This is a common debate amongst people on their way to retirement/financial independence and one that likely has multiple financial and psychological components. Meaning that there likely isn’t one cookie cutter answer to this question. So before making such a big decision, this question deserves some serious thought.
This post will by no means be a post telling you what you should do in your own situation, but it will be informative about what the math says about this decision. Thus allowing you to create an equation for your own unique situation/circumstances so that you have all the information available before you make the best decision for you.
To Pay Off Your Mortgage
Improves Your Savings Rate: Most people once they pay off their mortgage are officially debt free for the first time in their lives which is a major accomplishment. An accomplishment that ends up dramatically reducing your annual spending. Oftentimes reducing your spending almost $16,000 per year on a $300,000 mortgage at a 4% interest rate.
Which when you reduce your annual spending by $16,000 you significantly reduce the amount of money you need to retire with based on the 4% rule as you can now live on less and thereby will not need to withdraw as much each year in retirement. This alone can decrease your retirement age dramatically
Guaranteed Return on Investment: The best part is that, by paying down your mortgage ahead of schedule, you are getting a guaranteed return on your money. It’s an investment that returns whatever it is your mortgage rate is as long as your home value remains the same or goes up. Each time you make an extra principal payment, you will never have to pay interest on that money again.
Diversification: Paying down your mortgage also can result in diversification of your portfolio as your house is technically an asset. Your house value tends to be less volatile and will not lose significant value if the stock market crashes. Although it’s important to note that if all your money is tied up in your house then you are not diverse either and have less liquidity.
Untapped Cash: Houses also provide a source of cash if you sell, refinance, or take out a line of credit on them. Houses though, are not quickly turned around for cash like stocks could be, so they should not be relied upon for emergency situations unless you are comfortable going back into debt using your home as leverage.
I also warn that for those who consider owning a home an investment, most of the time the math says it isn’t. Outside of the guaranteed return of your mortgage rate that is. As the majority of appreciation unless forced appreciation tends to follow that of inflation but this is a discussion for another time.
No Debt Hanging Over You: Many people, specifically ones with roots in the Dave Ramsey camp, understand that debt is bad and you are truly not free until you are out of debt. This counts for mortgage debt as well.
It may not be quite like owing money to the loan shark in the movies who is ready to take out your knee caps, but until you are out of debt, someone will always be asking for their money.
Peace Of Mind: This is where the psychology of paying off your mortgage begins to appear. Because at the end of the day, no debt often helps many to sleep at night as their own personal financial anxiety is finally gone.
When you don’t owe anyone, you never have to worry as much about your family’s financial security in the case that you go through a financial crisis like many are experiencing right now. Without a big debt like a mortgage, your family will be better prepared to handle an economic fall out.
Basically, if due dates, financial letters, and debt stress you out and keep you up at night, it may make sense for you to pay off your home mortgage.
Post Debt Courage: When you are finally out of the grasp of debt, you now have the freedom and more importantly the associated courage that comes with it. You now have the courage to invest heavily even when the market starts to downturn or take that leap towards a potential business opportunity.
Whereas the person who still has debt may need to be more risk averse during these times due to the fear of potential job loss with no income to pay off their mortgage. You are running free, with your money right beside you.
To Not Pay Off Your Mortgage
The other side of the coin or argument is to put this additional money towards investing.
If you were planning to just save this additional money by not investing or paying off your mortgage then you are simply in a losing fight and you’d better plan on working for a longgg time.
Because if your money isn’t making you more money by investing. Nor is it being put towards your mortgage, then every discretionary purchase you make is being charged an extra 4% or that of your mortgage rate.
Math, 7%>4%: If you believe that your investments will make > than your mortgage rate, then the math says to invest. If you pay 4% interest on your home but make 7% interest in the stock market, then you are making your money work 3% more for you.
And like we have discussed ad nauseum, if you invest in low cost index funds that track the total stock market. Since inception, these investments have returned 7-10% annually. 7% to be conservative to account for inflation.
Delay/Avoid Taxes: This is especially true if this money is invested in tax advantaged accounts for you will get access to even more of your cash to invest as Uncle Sam will not be collecting on his tax payment until a later date. (which also gives us time to avoid these taxes LEGALLY which we can discuss in another post)
However, every dollar you pay towards your mortgage is already money that Uncle Sam has gotten his hands on. Making that money already less valuable. We want to try to use every dollar that we worked hard to earn.
Inflation Hedge: By locking into a 30 year fixed rate mortgage, you are locking in an interest rate that will not increase as inflation does. Our dollar likely will not be worth as much in 30 years, but your interest payments will not adjust for this. Meaning that over time, your payments are less valuable to you and to the bank receiving them.
Quick Access to Funds: Investing allows you to have access to your money very quickly. You simply sell stocks, and you have extra income for whatever emergency situation or opportunity, for that matter, that occurs. This becomes trickier in tax advantaged accounts, but we can still make it happen.
Tax Write Offs: Although a very small benefit, by maintaining your mortgage, you are allowed to write off your interest payments on your taxes which does result in a small tax break when you file your taxes each year..
Real Life Example
So before we break down the math, let’s look at the different situations that would allow someone to have the luxury to decide between paying their home mortgage off or investing.
First, someone could come into a large lump sum of money as with an inheritance, sale, or bonus at work. Secondly, it may be that you have more money per month that you now have to allocate due to a raise, or increased savings rate for example.
So to truly see the math, the best way is to create a few examples for each of the above situations to see how it plays out.
To set up these examples we are going to need to create some assumptions so we are comparing apples to apples.
Assumptions:
- $300,000 Home Mortgage
- 30 Year Fixed Rate Mortgage
- 4% Mortgage Rate
Person 1: Receives $50,000 from inheritance, puts it all towards a home mortgage after year 1.
Person 2: Receives $50,000 from inheritance, invests in a low cost index fund after year 1 that returns a consevative 7% per year. Does not contribute to this fund again.
Results:
Person 1: At the end of 22.1 years, person 1 has their house paid off and paid an extra $130,000 in interest payments. Person 1 also made an additional $185,602 at the end of 30 years from investing their original monthly payment, starting once their house was paid off.
Person 2: At the end of 30 years, person 2 has their house paid off and paid an extra $215,608 in interest payments. Person 2 also made an additional $355,713 from their original $50,000 investment.
At the end of the 30 years, both people own a paid off home. Person 1 made a difference of $55,602 over this 30 year period. Whereas person 2 made a difference of $140,105. A difference of almost $85,000 more money for person 2.
In this example, person 2 made over 2.5x more money than person 1 at the end of 30 years.
Next let’s look at someone who makes an extra $1,000 dollars per month.
Person 1: Puts extra $1,000 per month towards their mortgage.
Person 2: Invests extra $1,000 in a low cost index fund that returns a consevative 7% per year.
Results:
Person 1 : At the end of 13.33 year, person 1 again has their house paid off and paid an extra $87,057 in interest payments. Person 1 also made an additional $930,998 at the end of 30 years from investing their original mortgage payment plus the additional $1,000 dollars per month after their house was paid off.
Person 2: At the end of 30 years, person 2 again has their house paid off and paid an extra $215,608 in interest payments. Person 2 also made an additional $1,212,876 from their monthly investments.
Again, at the end of 30 years, both people owned a paid off home. Person 1 made a difference of $843,941 over this 30 year period. Whereas person 2 made a difference of $997,268. A difference of $153,327.
In this example person 2 made over 15% more money than person 1.
Example Summary
So you can see right away that the math says to invest your money. Not only does a 7% return yield more than a 4% interest rate, but in these examples you see the power of compound interest and the opportunity cost of not investing. By investing early, your money has more time to grow and work for you.
However, there is no magic crystal ball, so past results do not indicate future returns. So this is where risk tolerance begins to creep into the picture and this becomes more about your own personality.
The above examples assume that you are risk tolerant enough to be in the stock market. If you feel like you can’t handle the peaks and valleys of the stock market, then paying down your mortgage is likely a safer option for you.
Where Do I Stand?
If you have been following this blog long enough, you probably know that I follow the math. I trust history and the United States economy and am willing to bet that the stock market will continue to return similar numbers since it has from inception.
It’s made it through disease, war, political change and everything in between. So I can sleep easy assuming the same will be true in the future.
But remember, I do not currently own a house nor do I have a family so I’m not sure how these emotional changes in my life will impact this decision. I may flip flop along the way, and if I do, I’ll write about it.
But that’s the best part about this decision, is that it’s personal and ever changing. Just because you start with one strategy doesn’t mean you have to stick to it. Nor does it mean that you can’t adopt some variation of the two extremes somewhere in the middle. The choice is all yours.
Conclusion
As I researched for this article I found myself leaning each direction as both sides ultimately have very good pros. Many of my favorite bloggers lean towards the pay down the mortgage side and there is nothing wrong with that.
Though in the end, my analytical brain always seems to side with the math. And right now, the math says to invest over pay down your mortgage. I dislike debt as much as the next person but my personal thoughts are that not all debt is created equal. So if I can make more than my interest payment I’m going to jump at the chance to reach financial independence sooner than later.
But in the end, my goal is always to just present you with as much information as I can, give my opinion (for what that’s worth) and then ultimately let you make the final decision for I don’t know your past, present, nor future.
Let me know if you have any questions. Feel free to comment below, or if you have a personal question, feel free to email me directly at fiscaltherapist1@gmail.com
