Why pay off a negative real mortgage rate when inflation is so high
Paying off a mortgage with a negative real interest rate is a suboptimal financial decision. However, that is exactly what I did in this unusually high inflationary environment. Wrong move? Maybe.
The mortgage rate was set at 4.25% over 30 years and the latest inflation figure was 9.1%. It therefore had a negative real mortgage rate of 4.85% (4.25% – 9.1%). I had the mortgage for 15 years until it was recently paid off.
In general, you want to keep your mortgage with a negative real interest rate for as long as possible, because inflation pays off your mortgage for you. However, sometimes not all financial decisions are aimed at maximizing returns.
If you’re wondering if you should also pay off your mortgage balance with a negative real interest rate, let me share with you why I did.
Why you might want to pay off your negative real mortgage rate
Here are the top reasons why you should consider paying off your mortgage, despite its negative real mortgage rate.
1) Uncertain about the returns of risky assets.
After a banner 2021, it was hard to see another fantastic year for equities in 2022. Therefore, when I compared an expected return of 5% to a mortgage rate of 4.25%, getting a guaranteed return of 4 .25% by paying down debt was relatively attractive.
As the year progressed and stocks dwindled, my enthusiasm for stocks also faded. But I continued to buy lower, as I have usually done since 1999. After the Fed committed to aggressive rate hikes, I had the impression that risk assets would not rally not until there were clear signs that inflation was picking up. Fortunately, the signs are now there.
Therefore, if you are uncertain about the returns of risky assets, paying off debt is a relatively preferable decision. The higher the interest rate on the debt, the more attractive it is to pay it off.
Always compare your realistic expected returns to your mortgage rate. Unfortunately, many investment houses are forecasting much lower returns on risky assets over the next 10 years.
2) It is better to lose money to inflation than to lose money to falling asset prices.
When inflation is high, our money loses purchasing power. As a result, we tend to want to spend our money earlier to buy things before they get even more expensive.
However, it is always better to lose purchasing power due to inflation than to lose money due to an investment that decreases in value. Sure, the purchasing power of your money might be down 9% from a year ago. But you’d rather have a 9% drop in your purchasing power than a 20% drop in your investment plus 9% inflation.
Since my faith in the stock market waned once the Fed started getting aggressive, I logically decided to use my idle cash to pay down debt. This way the money was at least put to good use. I follow my FS DAIR methodology for paying off debt.
3) Have strong cash flow or receive a large cash injection.
If you have a high savings rate or are suddenly accumulating a lot of money, paying off your debt is the easiest decision to make. The guaranteed return on repayment of the debt is the interest rate. In the meantime, you don’t want to have too much money for too long if you’re still in debt.
Our savings rate is over 50% and I received a large private real estate distribution of $122,423 in July. Therefore, I had excess cash.
I figured I would invest 20% of the proceeds in the S&P 500 if it fell back below 3,700. As the market rebounded, I didn’t want to chase it. Therefore, I instead used 12.3% of the real estate distribution to pay off my negative real interest rate mortgage. If I waited, I could wait a long time (hopefully).
4) Decumulating or about to retire.
It’s a good idea to pay off all debts when you can’t or don’t want to work anymore. Once you pay off your mortgage, you free up cash flow equal to the monthly mortgage payment. Getting rid of a mortgage is one less worry in retirement. It is as if a burden had been lifted.
When I paid off one of my other mortgages in 2015, I felt lighter. However, the “downside” was that I also felt lazier. I lost fire for hard work as I had $2,200 more per month in cash. Never mind that having a child in 2017 rekindled the flame to grind.
Today, after more than 2.5 years of pandemic, I am completely exhausted. Writing my book for two years while raising two young children kicked my ass. I didn’t even want to write this post. But I promised to continue, so I persevered!
By paying off this last mortgage, I free up $2,480 per month in cash. Of course, most of the monthly payment went to repay principal, not interest. That said, having more cash is nice in this uncertain environment where I am exhausted. Now the extra cash flow will be used to pay 110% of our monthly unsubsidized healthcare bill.
5) Negligible remaining mortgage balance.
If your negative real mortgage rate becomes an annoyance or an insignificant amount, you may want to pay it off. If you’re that close to paying it and you have the money, you might as well do it now to get rid of the monkey.
At the start of the year, my negative real interest rate mortgage had a balance of about $50,000. Meanwhile, the vacation property is worth around $550,000. With a loan-to-value ratio of just 9%, the mortgage started to look like a pest.
Therefore, each month for seven months, we paid an average of an additional $5,000 in capital. With approximately $15,000 remaining, we decided to pay it back after receiving our last distribution from private real estate funds. And you know what? It feels good to get rid of that loan.
We have a complicated net worth, so the less we have to manage, the better. You’ll appreciate the joy of simplicity if you ever set up a revocable trust, write a will or create a death record.
The feeling of paying off a mortgage is similar to the feeling of getting rid of a troublesome rental property. Joy. You feel you have more ability to focus on better things.
6) If mortgage rates and inflation rates go down.
The last reason you might want to pay off your negative real interest rate mortgage is if mortgage rates and inflation go down. If rates go down, your current mortgage rate becomes relatively more expensive. Therefore, you would either want to pay off the additional principal or refinance with a lower rate mortgage.
However, in 2022, mortgage rates climbed about 2.25% before falling about 1% from their highs so far. Higher mortgage rates and inflation make my current rate of 4.25% more attractive. After all, the average 30-year fixed rate mortgage has peaked around 5.83% according to Freddie Mac.
Despite having a relatively more attractive mortgage, I still paid it off because the balance was low compared to the value of the property. I just wanted the pesky burden to go away so I could focus on making money somewhere else. If my mortgage amount was in the hundreds of thousands of dollars, I probably would have kept it.
The 4.25% mortgage I just paid off was also my highest mortgage rate of three. The combination of the highest mortgage rate and the lowest balance made the decision to pay off easier.
Not repaying my principal residence Negative real mortgage rate
I will be happy not to pay off my existing principal residence mortgage with a mortgage rate of 2.125%. This is a 7/1 ARM that can be reset to 4.125% at most in 2027. Paying off a negative real mortgage rate of around 7% is just too much. A mortgage rate of 2.125% looks like free money in this environment.
By 2027, when ARM resets, there’s a 60% chance I’ll buy another “forever home.” If I need funds, I will end up selling my existing residence, paying off the entire main mortgage anyway.
Finally, if you are considering paying off your negative real rate mortgage, please beware of certain mortgage repayment procedures. Paying off the exact balance can be tricky. It is better to overpay a little and get reimbursed.
Most importantly, confirm that the liens are removed with the title company and the bank. You can do this by requesting a retrocession letter of the mortgagee.
Although paying off a negative real mortgage rate was a suboptimal financial decision from a returns standpoint, it was fine with me. The feeling of having one less mortgage outweighs having a swelling mortgage balance.
Questions and action items
Readers, have you paid off your mortgage with a negative real mortgage rate in this highly inflationary environment? Why or why not?
After paying off three mortgages, I found that I like to pay off mortgages in about 10-15 years. Waiting 30 years seems too long. Therefore, getting a 7/1 or 10/1 ARM is more optimal given that the interest rate is lower. ARMs also motivate me to repay the additional capital.
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