Should I pay off my mortgage early or invest?
In my financial planning discussions a question that universally comes up with clients (young and old) is should they pay more on their mortgage each month or take the extra money and invest it. The answer is not always straightforward and there is no rule of thumb on how to approach this question. Getting out of debt is a crucial financial goal for all families but remember not all debt is created equal. Mortgages certainly have their benefits compared to other debt like credit cards.
The first step is taking stock of your current financial situation. Before you can make the decision to pay off your mortgage quicker or invest more there are other things to consider. If you have other debt outstanding it is smarter to pay it off first. Credit cards, student loans and other loans may carry a higher interest rate than your mortgage. It is a better financial move to pay off your higher interest debt first before tackling the mortgage versus investing question.
Another item to consider is are you taking full advantage of your work place retirement plan. If your employer offers a company match you should be contributing to receive the matching contribution before paying off your mortgage. You are essentially giving up free money by leaving this benefit on the table. Once you have reached a level where you are receiving a full matching contribution then you should make sure you are increasing your contribution to meet your retirement goal until you max out your contributions.
The last item to consider before weighing the pros and cons of the mortgage versus investing dilemma is how is your emergency fund looking? Your emergency fund should have three to six month of your expenses saved in checking, savings, money market funds or CDs. If you work in a cyclical business your emergency fund should have more than six month more socked away. If your emergency fund needs some work this is should become a primary goal before addressing the question at hand.
What are the positives of paying off your mortgage?
Save on interest: This benefit will jump off the screen. If you pay additional principal, each month or annually, you will save yourself thousands of dollars in interest over the life of your mortgage. For example, on a $250,000 30 year mortgage with a 5% interest rate by adding $100 a month to your payment you will save over $38,000 in interest. You will also pay your mortgage off four years faster.
Peace of mind: Paying off your mortgage will give you comfort that in the event of something unexpected happening (job loss or family crisis) you won’t have to worry about paying your mortgage if it is paid off. Your home is owned and for most households your mortgage is their biggest monthly expense. This is more of a benefit for people in their 50’s and older.
More cash flow: For parents in their 30’s and 40’s paying off your mortgage quickly is great because it will free up cash flow to pay for things like college expenses and play catch up on retirement contributions. Many families I meet with like this because they can rest easy knowing they own their home and will focus on retirement and college later. This ignores some of the benefits of compounding but the psychological benefit of being debt free trumps the math for some people.
Retirement Planning: You will have lower expenses in retirement because your home is paid off. For families in the Gen X and Y generation this may seem like a long way off but by eliminating your largest expense it allows you to spend your retirement dollars in different ways. You could free up money to spend on traveling, healthcare or early gifting to your children.
What’s the downside of paying off your mortgage quickly?
Lower return profile: Your home is usually one of your largest investments but it does not offer the most optimal return. Over the past decade the S&P 500 has returned 109.5% with dividends while home prices nationwide have declined 2.1% over the same period. If you are looking to accumulate wealth your home is not necessarily the best investment.The cheapest loan you’ll get is your mortgage. If you pay 5% and are in the 28% tax bracket your loan is more like having an interest rate under 4%. If you pay your home off and there is a bull market you may wish that you had invested your extra cash into the markets because it will compound at a quicker pace.
Real estate is hard to sell: Homes are a very different asset than stocks, bonds or mutual funds. They are illiquid, which means it is a difficult asset to sell quickly. In addition, it is expensive to sell with commissions running as high as 7%. You can certainly take out another mortgage or get a home equity loan to take advantage of the equity build up in your home. If you ever need money in a hurry your home is not necessarily an easy place to get it from.
Interest rates are attractive considering inflation: The current interest rates on mortgages are historically low. Most homeowners have locked in low rates by moving or refinancing over the past few years. Since mortgages are between 10 and 30 years long there is a strong chance that inflation will be higher along with interest rates in the future. By paying off your mortgage sooner you are not taking advantage of inflation which is lowering the real value of your loan. If you pay off your mortgage quicker you are missing out on the opportunity to benefit from both cheap interest rates and inflation making the real value of your mortgage lower.
Lose your biggest tax break: This is the most commonly cited benefit for having a mortgage. If you itemize your deduction your interest is a tax deductible item. If you are in your 30’s or 40’s you are still in the early years of your mortgage and your interest payments are high - you are probably receiving the benefit from this. It carries more weight if you are in a higher tax bracket. This item is very much specific to each individual because some couples may find the standard deduction works in their favor.
As you can see there is not an easy answer to this question. I lean towards investing over paying off your mortgage quicker but it depends on so many factors it really does come down to your individual situation. Some people the achievement of being debt free is a more important goal than accumulating the maximum amount of wealth. While others are looking to optimize their after tax returns and therefore investing is the better path. If you choose to invest, you have to invest. I have seen a number of people decide to invest but did not set up an automatic investment plan and ended up spending the extra money in their monthly budget.