I recently spoke with a friend (who has, at times, also been a mentor) for the first time in several years. We talked for over four hours.
Among other things, he told me about a website (My Insurance Reward Services) and a mobile app (Apple App Store link) he is developing for insurance rewards, and how he now has a back office in Lebanon with nine employees. My responses were a variation of "Wow," "That's exciting, "and "That's smart."
One thing he mentioned is that he is paying off his mortgages, which are at 4 and 5%, with the goal of retiring early. "That's smart," I replied.
I came across the same strategy in an article I was reading. In 10 Key Lessons About Life and Money That I Learned the Hard Way (Barron's, Aug. 26, 2023, Apple News link), Jonathan Clements writes,
While I viewed my stock index funds as my growth money, I saw extra mortgage payments as a bond substitute. That brings me to a second early lesson. Why buy actual bonds at 4% or 5% when I could effectively earn more than 7%—my mortgage rate at the time—by paying off my home loan? By 2005, I was mortgage-free. It was the best bond investment I've ever made.
One of the most effective ways to pay off a mortgage early is to make extra payments whenever possible. You can increase the amount of your regular monthly payments or make lump sum payments whenever you have extra funds available. Doing so will reduce the amount of interest you pay over the life of the loan and shorten the length of your mortgage.
With High Inflation, Paying Off a Mortgage Early Might Not Make Sense
Paying off a mortgage early is like a bond substitute and is generally a smart money move. But I will not be paying off my home's mortgage early since it is a mere 2.5%, which is lower than the historic inflation average of around 3%. Having an interest rate that is below inflation is like receiving free money, and even the safest investments can earn more than 2.5%.
Paying off a mortgage early may not make financial sense if the interest rate is lower than inflation.
Inflation reduces the real value of the debt over time, making it easier to pay off in the future. When the interest rate on the mortgage is lower than the rate of inflation, the effective interest rate on the mortgage is actually negative. This means that the borrower is essentially being paid to borrow money, as the real value of the debt is decreasing over time.
For an oversimplified example, suppose a borrower takes out a $100,000 mortgage at a fixed interest rate of 3% per year. If inflation is 4% per year, the borrower's debt decreases over time in real terms, effectively earning them 1% per year or $1,000 annually.
Interest rates on a loan reflect the risk that a lender is taking and take into account inflation. A dollar today is worth more than a dollar in the future because of inflation. When an interest rate on a loan is below inflation, you will pay back the loan with free money.
Another reason I will not pay off the mortgage early is because my dollars earn more than 2.5% in safe investments. My Apple Savings Account has an APY of 4.15%, and my Robinhood sweep is making 4.9% (although it costs me $5 per month for Robinhood's membership, which has some other benefits than a higher yield). If I was willing to lock my savings in a CD, I could also get an APY that is over 5%.
With a loan, you're using other people's money. There is a cost to the loan that is reflected as an interest rate -- in my case it is 2.5%. When I invest my money in something that earns more than 2.5%, the spread between the interest rate that I earn on my money (4.15%) and the one I pay to use other people's money (2.5%) is free money that goes in my pocket.
Opportunity cost refers to the benefits that are forgone when one chooses one option over another. It is the value of the next best alternative that is sacrificed in order to pursue a certain action or decision. In other words, opportunity cost is the cost of what you give up in order to choose something else. For example, if you decide to pay off your mortgage early, the opportunity cost would be the other ways you could have used that money, such as investing it at a higher rate of return.
There are two takeaway nuggets:
(1) Facts and circumstances are important. Advice that is generally good (such as paying off a mortgage early) might not be good for you. This observation explains why books, articles, and blog posts (like this) are not a substitute for working with a professional who can apply the rules to your circumstances.
(2) Financial literacy is important. Some people are uncomfortable talking about money, which is unfortunate because they rob themselves of opportunities to learn. I tell people that I got financial literacy with my meals growing up. I joke that my parents stuffed their pita bread with olives, mint, labneh, and financial lessons.
As an adult, I'm fortunate to have friends who share my interest in finance. They crunch numbers with me and inspire me with their brilliant financial moves. After speaking with my friend, I now put my head on my pillow at night and think about mobile apps and an overseas workforce.
I wrote this blog post with the help of an AI assistant, GrammarlyGO, an advanced algorithms and machine learning technology.