Why lowering the interest rate on your mortgage may cause you to go broke
September 15, 2021
Your monthly mortgage payment consists of two parts: the principal, which goes towards paying down the loan, and the interest, which is the cost of the loan. How much of the payment goes towards each will depend on how your mortgage is structured, particularly by the term length.
Short-term mortgages have lower interest rates, while long-term mortgages have higher rates reflective of the risk they represent to the bank. Because paying interest is money you never get back, most people opt for a short-term mortgage with lower rates that should result in owning the home outright more quickly. Seems like a smart, safe way to invest your money, right?
Actually, wrong. Or, more accurately, opting for a short-term/low interest mortgage could be setting yourself up for failure.
When you get a short-term mortgage, you are committing to making all the payments on the principal in 15 years, or about half the time of the average long-term mortgage. Your monthly payments will be relatively quite high, with most of that payment going towards paying down the principal - but is that the best use of your money?
Remember: your mortgage is more than just a loan to purchase a home – it’s also one of the cheapest ways to borrow money. Interest rates on mortgages are low compared to other kinds of debt (credit card debt, student loans, medical debt, etc.). It is virtually always better to pay off debt with higher interest rates first than to pay off debt with lower interest rates.
Also ask yourself: is the money you are putting into your home going to yield the best possible results for you or are there higher-returning investments you could be making? If it’s the latter, paying slightly higher interest rates to lower your monthly payments frees up that money to be used more productively elsewhere.
In addition, your home might not be as safe of an investment as you think it is. In the eyes of your bank, you are always only as good as your last mortgage payment. Choosing a short-term mortgage because it builds equity into your home faster is committing yourself to higher payments. If anything goes wrong, your cash will be tied up in your home and unavailable for you to use. Worst case scenario - you will either have to sell your home in a pinch or risk losing it to the bank.
Choosing a mortgage is about finding the right balance between preference, risk tolerance, and strategy. Just make sure that the choices you deem “risky” or “safe” are actually that. You may be saving money on interest payments as well as paying off your mortgage more quickly, but is that really the optimal long-term strategy for having your money work for you? It is definitely up for debate. After all, you may be unknowingly betting the farm, and who wants to end up broke?
For a deeper dive into mortgages, visit the Fortunately Mortgage Guide.
September 15, 2021