Why Paying Off Mortgage Early is Bad!
by Michael Lam | Jul 06, 2015
Most financially conservative people believe that paying off a mortgage as quickly as possible is the best way to handle a loan. After all, isn’t debt a cardinal sin in the obtainment of the American Dream? The thought of owning your home “free and clear” is certainly compelling. So, why is paying off your mortgage a bad idea? It’s not that the desire is a bad idea; it’s the financial implications that can make it a bad idea.
While paying off your loan early is in your best interest, it’s not in the best interest of your lenders. Lenders make money off the interest that accrues with each monthly payment, and the longer you have your mortgage, the more they earn. Prepayment penalties are often included in loan agreements, and discourage borrowers from paying off their loans early by applying a large penalty when payments are made in advance of end of amortization schedule.
Having a mortgage actually helps lower your taxes, because the interest you pay is deductible on your primary residence (the home you live in).
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If you paid off your mortgage, you wouldn’t have the interest to deduct against your income, requiring you to pay more over time than you would if you had a mortgage. One of the best benefits of owning a home is the mortgage that comes with it, offering an itemized deduction that can be used to offset your tax liability.
Average Age of Mortgage Churn
There is a misconception that once you buy a home you will live in it for rest of your life. That realistically isn’t true. Based on National Association of Realtors 2014 stats (www.realtor.org), the typical seller in 2013 lived in their home for about 9 years. The way you could interpret that is the mortgage you took for 30 years will most likely not stay with you. You may feel confident you will live in your new home forever. But, you have to keep in mind you can’t predict the future.
In addition, interest rates fluctuate over time, whether for better or worse. It’s hard to bet and believe you will never refinance your property in the 30 year span, if you actually end up living at the home for 30 years. There is also a potential for change in your life circumstances over the course of your life. Will your income remain the same? Will your family grow? Will you need to downsize soon? There’s no way to know now, making a 30-year commitment to a home is quite a gamble. Your life has undergone many changes in the last 30 years, virtually guaranteeing many changes in the next 30 years to come.
Equity Has No Appreciation
Let’s say you do pay off your entire mortgage of $300,000. Let’s say you now own your home free and clear. This means you have now $300,000 of equity in your home. Let’s also assume for the sake of simplicity that your home is worth $300,000 on the day you pay off your mortgage and you continue to live in this home for 5 years. The Federal Housing Finance Agency (FHFA) stats between 2014 Q1 and 2015 Q1, homes rose by 5% [FHFA Link http://www.fhfa.gov/AboutUs/Reports/Pages/US-House-Price-Index-1Q-2015.aspx)]. Let’s use this 5% for our example. By the end of year 5, your home will be worth approximately $382,000.
|Year||Rate of Appreciation||Value|
If you sold your home at the end of year 5, you take back $382K minus typical real estate and tax fees. This sounds like a pretty good investment doesn’t it? Every year the home appeared to appreciate in value by 5% but was it the property or your cash that appreciated?
Home appreciation does not care about equity. If you didn’t put any equity into the home and you carried a mortgage, would the home still appreciate 5% year over year? Of course it would, because a mortgage has no bearing on home appreciation. A home will grow in value regardless if there is equity in the home or not because homes appreciates in value based on market demand as a whole within an area. It’s not the money you put in that caused the 5% appreciation. This also means that your extra money you put into paying off your mortgage had no Return on Investment, or ROI.
In terms of financial benefits, your money isn’t working for you to grow in value. It’s the home itself that grew in value. You can think of any extra money put into your home as “dead-weight” money, or money stashed away with no future growth benefit.
Equity Is Not Liquid and Isn’t Easily Accessible
Let’s return to the above example in which you end up paying off your mortgage and have $328,000 of equity. You’re living under the notion of “free and clear” and are comfortable knowing there is no mortgage. However, as we learned earlier, no one can predict the future, and this includes real estate prices. They can go up or down and can go in a direction for an extended period of time, good or bad. Let’s say you lose your job, an unfortunate reality that millions of Americans face ever year.
You need money, and you know there is equity in your home you can access, but the equity you have may not be worth what you think. In 2006 and 2007, the real estate market crashed. In many cases home values were cut in half or more.
Now your home is worth $100,000. You try refinance to take money out to help pay bills, only to find out you don’t qualify for a loan because you don’t have a job. Not only is your home now worth much less than you paid for it, and the hundreds of thousands of dollars you invested are now lost and cannot be recovered. If you sell your home now, you lose $200,000 of your investment. While this may be a worst-case scenario, this kind of situation is entirely possible.
Let’s flip this scenario assume that you didn’t pay off your loan. You’re locked in a rate and you still owe $300K. Your home does decrease in value too, but your monthly payment is doable and you still have $200,000 in the bank that you didn’t use to prematurely pay off your mortgage. You lose your job but you have enough money to last for a while until you get back on your feet.
In this scenario you didn’t pay off your mortgage. Instead you saved your money and kept it for a rainy day. Even though your home value decreased, it’s not your money at risk. Your lenders are the ones who paid more than your property is currently worth, and your investments are still safe in the bank.
The unavailability of equity has other consequences, as well. Let’s assume that you did purchase your home and paid off your mortgage for $300,000 five years ago and that your home is currently valued at $382,000. However, you bought this home in California with a standard home owner insurance policy against fire. Unfortunately, an earthquake strikes and your house is leveled, leaving no livable structure remaining. What happens now?
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Your current home insurance only covers fire hazard. This means you’re left with a destroyed home that you must completely rebuild at your own cost. You have equity of $382,000 but it’s completely lost, unusable. This is example of why having too much equity in a home is risker than having little equity and your money invested in other areas.
This may seem like a cautionary tale promoting the necessity of flood and earthquake insurance, but realistically, these policies are more expensive than a standard fire hazard insurance and unaffordable for many homeowners.
Lenders Don’t Care About Equity When Your Payments Are Late
Paying extra every month lowers your principal, but it does not provide you any favors if you get behind on your payments.
R. Gino Santa Maria | shutterstock.com
Homes that have the most equity will be looked more closely by a lender for quicker foreclosure because there is less risk to take the home and sell it back on back. Lenders may not admit this, but it’s pretty common sense: if you have two homes that are nearly identical in geographic and physical dimension, but Home A has 80% equity in it and Home B has 10%, a lender would benefit by going after a home with more equity at stake.
The lender won’t care that you paid towards your principal. That won’t play any role in their decision to move on your home faster than another mortgage owner who has less equity.
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