Is Making Extra Mortgage Payments Worthwhile? | Michael Roberts

Professor Michael Roberts shares tips on how to better manage your money.

Worried about your money? Wharton finance professor Michael Roberts is here to help with common-sense advice on mortgage debt, personal budgeting, and planning ahead. This episode is part of a series on getting a “Fresh Start” this new year.

Can You Save Money by Making Extra Mortgage Payments?

Dan Loney: As we have hit the New Year, many people look to make changes in their lives so that they can have a better lifestyle. There are many different things to improve your financial health, even something like paying off your mortgage.

Michael Roberts: Yes, it’s probably people’s largest monthly or recurring payment, and it’s there for 10, 15, typically 30 years. So, it’s definitely a stressor from a psychological standpoint. But I think if people understand the mechanics, the basic finance of a mortgage, and the broader picture of their finances, it can be less of a stressor and actually become a potential asset.

Loney: How so?

Roberts: I’ll use myself as an example. We bought a home seven or eight years ago and refinanced into a mortgage that was 2.75%. That was certainly low back then, but it wasn’t low relative to what I could invest money in and earn a guaranteed or very safe return. If I put it in treasuries, I wasn’t earning 2%. I was lucky to get 1%. But fast-forward now, three years to today, and if you’re sitting on a 2.75% mortgage and interest rates on treasury securities, for example, or CDs are above 5%, that’s an opportunity.

You want to think about a mortgage as rationally as we can, in terms of our opportunity costs. If I’m paying 2.75% on a mortgage that I originated five or 10 years ago, and now I can earn 5+ basically guaranteed, there’s really no incentive for me to pay that mortgage down. I’d be throwing away money, effectively.

Loney: How much do people consider the benefit from that type of scenario? I wonder if sometimes that’s an element that is missed along the way?

Roberts: It is, and understandably so, because ultimately that decision is a broader trade-off. It’s not just a simple, “Well, I’m paying 2.75%. I can earn 5%.” It’s obvious. We need to think about tax implications, right? We’ve got to pay taxes on any earnings. There’s a psychological value to not having what academics like to call “dead overhang.” Being free and clear on the house and not having to make that monthly mortgage payment — there is a real psychological benefit to that. And depending upon your personal make-up, that might outweigh the additional money you could be making by not paying it down more quickly.

Loney: I guess it ends up being the individual’s decision, because even something like paying off an extra $100 a month on your mortgage can be such a benefit longer term.

Roberts: No doubt about it. You’ll shorten that mortgage. You will be free and clear sooner. But I worry that some of the other benefits of not paying down that mortgage and investing or saving that money sometimes get lost in the discussion. One of the issues with paying that mortgage down quickly is you’re basically investing in the house. You’re reallocating your investment from the stock market, bond market — whatever it may be — into real estate. And that can create problems.

No. 1, you can become incredibly under-diversified. If all your wealth is sitting in that house, and anything happens to that one asset, you’ve got a big problem. But No. 2, that’s a highly illiquid asset. You start plowing all that savings into the house, and something bad happens — a medical emergency, whatever it may be — and you need money, then you’ve got a problem. I can sell stocks or bonds instantly. You give up some diversification benefits when you go all-in on the home. I think people need to think about these other considerations in the context of their broader portfolio.

Why Financial Literacy Is Valuable at Any Age

Loney: It’s also part of the larger discussion about financial literacy at younger ages?

Roberts: Yes. One of the first things we do when we talk about financial literacy is we show the power of compounding. Saving $100 for me, now that I’m over 50, has a much smaller effect than had I saved that same $100 when I was 21. Just a basic understanding of some basic financial principles when you’re in high school or college can pay massive dividends, pun intended, going forward for years. It’s a huge stress reducer.

Loney: Are you a believer that the beginning of the year is a good time to take stock of where you are and adjust your plan?

Roberts: It doesn’t have to be the beginning of the year, but if that’s what motivates people, then by all means, yes. I think a more disciplined approach, every quarter, once every quarter, once every year, to take stock of where your finances are, where your expenses are headed, and whether or not you have enough liquidity today, and whether or not you’ll have enough savings in the future. It’s always a good time to have a look at that.

Now that’s costly, right? We’re busy people, but if we can do that a few times a year, it’s going to have huge benefits. I pay bills once a month. Rather than just paying the bills, I do my budgeting and look at my investments and make sure nothing weird is happening. There is no great science to it. It’s just a way to discipline me. Instead of spending 10 minutes paying bills, I spend an hour just sort of looking at what’s going on.

Loney: You do that on a monthly basis, even with the investments?

Roberts: Yes, absolutely. I’m not doing anything fancy with my investments. I’m simply looking, “OK, am I on course to where I need to be when I retire?” Or even before that, where my kids go to school, go to college — am I on track? If not, what do I need to do? Do I need to save a little bit more? Can I spend a little bit more? These sorts of things.

Loney: What’s the advice that you give for people who are maybe having issues doing that right now? What’s the path they need to consider?

Roberts: My path to doing that was pure necessity. I basically got very lazy, didn’t look at my finances, didn’t think about what I was making and what I was spending, and, frankly, I ran into trouble. Fortunately, I married someone far more successful than myself, so it really wasn’t a big deal for the family, but it was a big wake-up call for me. Rather than people having that sort of slap in the face, I think the next time you’re paying your bills, just pause and take a look at the bigger picture. Again, it’s an hour at most.

Managing Your Money for the Future

Loney: The other scenario that’s being talked about now is the rising credit debt and the concern about what that may mean over the next 12 to 18 months.

Roberts: Yes. I’m not going to get into forecasting the macro-economy. I’ll leave that to Jeremy Siegel, who is much better than I am at that. But what it does mean is if you’re looking for a house now, you’re paying 7%. If you’re lucky, maybe 6%. While there’s lots of talk about, “Well, don’t worry about it. Interest rates are going to go down.” Well, if we knew where interest rates were headed, we could make a ton of money. The reality is we don’t know what’s going to happen. The real question is, are we prepared for what may happen in terms of how much money we have on hand, how much we have saved, etc.?

Loney: But even where interest rates are right now, I think the safe expectation is we’re not going to see 2%, 3%, 3.5% maybe for a long, long time. At least you can put that level of expectation out there right now, with maybe some wiggle room?

Roberts: I 100% agree with that, Dan. In fact, my parents, I remember them paying 21% on their mortgage in ’81, when rates were up at 15%, 16%. At 7%, people feel the world is falling apart. Hardly. From a historical perspective, that’s not terribly high.

Loney: How often do you think people think about their home as an investment?

Roberts: Not often. That’s why I brought up those two points earlier, that you need to think about your home as part of your savings, your investment portfolio. Any equity in there, that’s an investment. It’s a risky investment, and it’s an illiquid investment.

Loney: When you go back to the height of the pandemic, when we saw home prices rise as quickly as we did, I think people bought into the incredible value that was added to their properties and that it was going to be there forever. There’s never a guarantee that’s going to be the case.

Roberts: No, we just have to go back to 2008, 2009, and the great financial crisis. Real estate values can fall, and they can fall dramatically.

Loney: What about the psychological benefits of having a focus on your investments, on your funds, on your savings, of being truly prepared for as many eventualities as you can foresee in the future?

Roberts: I think it takes a balanced attitude. If you’re looking at your investments on a daily basis, pulling your hair out because the stock market went down today, that’s the wrong approach. I’m looking, making sure that my money is still there, that it hasn’t been absconded, or there’s an error. Otherwise, I’m just leaving it.

The approach I’m really trying to encourage is one of awareness and knowledge, more than some sort of strategic investing strategy because most of us are not professional traders. I’m not. Despite my profession as an academic, I’m not a professional trader. I’m really just trying to make sure my investments are structured in a way that they reflect my risk tolerance, my family’s risk tolerance, and that they put me on a path to where I need to be.

It’s peace of mind, and that to me is invaluable, knowing that I’m going to be OK. Now, when you do this for the first time, it can be a slap in the face. It’s just scary. And I think that prevents people from taking that initial first step. But boy, once you get on top of it, it’s just a different world.