Negative Real Mortgage Rates Means Don’t Pay Down Extra Principal

As a homeowner with a mortgage, the holy grail is having a mortgage rate below the 10-year bond yield. When you have this situation, it’s like living for free and you should not pay down extra principal. If you had the money, you could invest an amount equal to your mortgage into a 10-year Treasury bond. The interest income can then be used to pay your entire mortgage interest.

The second best situation is having a negative real mortgage rate thanks to inflation and low rates. In such a scenario, although you can't technically live for free, from an inflation-adjusted standpoint, you kind of are. You shouldn't be in a rush to pay down debt.

To see if you have a negative real mortgage rate, take your mortgage rate and subtract it by the latest inflation rate. If the percentage is less than zero percent, then you have a negative real mortgage rate. If you have a negative real mortgage rate, you should also slowdown or stop paying extra principal because you're borrowing free money.

Example Of A Negative Real Mortgage Rate

The May 2022 CPI came in at 8.6%. With energy prices and commodity prices skyrocketing since the start of the war in Ukraine, inflation will likely stayed elevated for a while.

If you have a mortgage rate that is less than 8.6%, at the moment, you have a negative real mortgage rate. Enjoy it. Hold onto your negative real mortgage rate for as long as possible since inflation is paying down your debt for you. In fact, the average mortgage rate by interest shows 90% of mortgage holders have rates below 5%.

November 2021 CPI

Let's use my primary residence mortgage rate of 2.125% for a 7/1 ARM I took out in 2020 as an example. My real mortgage rate equals 2.125% minus 8.6% = -6.475%

A negative real mortgage rate of 6.475% means that in inflation-adjusted terms, it's like I'm getting paid to borrow at a rate of 6.475%. Free money! Or it might be viewed as a 6.475% decline in the real cost of my mortgage.

Therefore, I should try to hold onto as much of my primary residence mortgage as possible, especially while home prices are rising. Paying down extra principal in this situation is a suboptimal move.

Conversely, if inflation (CPI) came in at 1% instead of 8.6%, then my real mortgage rate is equal to 2.125% – 1% = 1.125%. But even paying a real mortgage rate of 1.125% is cheap. It's just that getting paid to borrow at a real mortgage rate of -6.475% is just fabulous!

In most economic environments, real mortgage rates are positive, not negative.

Inflation Is A Boon For Homeowners And Debtors

The higher the inflation, the more the real cost of your debt gets inflated away. Further, the higher the inflation, the more the price of your assets tend to go up. Therefore, for homeowners with a mortgage, inflation tends to act as a double win.

This double win is why I've been investing in rental properties and single-family homes. I don't want to be run over by higher rents. Instead, I want to benefit from higher rents to take care of my family.

What's interesting in our current scenario of high inflation is the 10-year bond yield staying level at around 1.5%, +/- 0.1%. This signals the bond market thinks elevated inflation will be temporary. I agree with this view because the bond market tends to always be right.

I expect inflation to normalize closer to 4% by the end of 2022 and to 3% by the end of 2023. In such a scenario, most homeowners with mortgages will still have negative real mortgage rates because everybody can wisely refinance right now at 3% or less.

A 3% – 4% inflationary environment might be the goldilocks scenario for real estate investors. On the one hand, inflation is high enough to act as a nice tailwind for rent and asset price growth. On the other hand, inflation is not high enough to spook the bond market and cause the Federal Reserve to hike rates too aggressively.

Banks Are Still Winning, Don't Worry

Let's say you can get a ho-hum 0.5% savings rate on $100,000 in cash. But with inflation at 6.8%, your real savings rate is -6.4%. In other words, your $100,000 in cash can now only buy about $93,600 of goods this year compared to last year, when it could buy $100,000 worth of goods.

Put it differently, banks LOVE gathering massive savings deposits in a high inflationary environment when they concurrently don't have to pay a high interest rate. Banks are getting to borrow free money from us to then lend out for a profit. To provide consistent logic, inflation-adjusted, we're actually paying the banks to hold our money.

Therefore, don't feel so bad if your lender is earning a real negative return off your mortgage. Your lender is also benefiting from a massive wave of deposits. Lenders can then turn around and lend out your money in a risk-appropriate for a profit.

This chart below is a beautiful site for banking executives. It is one of the reasons why the Financials sector has done well since 2020. Consumers are cashed up and ready to rumble.

Household deposits spiking higher in 2021 according to the St. Louis Federal Reserve - Banks love a massive surge in deposits

Negative real returns on a potentially devaluing currency is one argument for why money has found its way into cryptocurrencies like Bitcoin. Given the supply of Bitcoin is fixed and the supply of the U.S. dollar is not, Bitcoin is seen as an attractive alternative. Unfortunately, Bitcoin has proven to be a terrible hedge against elevated inflation.

One can also make the argument for gold, which has increased by a more subdued 20% since early 2020.

Still Makes Sense To Pay Down Debt And Invest

Although paying down a negative real mortgage is a suboptimal financial move, I still think it's wise to pay off some debt with excess cash flow.

For one, if you do not invest your cash, then your cash is getting negatively affected by inflation. So paying down extra mortgage principal is the lesser “evil” of the two choices.

Second, the money you invest could always lose value. Paying down debt locks in a return equal to the nominal interest rate of the debt. Even if the nominal interest rate is only 2.125%, it is better than losing money on a risk asset that declines by greater than 2.125%.

Finally, concurrently paying down debt and investing creates a perpetual hedge. You're always winning somewhere, no matter the environment. And when you feel like you're always winning, you tend to be happier and make even more optimal financial moves.

No one economic scenario will last forever. As a result, you should always adapt your debt pay-down and investing strategy. Luckily for you, there is the FS DAIR framework to follow where it adjusts with the times.

Negative real mortgage rates - historical chart

Please note I actually paid off a negative real interest rate mortgage. The mortgage amount was insignificant at less than 8% of the value of the property. I just wanted to get rid of it and simplify life.

Embrace Your Debt In A Negative Interest Rate Environment

Taking on debt to live a better life today is my favorite reason for taking out a mortgage. If the house then appreciates in value while the real mortgage interest rates goes negative, then you're living the ideal scenario. The same goes for taking out debt to buy and enjoy any appreciating asset.

Everybody loves getting something for free.

If you're a renter, you can still win by investing your cash. Stocks tend to do well in an inflationary environment. You could also buy real estate ETFs, public REITs, private eREITs, and individual private real estate investments. Then, of course, there are plenty of other alternative assets that do well in an inflationary environment.

The person who is losing in a negative interest rate environment is someone who holds all cash and never asks for or gets a raise. On the flip side, the person who takes on too much leverage will also lose big if a downturn ever comes and he cannot hold on. Therefore, proper risk control is necessary.

In our current elevated inflationary environment, I suggest slowing down your debt paydown schedule. Wait until inflation gets back down to about 3% before increasing your debt paydown again.

Yes, having a lot of cash in an inflationary environment is not great. However, having cash also gives you the liquid courage to take advantage of new investment opportunities. Get an investment right and it will more than make up for any losses due to inflation.

Invest In Real Estate More Surgically

The combination of rising rents and rising capital values is a very powerful wealth-builder. I encourage readers to invest in real estate to build more wealth for the long term. Negative real mortgage rates also makes investing in real estate very attractive.

Invest in real estate surgically without a mortgage through real estate crowdfunding. Here are my two favorite platforms that are both free to sign up. I've personally invested $810,000 in private real estate funds to diversify my holdings and earn more passive income.

Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. For most people, investing in a diversified eREIT is the easiest way to gain real estate exposure. 

CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends. If you have a lot more capital, you can build you own diversified real estate portfolio. 

For more nuanced personal finance content, join 50,000+ and sign up for my free weekly newsletter. This way, you won't miss a thing. Inflation will likely stay elevated in 2022 and 2023. Even though mortgage rates have come up, due to higher inflation, we still have negative real mortgage rates. Take advantage and invest in real estate with cheap money.

51 thoughts on “Negative Real Mortgage Rates Means Don’t Pay Down Extra Principal”

  1. Interesting article, coming from a new reader! A few points to clarify-

    When you say negative interest rates mean you get ‘paid’ to borrow at a given rate, what do you mean by ‘paid’? Does it assume your income rises at the inflation rate?

    And under ‘Banks Are Still Winning, Don’t Worry’, what is the rationale for increased bank deposits when savings rates are paltry (<1%)? I know folks have a lot of money in recent years, and yes that is a slight buffer against inflation, but the better move is putting that into higher returning assets I'd think. Was the point just that people have lots of cash now and the banks don't pay out much on it?

  2. Hi Sam

    What are your views now since 30 year mortgage rate is close to 5% and Fed is thinking hiking it further in May 2022.

    Please write a post on this development which no one predicted. ( Fed raising the rates so aggressively).

  3. For all those people who think it’s low rates that are driving prices, come to so cal where down payments are HUGE, and many 1.5-5m homes are bought in all cash….. lots of money flowing out of stocks, crypto, tech, into houses. 05-07 everything was stated income with 3-20% down. Today, you get 2m new developments built by big home builders, where many deals are cashed and the ones that aren’t are 30-60% cash down. It’s a different animal than the 03-07 run.

    Look at newer construction 2+m end everything has multiple offers with many selling for cash. I have a lot of friends in the R/E world and they are astonished at how much cash is out there.

    Also remember that with Covid, lenders tightened up for a bit, have opened back up but there still aren’t a ton of big banks doing HELOC, etc like they were.

    We are slowing adding to our R/E portfolio. Holding 5 Rentals in heartland America plus our primary in So Cal. Looking to add one more in the next few months while money is still cheap. 25% down and mid 3’s on a rental is a deal all day long when you can get 8-9% cap rates.

    Take advantage while you can!

  4. I have a 10/1 ARM on a vacation home on track to pay it off in 15 years total “11” years left out of 30. I’m not slowing down on my additional principal payments whatsoever. My interest will re-set in 11 years, so I want it paid down. Primary residence will be paid off in 4 years and I will spend more time in my vacation home.

  5. One thing that’s always interesting about paying off the mortgage is that it’s tax free. If your mortgage is 3% and you could get 3% in a savings account you’re still better off paying down the mortgage because you will be taxed on the interest gained in the savings account.

    Obviously with Series I bonds being over 7% the math is clear, but I think it’s still something to keep in mind.

    Also, paying off a little extra principal at the beginning of a 30 year mortgage makes a much, much bigger impact than extra principal towards the end.

    1. I know this is an old post, but if you itemize your taxes – your 3% mortgage rate would be lower after factoring in the mortgage interest deduction

  6. I have always enjoyed the articles on mortgages. I paid off my house a couple of years ago because of job insecurity. Now, I am building a one story house to better age in place on land we have owned for years. I have changed my view on paying off my mortgage in my upcoming situation. Also, I am not going to put down then entire amount I will make on the sale of my house due to the lower interest rates. I also want to rebuild my cash preserves that has greatly decreased due to repairs on the existing house and the new build. I know some people don’t believe in having cash on hand but it has helped me greatly in the past.

  7. One thing that is certain is that the dollar will ALWAYS lose value. Since 1913, the year the Federal Reserve was created, the dollar has lost over 98% of its value. This will only continue.

  8. I took on as much cheap debt as I possibly could. I know my debt is losing value faster because of inflation.

    A 4.33% unsecured interest rate? How can I possibly turn that down? I could even take on that debt and invest in 7.12% IBonds for a literal ~2.8% risk free return for 6 months if I want to! Give me all the debt!

    1. Yes! You go, David! We have to take advantage of the trades that let us maximize cheap debt. It will not always be like this.

      1. A follow up to this- what happens in scenarios where the inflation rate cools? The trade looks attractive now but the interest rates are locked in and inflation is not. I might be misunderstanding something but taking out debt now, if inflation moderates, the interest rate may exceed inflation rates and the debt grows.

  9. Heck, yeah, I have a negative interest rate! My interest rate is 2.385%, 7 years, interest only. I am fairly certain I can safely invest the money at a rate over 2.385% in the next 7 years–and the bank doesn’t want any of the principal back until then! This is a great vehicle for personal finance, however…
    Caveats: 1) this will not be my forever home, so if I cannot, or choose not to, refinance the loan in 7 years that’s OK. I will sell. Which brings up caveat 2) LTV is 29%, based on recent appraised value–which was well below both Redfin and Zillow. Here on the S.F. peninsula I should have no problem selling quickly. I can always pay down principal if I choose, which will lower monthly contracted payments. Also, I have earthquake insurance, just in case. This was one of my favorite articles ever, Sam(urai). Go, Bears!

  10. Can you explain “As a homeowner with a mortgage, the holy grail is having a mortgage rate below the 10-year bond yield. When you have this situation, it’s like living for free and you should not pay down extra principal. If you had the money, you could invest an amount equal to your mortgage into a 10-year Treasury bond. The interest income can then be used to pay your mortgage.” ?

    -$100k invested in a 3% bond pays $3k/yr.
    -$100k mortgage at 3% for 30 years (to be generous) requires a $5100/yr payment.
    It looks like we’ve got a 40% shortfall in this situation! Am I misunderstanding your statement?

      1. Make the duration consistent? That makes it worse. Here’s “apples to apples” with a lower mortgage interest rate:
        -$100k invested in a 3.5% 10 yr bond pays $3500/yr.
        -$100k mortgage at 3% for 10 years requires a $11,700/yr payment.

        We now have an even more massive shortfall.

        1. “ $100k mortgage at 3% for 10 years requires a $11,700/yr payment.”

          Can you explain how it costs you $11,700/year for a $100k mortgage?

          Thanks so much!

        2. Nathan Shaffer

          Ron, I think you are confusing interest with total payment (includes interest and principal reduction). If you are simply looking to compare cashflow, you are correct in that once you pay off a loan that costs 11,700/yr in payments, you are technically ahead of a 3% investment return.

          1. Jack: That’s just the math of it. A $100k mortgage at 3% for 10 years requires a $11,700/yr payment. I don’t know how to simplify it any more. If you’re trying to equate “payment” with “interest”, then I could understand your confusion. They’re obviously (?) different. But I didn’t say interest (nor did Sam), we said “pay/payment”.

            Nathan: You mean he didn’t mean the interest income can then be used to pay your mortgage? Because those are the exact words he used. If it’s worded poorly, that’s fine. No one ever says “I just paid my mortgage” and refers to only paying the interest. I even tried to give him the benefit of the doubt by saying I might not of understood! But instead of clarifying (if that is indeed the case) he oddly made it a worse example by suggesting if we make the duration of the bond and mortgage the same it will work out. Which, as stated, only made it worse.

            1. Weird. A $100,000 mortgage at a 3% interest would only cost me $3,000 a year in interest.

              Earning 3.5% on $100,000 would generate $3,500 in risk free income.

              Is that not clear to you? Why would you use a 10-year amortizing loan? Is that what you are using?

              I’m afraid you are comparing apples to oranges. Do you even own property?

          1. At a 3% mortgage rate, there is NO WAY the mortgage payment would cost $11,700/year.

            Ron clearly has to be a renter bc he doesn’t seem to understand how mortgages and interest works at all.

            This is kind of a concerning, but real example of the lack of financial education in America. So it is really good we have more financial education from FS and other sites!

        3. Ron,
          I think what you are missing is that the mortgage payment figures you have listed include principal and interest, whereas you should only look at the interest portion when comparing the savings from paying down the mortgage early versus investing. The principal portion is just you buying equity in the property, much like the invested capital in the bond that is then going to produce a return.

      2. The problem here is you’re paying income taxes on the 3% treasury return. In CA, that’s a minimum of 24 + 9.3%, so you’re really getting 2%.

        Unless the SALT cap is lifted, you’re getting little to no deduction for that 3% mortgage.

        And there is still the opportunity cost of getting a 3% return on that 100k instead of something higher. If I didn’t want to take on market risk, I might as well just pay off the mortgage.

  11. So, would this be a good time to sell and upgrade a home in a negative real mortgage rate environment? Take on a larger mortgage?

  12. People paying back borrowed $$ generally have an advantage during an inflationary period (as long as it’s not an adjustable rate loan). That being said, there’s no guarantee that wherever you park the $$ you’re not using to pay off the mortgage is actually safe. I would be very hesitant to get a loan because I’m not sure I could actually do something worthwhile (and safe) with the $$.

  13. I have two duplexes, on neighboring parcels. My spouse and I live in one of the units. We plowed extra money into the mortgage to get those notes paid off five years after we started. It’s our primary home and three rental units. We made our last mortgage payment in November 2019…just months before COVID mayhem. The feeling of being mortgage-free at the onset of the pandemic was incredible. It also allowed us to be generous to our renters during that time of uncertainty.
    My stock portfolio would be bigger had we not paid off the mortgage…but we may have had more worry in our hearts. Also, we can deploy a lot more each month into other investments.
    Not everyone has the same temperament. For us, NO REGRETS on paying off the mortgage.

  14. Do banks even lend our money out any more? I always thought they needed our deposits, then benefit from the fractional reserve system, to do just that. The reserve requirements were eliminated in March of 2020 by the Federal Reserve. So are we all just making it up as we go along, hoping that the wheels don’t come off the metaphorical bus? Or maybe i’m just misinterpreting what i’m reading.

  15. How timely, thank you! I was just debating with myself if I should pay down some extra principal this week. I think I will put more money towards investing instead and circle back to pay down more debt in Q1.

  16. As the kids say today: “I can’t even.” Personal finance is ~ 80% psychology, 20% strategy*. And the feeling of living in a paid-off house far outweighs the tactical value of not doing so. So I understand the position of D c’s wife in a comment below. That’s not even accounting for any fears/concerns people might have about the future.

    I’m on track to soon not having a mortgage for a house I’ve only owned for nine years this month. My father-in-law did it in seven years while working three jobs, but he was very allergic to debt and bought land whenever he had cash. Worked for him and me being mortgage free will work equally well for me.

    * This is why Ramsey’s Debt Snowball is built the way it is. It’s not fiscally sound, but it gives courage to people trying to get out of debt by making the milestones more visible.

  17. I can’t see how you come to this conclusion Sam! Higher inflation means higher interest rates to combat inflation, the Federal Reserve has a dual mandate to keep inflation at 2% and stable employment; with YoY CPI running near 6.9% they have no choice but to raise rates (Goldman Sachs is already forecasting 7 rate hikes over the next year or two)! Since 2000, we’ve established that home prices are a function of interest rates (especially in coastal areas where Price/Income ratios > 10). A rising interest rate environment is toxic for real estate values, it’s also bad for stocks as intrinsic valuations are computed using benchmark AAA corporate bond rates. You may save some money on your mortgage rate spread, but you will lose more money in the loss of market value of your real estate purchase. It’s a better investment decision to buy a home for a lower price in a high interest rate environment and refinance (or sell) in a lower interest rate environment.

    1. Check out what the 10 year bond yield is doing this month and today. The yield is going down. And mortgage rates are going down despite a high inflation print.

      It is truly an amazing situation where inflation is boosting home prices while mortgage rates stay low or go down.

      On the flipside, take a look at the latest rent increases. It is much faster than the CPI rate.

      1. I don’t think inflation is boosting home prices, I think the low mortgage interest rates are. Last I saw, the owners equivalent rent was 3.5%. it’s durable goods, food, and energy driving the high inflation in the govt CPI calculation.

          1. It makes sense that a home buyer would get some “cash back” given that residential real estate is a massive risk at current valuation levels. Inflation adjusted housing prices are the highest ever recorded.

              1. Funny you mention I Bonds, just purchased them yesterday, and will do it again on Jan 2nd. The yield is 7.18% (no state tax), it’s the best investment you can make with $10k right now.

                1. you can purchase that ibond on Jan 28th and still get the same January interest as if you purchased on the 2nd. Of course, that money sitting in a 0.01% bank account isn’t doing much for you in those 4 weeks.

    2. Except they can never, ever, never, raise interest rates anywhere close to even 3%… well below the historical mean….without crashing the whole system. The dollar is in its death throes. Own real things while it dies

      1. Have to be careful as to what “real things” you choose to own Brent. How did owning real estate work out for the people of Weimar Germany when inflation took off? Here’s a quote from a study by Bresciani-Turroni’s on the subject:

        “In 1922 and 1923, because of the rapid depreciation of the mark, the old house-rents became ridiculous. Consequently the value of houses fell considerably. Many landlords, for whom houses were now valueless because the rents did not cover maintenance expenses, were forced to sell them.”

        Gold is one of the vary few real things that will store your wealth if we get into a hyperinflationary cycle.

        1. Thanks man, I agree. Cashflowing apartments are about 85% of my net worth. Physical gold and silver (insurance) is 10%. I expect values to go… higher… if we stay on this globalist reset path.

  18. I just sold a rental property to simplify my life. We are getting around 1.1M. Unfortunately, my wife is only interested in paying our 950k 2.625% loan and will not consider any other options.

    1. Your primary residence will still appreciate in correlation to the CPI rate, you just won’t benefit from the debt leverage. And your wife will be happy.

      So you’re still winning in more ways than one!

  19. So I’m in year 6 of my 5/1 ARM and it is 2 5/8. So I guess I’m doing well! Unfortunatley, the LIBOR rate is going up, and I saw something from CFPB they may be switching it something else, so my rate come February may be a bit higher (2.25 + 1 year LIBOR). I started this loan at 3%, so per your older post, I have done pretty well. Luckily, I do not have any savings account (or if I do, just a bare $100 to get access to the credit union), just money invested and in checking.

    1. I’m in year 6 of a 7/1 ARM at 2.75% for a rental property. I got a lower rate when I originally lived in the property before moving out, and now facing higher refi costs.

      Sam – any thoughts on refi into another ARM or fixed longer term (or let ride and hope interest rates don’t soar)? I know tough to evaluate without more info but figured I’d ask your intelligent FS readers and see what happens…

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