Planting Our Pennies mentioned this on her blog the other day.
I argue that pre-paying a debt is saving, not spending. But there’s also an argument for thinking about the regular mortgage payment, even the part that goes into principal in terms of spending. These can both be true at the same time depending on whether you’re thinking about the stock or the flow.
Ok, so what are stocks and flows?
The text-book example is to think of a bathtub. The water in the bathtub is the stock of water. Turning on the faucet (or opening the drain) provides the flow. Your net-worth is a stock. Saving is a flow, and spending is a flow. Since we’re allowed to borrow, the analogy breaks down a little bit unless you can fill the tub with anti-water.
So given that your net worth is a stock, anything that increases your net-worth is saving, and anything that decreases your net-worth is spending. If you have debt [defined here as your debts>assets], then your net worth is negative. Prepaying that mortgage is increasing your net worth. It’s the same as saving. Putting that money in a safe investment is also increasing your net worth. It’s saving.
If, in this framework, you think of mortgage pre-payment as spending rather than saving, then you’re saying it decreases your net worth and it’s equivalent to going on fancy vacations or buying super expensive meals etc. It isn’t. Pre-paying your mortgage increases your net worth, spending money decreases your net worth.
In terms of your regular mortgage payment in this scenario, the part that goes to principal is savings, because it increases your net worth by removing debt, and the part going to interest is spending because it just sort of disapparates. (It’s true that if you didn’t pay the interest, your net worth would become even more negative, but if you paid off all your debt at once, there would be no more interest on it going forward– the interest is the variable cost of renting the money.)
However, if what you’re concerned about is your month-to-month expenditures, you are focusing only on the flow. In this sense, it may make sense to think about your mortgage prepayment as spending, and it certainly makes sense to think about the principal (in addition to the interest) portion of your mortgage payment as spending. Here you’re not thinking about the stock of your net worth, you’re only measuring the flow of the money (or water flowing in or out in our tub analogy). You have some amount of income to spend each month, and you have various places to put it. You have to put the regular mortgage payment money towards the mortgage– it is a fixed obligation. You have to pay it no matter what. As you’re trying to figure out where to put the rest of the money in your budget, you can only put it one place at a time. So you can put it towards true spending, or you can put it towards retirement, or the stock market, or you can put it towards your mortgage principal. A place for every dollar, and then you’re done for the month. From your check-book’s standpoint you had inflow and you had out-go and it doesn’t really matter where you put the money short-term so long as you fulfilled all your obligations. Where it matters is next quarter or next year or 30 or 50 years from now– those are net worth (or stock) concerns.
So from a year’s reconciliation standpoint, no, I don’t think you should count mortgage prepayment as if it’s a bad thing. In terms of whether or not PoP over-spent given that size mortgage prepayment, it’s probably just an accounting thing– if they’d planned that exact amount of prepayment then they could just say that they meant to spend $spending – $mortgage_prepayment instead of $spending, and they’d still feel like they’d over-spent. (As DC1 has been learning, X + Y -Y is just X all over again.) If, instead, they diverted additional money they hadn’t been planning on spending to the mortgage, then I don’t think they should be beating themselves up about not making their spending goals. (Where else was that money going to go, and why didn’t they put it there instead?)
What about you? Do you think of your mortgage prepayment (or other loan prepayment) as saving or spending? And over what term?