To keep the mortgage or pay it off early? That is the question…..
Imagine the following scenario: One day your doorbell rings and standing before you is the pitchman for a contest you entered previously. “Congratulations,” he says. “You’ve just won the grand prize in the ‘We Pay Off Your Mortgage’ contest. As the winner, we’ll immediately pay your mortgage in full!” The rules of the contest state that you can’t take the cash, you can only allow them to pay off your mortgage.
Happily you agree – who wouldn’t – and soon your mortgage is paid. You celebrate by having a mortgage-burning party attended by your elated friends and family.
When the next month arrives, your bank account suddenly has more money in it! There is no mortgage payment to make, so that $1,500 (in this example) is no longer being withdrawn. Your mind wanders about what to do with this “extra” money:
• “Surely there are some charitable causes we could never support before but now we can.”
• “We can increase some of our monthly spending – maybe eat out a bit more, spend a little extra on clothes we’ve been putting off. How about that vacation we never went on?”
• “Maybe we can add a little more to the kid’s college savings accounts each month.”
• “How about bumping up our retirement savings, too?”
Even better you decide to do some to all four! You feel so much more relaxed knowing the debt is gone and now you can live a little differently. More free – more flexible. Life is good.
Then one day a financial planner friend stops by to present you with a great investment opportunity. For this scenario, let’s assume it’s a totally legitimate investment – he’s not trying to pitch a scam or high priced, questionable product.
He shows you that this investment has always worked out well over the long term, but it can bump up and down significantly over short periods of time. There are no guarantees about future performance, but in the past it has always done well over long periods of time.
The catch: Your initial investment has to be $250,000 or more. Since you don’t have $250,000 readily available, your only option would be to re-mortgage the house for this amount.
Since you have plenty of equity in your home, getting the loan wouldn’t be a problem but the following month you’d have a house payment of $1,500 again. No more extra giving. No higher standard of living or vacation next summer. No more extra saving for college or retirement.
What would you do? Let me know your opinion:
We all probably like the idea of having a nice $250,000 investment that should do well over time, but borrowing against our paid for house isn’t how we’d like to get there.
With this scenario in mind, let’s address the question of which is a better use of available cash: Pay off the house early or invest?
Too often the question is only asked one way: Assuming you have a mortgage, would you apply extra payments to it, or instead make only the required payment and invest the difference? It’s less frequently asked the other way: If you have no mortgage, would you borrow money against your home for an investment?
Many would argue to invest is better. You get in the market sooner. Over long periods of time, the stock market has proven to return more than the interest you’re paying on your mortgage (especially at today’s low rates). Your mortgage interest is tax deductible, so your actual cost is even less, the “pro-investing” group will say.
Honestly, these are solid arguments. I couldn’t fault someone for deciding to forgo paying off the mortgage early to invest instead.
What they fail to address (in my opinion) is risk. Yes, the stock market has done well in the past, but there is no guarantee the future will do the same. Yes, you do get a tax deduction, but you’re spending $1 in interest to save $0.30 in taxes – not a great trade.
I keep going back to the alternative framing of the question mentioned earlier: If you had a paid-for house, would you borrow against it to invest in the stock market? I think most would say no.
Perhaps we have a bias based on where we are starting. If we have a mortgage already, we can see keeping it and trying to beat the interest cost by investing in the market. But if we don’t have a mortgage – and already enjoy the freedom of no monthly payment, we don’t want to go back into debt.
I have read a lot on investing and personal finance, and I review a lot of case studies. Thus far I’ve never read one where the homeowner regretted not having a mortgage, even if they would have done better in the stock market.
In my personal case, we paid off our house in 2006 using a lump sum we had accumulated. As the stock market peaked in late 2007 and proceeded to suffer a heavy decline, we were obviously elated to have paid the mortgage off instead of investing the money. We would have surely lost a huge portion of it!
However, we now know that the stock market bottomed out in early 2009 and has risen significantly since then. Perhaps (I’ve never calculated it) we would have made back all of our losses and actually be further ahead if we had invested it in 2006. Or perhaps I would have pulled these funds out of the stock market when the Dow Jones Industrial Average dropped about 54% in 18 months! Let’s not forget how emotionally tough it was to stay in the market back then.
What I do know is that I’ve never regretted paying off the mortgage. I used a large portion of the cash freed up each month to invest consistently during the 2007 to 2009 bear market and we’ve reaped the benefits of doing so. But I eliminated the extra risk (and sleepless nights!) that would have come along with keeping the mortgage and investing the cash instead. There is a value in that – even if I can’t quantify it with a specific number.
Obviously, the beginning scenario is a bit faulty in that it’s unlikely any of us will win such a contest. But it’s very realistic to suggest that making a modest extra payments each month on a 30 year loan could easily allow it to be paid in only 18 years. In the subsequent 12 years you’ll have much better cash flow than you would have if you had a mortgage payment. Part of that cash flow can go towards long term investing, but with the safety of a paid for house.
To be clear: I’m not suggesting that one should forgo all retirement savings while they are paying their mortgage. I believe that we should save 15%-20% of our income each month for retirement. But if you have the ability to save more than this amount, I believe most are better served by applying it to the mortgage as an additional principal payment.
Please feel free to leave your thoughts and comments below! What would you do in this situation?