No one likes to be in debt. In a perfect world, we would pay off all our liabilities and own all of our possessions free and clear. Unfortunately, in the real world, many of us have debts, and a finite amount of money that cannot pay all of them off immediately. We must make choices about which ones to pay off first. In some cases, a given liability might have such a low interest rate, it is better to invest that money than it is to pay off the debt immediately. What about when said debt is a mortgage for a home? Is it worth it to pay it off early? How does Japan differ from other countries in this respect?
The Case for Not Paying It Off Early
Early Payments May Not Apply to the First Months of the Loan, But Rather the Last Months
Lets look at investments. Compound interest has a snowball effect. Money that is put in and left to sit for 30 years will earn interest. During this process, interest will be generated. Then, not only will the principal continue to earn interest; the interest on that initial investment will earn interest as well.
Therefore, it is much better for the purpose of investments to put in ¥100 and wait 30 years for it to accumulate interest than it is to put it in after 25 years have already passed, allowing it to accrue only five years’ interest. In this case, the snowball effect helps us.
30 years of investing:
¥100 × 1.05 (i.e 5% interest)^30 years = ¥432
5 years of investing:
¥100 × 1.05^5 years = ¥127
With investments, this means investing earlier is far more advantageous than investing later. What about debts like mortgages? Well, remember, a mortgage for you is actually an investment for the bank. The bigger your debt at the T-minus 30-year mark, the more money he makes from you, and the same debt at the T-minus 5-year mark just will not fatten his wallet the same way. Therefore for the borrower, if paying off a mortgage early, it is best (for the borrower, not the lender) to do it before decades of interest accrue on the principal of the loan.
However, in the case of many mortgages, the bank will apply early payments to the last month first. Imagine a 30-year mortgage. That is 360 months. Imagine the interest rate is 5%. Imagine that, after 60 months, Mark decides to make an extra payment, expecting that the payment will apply to Month 61, saving him decades of interest and interest-on-interest payments. However, instead of the bank applying it to Month 61. They apply it to Month 360, first. If he makes another early payment, they apply it to Month 359, and so on. The interest on these last months is negligible. Mark would be better off investing that money somewhere else- not giving it back to the bank.
Now imagine that Mark somehow manages to start making payments that affect the early part of the loan—not the 360th month, but the 61st, 62nd, etc. months. Is it worth it then, assuming that the mortgage’s compound interest rate is 5%? Well, it certainly makes more sense than in the former example, but…
It Might Make More Sense to Invest the Money in a High-ROI Investment
…Mark might be able to find an investment that yields more than 5% interest, in which case, for the purpose of having a higher personal net worth, it would be better to invest that money at, say, 6% or 7%. Another thing to consider is that mortgage interest is tax-deductible. Whether this is a major or minor advantage will be determined by Mark’s annual income. If that annual income is ¥2 million, then the tax deductions for mortgage interest will be worth little if anything. However, if his annual income is over ¥40 million, meaning that his marginal tax rate is 45%, then mortgage interest tax deductions will make a much bigger difference.
Remember, in Japan, things are different. It is highly unlikely that, in Japan, Mark would be paying 5% mortgage interest. 1%~1.5% would be far more likely. It is very easy to find investments that would yield more than that. He could instead invest that money in stocks, bonds, or real estate. Real estate investments in the 23 Special Wards of Tokyo have an average 5.5% gross return (and this can go even higher, such as if buying an older building and/or refurbishing it).
The Bank Might Charge a Hefty Fee for Early Repayment
Of course you should check the terms of the mortgage, but some mortgage contracts require that you pay a fee if you repay it early. The lender basically considers your mortgage an investment vehicle, and he or she does not want you to repay it early; for you to repay it early would be the equivalent of a company calling a bond before its maturity date. Therefore, as compensation, a ‘break-up’ fee may be required.
The Case for Paying It Off Early
The Psychological Aspect
At least in some situations, it might make sense to pay a mortgage off early. First of all, there is the psychological aspect. Would you rather have ¥10,000,000 in debt, ¥21,000,000 in assets, and a personal net worth of ¥11,000,000? Or would you rather have a net worth of ¥10,000,000 and be totally debt-free? Believe it or not, many people would choose the latter for various psychological reasons, even though, from a mathematical and personal finance standpoint, a net worth of ¥11,000,000 is better than ¥10,000,000.
Doing It Early On
Although applying extra money to a mortgage late in the life of the mortgage makes little financial sense, doing it early on can save you compounded mortgage interest. It is far better to do it early on than to wait and do it later if doing it at all.
If paying down the mortgage early means that one can refinance (for example, from a 5% mortgage to a 3% mortgage, or from an adjustable-rate mortgage to a fixed-rate mortgage), then it can make sense to make those early payments. However, in Japan, with mortgage rates already so low, usually 1~1.5%, this makes less sense than it would in another country, for example, the US, where mortgage interest rates are much higher.
You’re Not Sure About Investments
If someone has a choice between paying off a mortgage with 5% interest, or investing in a market full of investments with 6%, 7%, or even higher returns, then he or she should probably invest instead. However, what about if you’re not sure about how to invest and you are not willing to experiment? It might make more sense to pay that mortgage off early.
Some lucky (or perhaps hard-working, smart) individuals will end up with windfalls, and have the option to pay off their mortgages early. Should they do it? It might not make much sense if the early payments are applied to the end of the loan, the part that accrues the least mortgage interest. There are many investments that can outpace a 3~5% mortgage, and in the case of Japan, where mortgages are 1~1.5%, this is especially true. Mortgage interest is tax-deductible, which might make investing that money smarter than paying off the mortgage, especially considering that in Japan, the marginal tax rate of the highest tax bracket is 45%. There could even be extra fees for paying it off early.
However, on the other hand, there are psychological benefits to paying off a mortgage early, and even if not paying the whole thing off early, it might allow one to refinance with a lower-interest mortgage, or get a fixed-interest one instead of an adjustable-interest mortgage. That said, in Japan mortgage interest rates are so low that the points for early-repayment are often outweighed by the returns received from investing your money elsewhere- not giving it back to the bank.
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