I have twice written recently about the two main debt repayment strategies, the debt “snowball” and the debt “avalanche“. The avalanche is the mathematically correct method, but the snowball method works better psychologically for many people. As part of analyzing which debt you should pay off first, you should also be thinking about whether it is best to pay off any particular debt at an accelerated rate.  While I am going to focus on mortgages, the same logic applies to all debts.

Start your analysis by adjusting your mortgage’s interest rate for the interest deduction, so your mortgage’s tax-adjusted interest rate is going to be about ¾ of your stated interest rate. For a 4% interest rate, your tax-adjusted rate is closer to 3%. Keeping that in mind, we should then factor inflation, which is less than 2% now, and will likely hover between 2% and 4% for the foreseeable future.  Inflation basically causes things to cost more in the future than they do now, because each dollar becomes worth a little less over time for various reasons (a vast oversimplification).  An easy example is that a piece of bubble gum that may have cost a penny 25 years ago now costs 10 cents.  The gum isn’t ten times more valuable now, it’s just that a penny isn’t worth as much now as it was then.

For an example, assume you have a $2,000 monthly mortgage payment on your brand new home, with interest at 4% fixed for 30 years.  If inflation averages 3% going forward, then at the end of the 10 years, your $2,000 monthly payment will only have the purchasing power of about $1,500 in today’s dollars.  At the end of 20 years, the $2,000 monthly payment will have purchasing power worth only $1,100.  At the end of 30 years, that $2,000 monthly payment will have purchasing power of $825.  Meanwhile, your $500,000 home (based on the $2,000 monthly payment and a 20% down payment) will be worth about $1,200,000 if it grows in value at 3% per year on average (although in future dollars that is still worth $500,000 because the growth rate and inflation rate are the same).  In other words, you are paying a fixed amount of money each month, the inflation-adjusted cost of which decreases over time, for something (the house) that should, on average, maintain its inflation-adjusted value.  To me, the only reason that this is not a no-brainer strategy is that it involves the risk that your home may not increase in value to any reasonable extent and the risk that we experience deflation instead of inflation over the long-run, each of which are unlikely, but both of which can cause significant harm.  Interestingly, Warren Buffett has stated that if he could pull off the financing, he would purchase hundreds of thousands of homes with 30 year mortgages.

Paying off your mortgage early causes you to give up the benefit of inflation during the years when those dollars are the least valuable, which is at the end of the mortgage.  In other words, in year 30 of your mortgage, your $2,000 mortgage payment will be at it’s lowest inflation-adjusted value.  You also lose the interest deduction, which alone is not worth slow paying your mortgage, but it is kind of the icing on the cake in this analysis, because it causes your tax-adjusted interest rate to be even closer to the inflation rate.

Another consideration is that when you make extra principal payments on your mortgage, you are giving up the ability to put that money to other uses. Very few people are capturing their employer’s full 401(k) match, maxing all of their tax-deferred investment options and have an ample emergency fund, all of which should be priorities. Even then, it is likely preferable to invest in a taxable account or further build up your cash reserves over paying off your mortgage early, as you can always put that cash towards the mortgage later if needed, but it is more difficult and costly to pull that cash out of the house in the future. There is also the risk that when you most need the cash, a bank would refuse to release the equity to you or that the home has decreased in value and there is not enough equity to borrow against.

Some people really like the idea of being debt free. If that is the case, then I want to help you get there, understanding that there are some tradeoffs in paying down low interest debts early compared to saving or investing. If you want to follow the mathematically correct path of debt repayment, then that may include not making extra principal payments on your home, and instead putting that money to other uses, understanding that there are some risks to this plan as well.

-Richard

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