Everyone would like to live debt-free. I get it. And I agree. Most of the time... with most of the credit lines with extraordinary interest rates, by the end of your payments, you will have paid double. But not all loans are made equal, and depending on what you are using them for, the more leveraged you are, the better.
CREDIT CARD DEBTS
According to WalletHub, as of August 24th, the interest rates in credit card lines can go anywhere from 13% to 23% per year. That means that if you have a $1,000.0 credit card debt and you pay it monthly during one year in equal payments, by the end of that year you would have paid about $129 in interests. That's 12.89% of your debt! Now, imagine if you have $10,000! You'd paid $1,289.00 in interests!
It gets even worse if you don't pay it. At a rate of 23%, it would take 37 months for your debt to double. Tell me: what kind of investment do you do that can double your principal in just 3 years? Not a lot... not without a very high risk for you.
Personal loans are something else. The rates can go from 5% to 36%, depending on your credit history, your income, the length of the contract, your zip code. The Bank Rate website you can simulate your rate on a personal loan. Also, the rate can change depending on the purpose of your loan: home improvement, debt consolidate, credit card pay off.
Another very common credit line is the car loan. Buying a car with credit is not the best decision. Actually, you don't finance depreciating assets. If it wasn't bad enough that your object of purchase is losing value over time, you are also paying more for it in carrying costs.
Nevertheless, most of the time, people do it because it is easier (and faster) to solve their problem (buying a car) without having all the money. I get it. I do this a lot. But have in mind that, financially, this is not the best option.
The car loans can vary from 4.7% for a person with good credit and a longer contract to 12% with someone without a credit history.
All those lines of credit, it is best for you if you can pay them as fast as possible. As shown in the examples above, the interest rates are high, the purpose of the use is not bringing you any financial advantage, and keeping those lines of credit open will drain your hard-earned money. That's not the case for a mortgage.
HOW MORTGAGES WORK
A mortgage is a very low-risk credit operating for a financial institution. Excluding the excesses of the 2000's years, usually, a bank has a lot of gains coming out from their mortgage-backed loans: long term relationship with clients, low history of default (again, 2007/2008 was an exception), very strong collateral.
When a bank lends person money to buy real estate, they know that the time is on their side. Not only they will keep that client paying bank fees for a long time, but also their collateral/loan ratio increases over time.
As the individual pays their mortgage, the amount of money has to get back from the loan decreases. At the same time, real estate property tends to have an increase in prices in the long term.
Therefore, as far as the contract goes, and the client keeps paying their mortgage, the bank is a good position. In an event of stress, where the financial institution has to execute the mortgage (for lack of payment, let's say), they will have a greater chance to have their balance back, because the property should be worthing much more than at the beginning of the contract, and the individual has paid a great part of it.
At the time I'm writing this article, the mortgage rates are at their all-time low. They can go as low as 2.45%. This means that the cost of money is very cheap. As we did in the example before, if you have a credit card debt for 30 years, with an interest rate of 12% (let's use the lower tier), at the end of the period, you would have paid $2,724 in interests. That's 2.7 times your principal amount!
Just to have in perspective, if you have a mortgage of $100,000.00, with a 2.5% interest rate, for 30 years. during the term of the contract, you would pay $43,332 in interest. This is a lot of money but look at the principal: $100,000.00. The interest is "only" 43% of the total.
Opportunity cost is how much money you DON'T make because your cash is allocated in a different asset. In another way, is how much money you are preventing yourself to make, because your money is finite: you can't put it in all the available opportunities.
If you have $100,000.00 invested in Treasury Bonds that yields 1.25% per year, and you have another option, that could return 3% per year, your opportunity cost would be $1,750.00, or 1.75%, which is how much money you are NOT making by choosing the first investment option.
And that's the most important concept to understand right now.
According to the website Ownerly, the Black Knight report shows that, in the long term, homes appreciate at an average of 3.8% per year. So, here, we already have a great conclusion: your house is appreciating at a higher rate than your cost to purchase it.
If your mortgage rate is 2.5% and your property is increasing in value at a rate of 3.8%, your net cost is 1.3%. And that's the number you should look at.
Let's say you have an extra $500.00 every month, and you don't know what to do with it. Because you always were told to pay off all your debts, you start to apply this money to your mortgage and reduce your long term cost. That looks like a smart move: you will have your house free and clear before you ever expected.
But is it, really, a smart move?
When you pay off your debt and increase the equity you have in your house, you are actually making an investment that will return you 3.8% per year. Why? Because that's how much your house will appreciate, on average. As you increase your equity, you are increasing the slice of your investments in real estate. You change debt for equity.
But, what about the opportunity cost?
The S&P500 average return in the last 90 years is 9.8%. And we went through a war (World War II), 3 oil crises, terrorist attacks, market crashes (1980's, 1990's, 2007), and a pandemic (2020).
So, let's say you own $100,000.00 and you received a bonus in that amount. If you use it to pay off your mortgage, you will lose 6% every year. COMPOUNDED!
Yes, if you pay off your debt, you will save $43k dollars in interest in the course of 30 years. But if you put it into an S&P500 fund, with a net return of 6% (9.8% minus the opportunity cost of your house, 3.8%), at the end of the 30th year, you would NOT make $474,000.00!!
You could buy your house... 4 times!
So, next time you think about paying your mortgage faster, think about NOT how much money in interest would you be saving, but how much money you would NOT make investing in other opportunities.