John Paul Getty once said: “If you owe the bank $100, that is your problem. If you owe the bank $100 million, that is their problem.” Getty’s observation offers an important insight into the value of understanding the incentives of those around you.
When you take out a mortgage, the only secured interest that the bank maintains is the parcel of real estate itself. Understanding this perspective of the lender should serve as an important caveat against paying off your mortgage early. When you owe $150,000 on a piece of property appraised at a value of $300,000, the lender may be perfectly willing to foreclose against you in the event of a default because they know that they will receive the full value of the amount owed.
On the other hand, if you owe the lender $280,000 on a piece of property appraised at a value of $300,000, the lender will have to show up at the foreclosure auction and make a credit bid of $280,000. If someone or some entity bids over $280,001 or more, then the bank will have their interest paid off. But, if the bank’s $280,000 credit bid is the highest bid for the property, and no other bidders come along, the bank is saddled with the obligations of maintaining the property (after all, it has become the owner by winning the foreclosure sale) until it is able to sell it–which may or may not be for an amount greater than $280,000.
The lender does not want to be in the business of maintaining homes, and so it may be more reluctant to foreclose upon a defaulting party with minimal equity in the property than someone with a high amount of equity in the home in which the foreclosure has a higher probability of satisfying the obligations to the bank.
This is something important to know. A third of homeowners, over the course of their lives, will experience some event in which they have a cash crunch–it may be the result of an unexpected job loss, a medical event, or some other unforeseen circumstance.
If you have been aggressively pre-paying your mortgage throughout this time, you can’t recall the amount of extra payments back to sail through your cash crunch. It is a perverse incentive–paying off your mortgage early gives you more equity in your property which makes it more favorable for the bank to foreclose on the property rather than work with you in the event of a default.
If there is no chance that you will experience some unforeseen circumstance that will result in you ever defaulting on your mortgage obligations, paying off your mortgage early does make sense if (1) your mortgage debt carries a high interest rate such that there is not a high probability that you will earn higher returns investing elsewhere, or (2) you wouldn’t actually invest in the money that would go towards a padded mortgage payment but would instead spend the funds.
I was provoked into writing this article after receiving an e-mail from a reader who decided fifteen or so years ago to open up an account at Computershare to purchase $500 worth of ExxonMobil every month rather than pay an extra $500 per month towards the mortgage. The net result is that he just a little bit shy of $200,000 worth of XOM stock accumulated over the past generation that generates the equivalent of nearly $600 per month in dividends–at this point, the Exxon dividend payouts could pay half the mortgage itself and take him to the finish line.
But to figure out what is best for you, you should perform a two-step analysis: (1) Determine whether there is any possibility you may default. If yes, you should take the extra payment amounts, let them build in a separate savings account, and use them as a safety reserve in the event of default. If no, go to question two, which is (2) Determine whether your projected investment returns exceed the interest rate on your mortgage. If the answer is a clear yes, you should invest. Otherwise, you should put the excess funds towards your mortgage.