Owning a home might be one of the worst investments you can possibly make in the foreseeable short-term, but not for all of the obvious reasons. I am going to talk about the most overlooked cost of ownership that people rarely realize. The opportunity cost of your equity.
Let’s say you are a young couple in their 30’s and you buy a $250,000 house @ 4% (or less) in today’s market. You then make extra payments and by age 40, you have no mortgage! Just think about it, that $1193 monthly(rate calculator) payment is gone forever, but at what opportunity cost.
I am not here to talk to you about the money you could have earned at age 30 to 40, even though you surely have lost a lot if you were able to obtain a larger than 3% return on your investments (approximate effective rate of mortgage until non-itemized), but let’s put that aside.
I want to talk to you about the $250,000 you have your house, in equity.
I personally was able to achieve double digit growth 11 out of the last 13 years in stocks. Let’s say you were able to earn just 7% on investments – your equity is tied up in your home. If you had $250,000 in cash and earned 7%, you could earn $17,500 a year or $1,458 a month – MORE than what you are saving by not having your $1193 monthly payment. If you were able to obtain 10% it would be $25,000 or $2083 a month!
Let me break it down to you this way, if you are able to get a 10% return you would save $890 a month or $10,680 a year by putting the money into stocks and into your home.
Your cash is locked up in your home and odds are 10 years from now you can no longer borrow cash for an effective rate of 3% or even 4% – you have destroyed your mechanism for cheap borrowing. If the market does recover and people start earning 10% annually, I promise rates will sky rocket.
Hypothetically you might be able to get a HELOC (Home Equity Line of Credit) during this time, at a higher rate, let’s assume 7+% versus your old effective 3%. If you were to borrow that $250,000 you would pay $10,000+ more in interest a year at 7% vs 3%. A harsh penalty for paying down your mortgage. I know most people simply would rather live mortgage free, but I for one always like to maximize the amount of money I have, but hey – that’s me.
Moral of the story – Your home is a very cheap form of debt now a days and should not be paid down unless you either get an extreme psychological benefit or you are sure you cannot out perform your effective rate on your loan. But I’ve said it before and I’ll say it again – if you think 3 or 4% rate of return is good enough, then you are going to have some struggles ever obtaining real wealth.
I know this article makes a lot of assumptions, but I hope you take home the message that if things turn around in the economy or if you think you can out perform 3% in stocks/options – then paying down your mortgage might not be a smart financial move.