Is prepaying a debt saving or spending?

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?

39 Responses to “Is prepaying a debt saving or spending?”

  1. plantingourpennies Says:

    I look at it like you have 3 choices of when to account for spending on large objects that are paid for with (typically) borrowed funds.
    1 – all principle counted as “spent” on day of purchase
    2 – principle counted as spending as it is paid off (this is what we do)
    3 – count principle as spending according to a depreciation/amortization schedule

    I *think* all of these would be GAAP acceptable ways to account for spending on CapEx.

  2. Comradde PhysioProffe Says:

    I suppose you could think of the mortgage payments–both principal and interest–as delayed spending on the house you bought in the past. The principal is spending on the house, and the interest is spending on the right to delay the spending on the house.

  3. First Gen American Says:

    You are saving on interest. Also, Like stocks, homes can be sold and retain some of their value and can appreciate or depreciate, so it’s not at all like taking a vacation. You actually have something to show for your spending and can use it to supplement your income by taking on tenants or growing a garden or creating another home based business that you couldn’t do otherwise without the asset.

    • GMP Says:

      I just did a calculation on how much we would save via prepayment if we started putting extra $500/month towards our 15-tr mortgage. It would overall save us about $30K overall but loan duration would be down by 3 yrs Just putting that extra money into savings would yield about $70K, so it is a substantial chunk of change. DH and I have decided that we would rather we put that money towards travel with kids while they are still young.

      • nicoleandmaggie Says:

        Into savings where?

      • GMP Says:

        Oops! My comment above was not supposed to be a reply to FGA, just a stand-alone comment…

      • GMP Says:

        Just bare bones minimal interest savings (12 yrs at $6K per year is $72K, I am not even counting interest).

      • nicoleandmaggie Says:

        Ah, I understand now. I was wondering where you were getting a 22K (=72-50) return off of $500/month for 3 years!

      • First Gen American Says:

        So, GMP, you’re not counting the 3 years of mortgage payments that you don’t have to make at the end of the loan for your comparison. Just from my perspective, not having a mortgage at all for 2 years was like hitting the lottery. Money was just piling up all over the place. I saved more in 2 years than the previous 10. Granted, our incomes were higher than they were 10 years ago, but just having such low expenses was great. I didn’t go crazy with the pre-payments til the payoff amount was within spitting distance. Just a little here and a little there. Rounding up the payments, putting random windfalls towards it. I still wanted a buffer for vacations, emergencies, but the little bits do add up.

  4. Thisbe Says:

    Here’s a comment that might be a question:
    You said, “If you have debt, then your net worth is negative.” That might be true in the general case, but it’s not true in mine. I have debt, and my net worth is positive – e.g., I could pay the debt off tomorrow if I wanted to, but I don’t.

    For me this (positive net worth) weighs heavily in my assessment of whether pre-paying debt would be spending or saving. I have to see it as spending. The interest rate on the debt is low enough that the money is more effectively used as investments; pre-paying debt would be sacrificing investment appreciation for the mental satisfaction of being debt-free, which to me is pretty clearly spending (in the same way I sometimes spend money on other things just to clear my mental space and make problems go away). It might be that in a few years circumstances will have changed so that I would rather collapse the (money in investments + outstanding debt) into the actual positive net worth in reality instead of just in my mind, but I’m not there right now.

    The maybe question seems to be here, do you think I’m being crazy? Not that I will do anything differently necessarily, but I’m curious to know. :)

    • nicoleandmaggie Says:

      Ok, making it more clear. It’s hard for me (from my training) to separate the math (where we add up the + and the – to get an overall number, and then call that debt or surplus) vs. remembering that not everybody thinks of debt as the sum of red and black, but just the red part.

      • Thisbe Says:

        Interesting – just checking, does that mean that you would say (in your field) that I don’t really have debt, because my net worth is positive?

      • nicoleandmaggie Says:

        Yes. :) Depending on the discussion. (If discussing amortization or interest or debt payment, then you’d have debt.) But just in general terms, no.

    • chacha1 Says:

      I’m in a similar position. I have a relatively small balance on my credit card, which could be paid off entirely from my “emergency fund.” But I choose to maintain the emergency fund and leverage the debt because of A) if you don’t have a cash emergency fund then all you have is credit cards and B) I’m trying to work my way back to a 100% cash-basis lifestyle but see A). :-)

  5. kellen Says:

    I count the principal as “savings” whether regular or prepaid, because it doesn’t increase/decrease my net worth directly. I mentioned this to a friend the other day though, and they seemed to think that “of course” your full mortgage payment should be considered an expense. I guess it depends on whether you are concerned about your cash flow, or your net worth.

    • nicoleandmaggie Says:

      Exactly– cash flow = flow and net worth = stock. One matters on a month to month basis and one matters for overall financial health. Pre-payment is still an optional expenditure that is more like putting money in a CD than towards a vacation. It’s something I do after making sure we’ve met our actual obligations and weighed our investment opportunities.

    • Rosa Says:

      I think for a lot of us that’s a mental trick because we might not save as much overall if we thought of home equity as savings and that gets people in trouble in market downturns. Plus the equity on the home in a decade or three isn’t really knowable – it might go up, it might go down. My parents retired and sold out just before their neighborhood lost almost all of it’s value because of one especially bad multi-home-buying landlord. My own neighborhood had a huge crash (long before I bought here, and it had recovered before we bought) because of a shooting at a neighborhood restaurant one year. It feels much less of a sure thing than a stock index, more like a single-pick stock holding.

      • nicoleandmaggie Says:

        You have to pay the debt no matter what the equity is (unless you foreclose). The debt repayment is a safe investment even if investing in a house isn’t.

        The thing that concerns me with counting pre-payment as spending is that it penalizes pre-payment.

      • Rosa Says:

        Given the foreclosure rates around here the last few years – we lost 1/3 of the neighbors on our block to foreclosure or short sale – it’s hard to think of mortgage repayment as something inevitable even if the value of the house drops drastically.

      • Rosa Says:

        But also, I’ve never been in any debt other than this mortgage (my partner and I both had parents who paid our tuitions as long as we went to state colleges) so I don’t have any kind of general “how to account for debt” in my head. It’s all tied up with the house and whether it’s an investment or a luxury or both and in what proportions.

  6. bogart Says:

    Saving, without question (at least in my mind!). Depending on the debt, it may well be saving in a very inaccessible location, i.e., you couldn’t again access those funds if you discovered you needed them for something else. As I’ve said previously here, I’m preferring having a fixed-rate mortgage that is at a low interest rate, by comparison to recent history, to paying it down early for that reason. I know you feel differently and I think both perspectives are equally good/valid/logical depending on goals, resources, and expectations about the future.

    • nicoleandmaggie Says:

      I was thinking about the accessibility question this morning, but I think mortgage savings is actually more accessible than 401(K) investing.

      I don’t feel differently at all– my mortgage rate just isn’t that low.

    • kellen Says:

      Nicole&Maggie have mentioned before getting a mortgage “recast” so that your prepayments can pay off by you getting a reduced monthly payment, I think? This is something I would consider looking into after I get 20% of the loan paid down, but it’s not something I’ve seen my bank advertising. But it’s a way to make your prepayment “savings” more accessible in the future.

  7. bogart Says:

    I’m not sure which I think is more accessible, seems that could depend on various variables that will, well, vary. Department of redundancy department! And, right, I guess I’d forgotten about the discrepant rates (though you could, I assume, refi. But for the value and your situation, likely not a sensible plan).

  8. Rosa Says:

    we do a pretty low amount of overpayment, just a few hundred dollars a month, and it puts our mortgage in line with what rent would cost, so I think of it as spending. Spending on mental health really, like paying for childcare when we *could* get by with opposite shifts.

    Back when we were doing big overpayments, that had a big effect on the overall cost of our mortgage, I thought of it as investing, which is kind of different from saving or spending in my mind.

  9. Linda Says:

    I completely understand your analogy and agree that “it depends” on how you look at it.

    When I first secured my mortgage at 41 years old [prior to that, it was a joint mortgage with my ex] I had a goal to get my mortgage paid off by the time I turned 65. Since I had a 30 year mortgage, I used pre-payments to work towards that goal. Once I was able to refinance to the sweet deal I have now (15 yrs @ 3.125%) I stopped pre-paying. Between pre-payments and re-financing to a lower rate, I shaved 15 years off the lifetime of my mortgage debt, and would easily be able to meet my goal. Instead, I now use the money I would have put towards pre-payment for other investments.

    When I calculate my net worth, I do use an estimate of my home’s market value, but I know that the only true way to know the value is when it is time to sell.

    What about the maintenance expenses of a home? I ask because I think that over the years I’ve been here “capital improvements” and maintenance/repairs would be considered against whatever market gains have been made, right? I guess that doesn’t affect my net worth, only my calculations as to the “value” this “investment” has brought, no?

    • nicoleandmaggie Says:

      Well, if you were doing it “correctly” you’d take into account annual depreciation the minute you bought your home! That’s too complicated for me though. (I consider capital improvements as spending because I don’t think of the house that I live in as an investment, although it is an asset. However, the debt must be paid.)

  10. OMDG Says:

    I really enjoy reading these columns. One of my goals for the year was to do some financial planning for the family, and you’ve given me confidence that I’m doing things the right way. So, thank you!

  11. schooze Says:

    I’m not sure how you feel about Elizabeth Warren, in her book she splits all spending into three categories: needs, wants, and savings. She counts regular mortgage payments as needs and any prepayment as savings. I like that approach as well.

  12. chacha1 Says:

    I agree that prepayment *on a debt related to real estate* is savings. You are building an asset (a relatively illiquid one, but an asset nonetheless) so = savings.

    I would not necessarily put prepayment of any other kind of loan in the same class. Say, on a car. In that case I’d say it’s simply getting out from under the debt as soon as possible because the value of the property is dropping each month you own it. A loan for anything other than real estate is just stretching out the life of an expense.

    Mortgage interest is a straight-up expense = spending.

  13. Leigh Says:

    I count mortgage pre-payment as saving. The required payment, however, is spending. I mean, when I was renting, the rent cost was spending and the down payment savings were savings.

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