Imagine Alex and Sam both took out mortgages for $200,000, with terms of 30 and 15 years, respectively. Five years in, they both lose their jobs. Sam faces a dilemma with $143,000 still owed and no income to cover the $1,381 monthly payment. Without an emergency fund, Sam faces the very real possibility of losing their home to foreclosure. Alex, on the other hand, has over $180,000 left on their mortgage but has been saving $426 monthly with a 7% return, amassing nearly $30,500. This means Alex can cover their $955 monthly payment for over 2.5 years without even touching their emergency fund!
Sam rushed to pay off his mortgage, sacrificing financial flexibility in the process. This lack of liquidity became a problem when unexpected expenses arose, leaving Sam “house rich and cash poor.“ On the other hand, Alex chose to maintain liquidity by investing the money instead of pouring it all into their home. This strategy not only helped Alex build more wealth than Sam but also provided a safety net for financial setbacks. So, consider carefully: How much do you really want that home? Are you willing to stretch your budget to get it? And if you do take out a mortgage, how eager are you to pay it off, knowing it could compromise your financial flexibility in times of unexpected financial challenges?
In addition, for anyone who’s wondering why they shouldn’t prepay their mortgage, then check out this paper:103
We show that a significant number of households can perform a tax arbitrage by cutting back on their additional mortgage payments and increasing their contributions to tax-deferred accounts (TDA).
Using data from the Survey of Consumer Finances, we show that about 38% of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice. For these households, reallocating their savings can yield a mean benefit of 11 to 17 cents per dollar, depending on the choice of investment assets in the TDA. In the aggregate, these misallocated savings are costing U.S. households as much as 1.5 billion dollars per year. Finally, we show empirically that this inefficient behavior is unlikely to be driven by liquidity considerations and that self-reported debt aversion and risk aversion variables explain to some extent the preference for paying off debt obligations early and hence the propensity to forgo our proposed tax arbitrage.
Keep in mind, that was published in 2006 — in the middle of the US housing boom that would collapse less than two years later.
Exercise caution when deciding on a mortgage rate — although your finances may appear stable on paper, only you fully understand them in the context of your lifestyle. Opt for a house that is within your budget, rather than the maximum amount the mortgage company believes you can afford. It’s wise to allow for a financial cushion to cover unexpected costs or potential changes in your income to avoid the risk of becoming house poor.