What Happens When You Pay Your Mortgage Early? “6% interest rate, 21 years forward”… Forward Rates Makes It Less Obvious What Your Effective ‘Return On Investment’ Really Is
The Truth About Paying Down Your Mortgage Early
First, it’s helpful to understand mechanically what happens when you make an extra, partial, principal payment on your mortgage.
After making your regular monthly payment, let’s say you send an additional $1,000 to the bank for principal. The bank – actually the mortgage servicing company, but let’s not nitpick – applies that principal to the furthest-away-in-time mortgage payment. In Manny’s case, his $1,000 payment gets applied toward a payment due 21 years from now.
In other words, Manny’s total mortgage principal gets reduced by $1,000, but not in any way that affects his current monthly mortgage costs. He’s still obligated to make regular mortgage payments next month.
You may have read, not entirely incorrectly, that when you pay debt principal early you get a guaranteed return on your money equal to your interest rate. If you have a 6% mortgage, the conventional wisdom goes, you get a 6% “return on investment” when you pay off your mortgage.
21 years from now a 6% mortgage interest rate may be extraordinarily high or it may be extraordinarily low (I’m agnostic on the issue) but the imprecision around the question of forward rates makes it less obvious what your effective ‘return on investment’ really is, or what you should reasonably expect to earn on your money 21 years from now.