.
Benefits of Fixed-Rate Mortgages
Not only do interest rates remain the same throughout the life of the mortgage, in today’s interest rate environment (article written in 2021) you may be enjoying a very low rate as fixed rate mortgages of 3.5% or less are not uncommon.
But why the case for not paying additional money every month?
It’s the opportunity cost of paying down your mortgage vs. investing for long-term growth. Take for example a couple with a $300,000 mortgage, 3.5% interest, and 30-year term. They have $250 additional monthly cash flow and are deciding whether to invest or pay down the mortgage.
If this couple paid the same mortgage consistently for 30 years, they would pay $184,968.26 in interest over the life of the loan.
By paying an additional $250 per month toward the principal every month, they would not only reduce the total interest paid over the life of the loan by $49,683 ($184,968-$135,285), they would also reduce the number of payments from 360 months to 273 months. So the home would be paid off in 22 years and 9 months as opposed to 30 years.
Sounds great doesn’t it?
But let’s see the difference if they were to invest the $250/month instead and earn an inflation adjusted annual return of 6%.
As you can see, by investing the funds they will have earned $141,272 over 22 years and 9 months.
So which is better?
By making $68,000 total in extra payments toward the mortgage, they would have saved $49,683 in interest over the life of the loan. By investing the extra $68,000 ($250 * 22 years 9 months) with a 6% annual return, they earned $73,272 ($141,272- $68,000). The data shows they would be better off investing.
Of course other factors certainly come into play, such as how the stock market performs, how you are investing the $250/month from both an asset allocation perspective but also asset location perspective (401k, Roth IRA, Brokerage account, etc.) as well as the deductibility of mortgage interest if you itemize.
If you’ve been paying attention to the news recently, the sharp rise in the consumer price index (CPI) which measures inflation has been a trending topic. October 2021 saw the largest rise in the inflation index in over 30 years at 6.2%!
So how can you protect yourself against inflation?
You guessed it, a fixed rate mortgage. If you take out a 30-year mortgage today, your payment will remain the same over the next 30 years. What are the odds that other goods and services will be the same price in 30 years that they are today? Pretty slim.
Inflation protection rarely comes to mind as one of the selling points of maintaining a fixed rate mortgage but can provide a reasonable argument as to why you should keep a mortgage on a property, even if you are able to pay off sooner.
What about a 15-year fixed mortgage?
A 15-year fixed rate mortgage may seem to be the best of all worlds. Lower interest rates, quicker payoff, and inflation protection from the fixed rate. I always encourage folks to look at their financial situation before deciding on a 15-year fixed mortgage. By going with a 30-year mortgage, yes the interest rate may be higher but it affords you the flexibility to pay as a 15-year as opposed to being locked into it.
If you really want to have your mortgage paid off sooner and are considering a 15-year mortgage, understand this will come with higher required monthly payments. A 30-year mortgage affords you the option of making additional payments to pay off the loan in 15 years without locking you into a higher payment. So if something comes up (job loss, early retirement, travel, etc.) that prevents you from making the higher monthly mortgage payment, you have the flexibility to stop making additional payments.
In summary, the decision to pay off or keep a mortgage is dependent on many variables, some of which are financial and some of which are emotional. I for one cannot stand to be in debt, and even though I am confident that by investing excess cash flow and using my mortgage to protect me from inflation makes sense financially, I am constantly tempted to rethink my philosophy and to become debt-free even if it doesn’t make the most sense financially.
Your decision is also very personal to you, your goals, and your relationship with money. Speak with your financial planner to make a plan on how to best utilize your cash flow to keep your wallet and your mind at ease.
Andrew Langdon is a CERTIFIED FINANCIAL PLANNER™ and the founder of VetWorth, a fiduciary fee-only financial planning firm dedicated to serving the unique needs of veterinarians and their families.
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Andrew Langdon, and all rights are reserved. Read the full Disclaimer.