A goal properly set is halfway reached.
Recently, Forbes magazine published an article entitled “Paying Off Your Mortgage Early Will Destroy Your Finances“.
It was nice clickbait.
I clicked on it, after all.
The premise of the article was that, if you don’t have your mortgage paid off, then, in a financial emergency, like layoffs due to COVID-19, the bank is going to foreclose on you, and having tried to pay extra down on your mortgage isn’t going to help you. In fact, the bank will be happier because they’ll have more equity when they sell the house.
This is half right.
First off, if a foreclosure auction gets more than the amount owed and what it cost to foreclose, , the bank does not get to keep the extra money. Bids in excess of what is owed go to the homeowner. So, there’s not equity that disappears from the former homeowner.
However, that’s not the main point of my disagreement with the article.
The author suggests putting extra money in whole life insurance policies. As we’ve seen in “An Evaluation of an Indexed Universal Life Plan,” most of the money that is paid early on in the life of a life insurance policy goes to the commission of the agent who sold it to you. You won’t be building up cash value like the author claims.
The next miss is in the magnitude of the mistake of using a 15 year mortgage versus a 30 year mortgage (or, as the author suggested in his comparison, an interest only mortgage).
Let’s assume that the homeowner needs a $200,000 mortgage.
Currently, it’s almost impossible to actually find an interest only loan.
I looked at all four lenders of NerdWallet’s Top Four Interest Only Lenders. None of them currently offer interest only loans.
I also looked at the #1 paid ad spot on Google for interest only loans, and they don’t offer interest only loans.
So, if you can get one of those, you’re a rare bird.
Furthermore, you’re merely kicking your mortgage can down the road.
So, let’s look at 2 actually attainable loans:
- 30 year mortgage: Bankrate lists Cadence Bank as the best rate, with a 3.125% rate. That would make your payment $856.75.
- 15 year mortgage: Bankrate lists Bank of America as the best rate, with a 2.625% rate. That would make your payment $1,345.68.
The difference in the two payments is $488.63 per month.
28% of Americans have no emergency savings at all. For them, it doesn’t matter how much their mortgage payment. In an emergency, they’re losing the home.
According to the same research, 25% have less than three months of expenses.
Meanwhile, the average household monthly expenditure is $5,102. So, not paying off the mortgage early by getting a 30 year mortgage versus a 15 year mortgage represents 9.6% of monthly expenditures. The average American could probably find that in other savings if needed.
The author of the Forbes article is hitting on a very pertinent point, but he has the wrong solution to the problem.
If you have no emergency fund, putting money into a whole life insurance policy is not the right answer. It’s paying an insurance agent’s commissions, so that agent will have an emergency fund, but you won’t.
As I outlined in many of the lessons in The FIRE (financial independence, retire early) Playbook, the first thing that you want to do is play defense. You want to make sure that if the sky falls in your life, you have adequate protection. As Nassim Taleb says, the first duty of any investor (and by extension, you, with your personal financial life) is to survive, not to lose so much that you damage your financial future.
How do you make sure that you survive?
As we saw in “Should We Raise Emergency Fund Amounts Because of COVID-19,” the goal of an emergency fund is to survive a large financial shock. The two biggest financial shocks that most of us potentially face are big healthcare costs, for which we know the upper limit based on the out-of-pocket maximums of health insurance, and loss of employment.
With a robust enough emergency fund, we have enough funding to survive the crises that the Forbes author cites, which is happening all over the United States right now.
An approach that I have suggested to clients in the past is to:
- Get a 30 year mortgage
- Fill up the emergency fund
- Refinance into a 15 year mortgage if you don’t have to pay points (it’s a pretty simple breakeven analysis to show how much you’d be willing to pay in fees), or, alternatively, pay each month like you had a 15 year mortgage
This obviously oversimplifies the situations of a lot of people, but the takeaway is that once you have a robust enough emergency fund, you can aggressively attack non credit card debt (you should kill that off first unless you have an amazingly low interest rate).
Until you have that robust emergency fund, you’re going to be susceptible to the financial risk of losing your home in a big personal financial shock, regardless of whether you have a 15 or a 30 year mortgage.
Furthermore, you shouldn’t be paying extra on your mortgage if you don’t have an emergency fund already set aside.
Finally, if you want to prepay your mortgage or shorten your term, do not, do not, do not put that extra money into a whole life insurance policy.
Hopefully, this article has the same clickbait that the Forbes article did!
Are you worried about the financial risk of prepaying your mortgage? Let’s talk about it in the comments below.