Most of the content I’m inspired to write comes from the conversations I’ve had with current and prospective clients. Whether or not they should pay off their mortgage balance is one of the most popular questions I’ve received over the past few months.
I’ve learned over the years that we tend to make decisions that do not always align with our best financial interests. That’s not to say you should always do what ‘the numbers’ tell you to do, but rather that we are all human and we are all subject to human emotion. With that said, I feel that whether you should or shouldn’t pay off your mortgage comes down to a financial factors and non-financial factors.
The non-financial factors have to do with your feelings toward carrying a mortgage. Some folks grew up absolutely hating debt and anything relating to it. They might have had a bad experience with the housing crisis in ’08, maybe they racked up credit card debt in their early years, or maybe they have always had a bad experience with lending institutions. Regardless, debt in their eyes is something they want to get rid of and get rid of fast. This leads to making double payments towards their mortgage (the minimum + extra principal payments) or towards using cash or investments in paying off the balance in a lump sum fashion. Either way, they’re accomplishing their goal of paying down the debt.
The financial factors vary and involve low interest rates and your opportunity cost. At the time of writing this, interest rates are at record lows. Without getting into the details, this basically means you’re able to borrow at very low rates. This makes your mortgage (particularly a primary residence mortgage) an enticing investment since the cost to borrow is currently very cheap.
This brings up the opportunity cost of pursuing other investments. For example, if an individual is making extra principal payments, they’re giving themselves a guaranteed rate of return equal to the interest rate of the mortgage (minus the tax deductions associated, making the ‘investment’ rate of return less). Well, with interest rates so low, as discussed above, this isn’t exactly a competitive rate of return when projecting out long term. It’s important to compare the OPPORTUNITY you are giving up by making the double payments. If you can get a rate of return that is MORE than your net interest rate, you would be better off NOT making double payments. The easiest comparison is the stock market.
For example, if your 30-year fixed interest mortgage rate is equal to 2.75% and you’re deducting the interest on the property, your NET interest rate is LOWER than 2.75%, depending on your marginal tax bracket. Let’s say for the sake of the example your NET interest rate is 2.25% after deducting taxes. Here’s the million dollar question to ask yourself at this point:
Can you achieve a rate of return equal to at least 2.25% annually in the stock market (or another investment) long term?
If you CAN, then you would be better off NOT making double payments and instead investing your money in the stock market (or another investment). If you CANNOT or if you believe that’s not going to happen, then make the double payments.
I used making double payments as an example, but if you’re sitting on a lump sum of cash and having to make this decision, the principal of the exercise is the same: Can your net investment rate of return beat your mortgage interest rate?
A few items to think about when making your decision:
- There are tax advantages of holding a mortgage. Most folks itemize due to the mortgage (and possibly state income taxes), but if you’re making double payments, you’re lowering the interest paid, which lowers how much you can deduct. With the standard deduction doubling recently, this could change projections for you. Are you taking charitable deductions or planning on medical expense deduction on your schedule A? Be careful and plan accordingly.
- No investment is guaranteed: Investing your money is never guaranteed. Investing gives you upside, but the downside should be a factor in your decision.
- Is your advisor managing your money? Being fee-only, I eliminate many conflicts of interest, but not all are eliminated. If I’m managing a portfolio for a client for an asset based fee and they want to use a lump sum to pay off their mortgage, I am faced with a conflict of interest. If I advise the client to use a lump sum to pay off their mortgage, I will lose revenue based on the managed account. This should be considered and disclosed when receiving advice from your investment advisor.
- Taxes on your investment: If you’re instead investing and NOT making double payments, you should consider the tax consequence of your choice. For example, if you’re investing in the stock market, your gains would be subject to long term capital gains after a year. This would lower your gross investment returns when trying to do an apples-to-apples comparison of each strategy.
So, what should you do? It depends! I know, not a fun answer and certainly not the one you were hoping for. But in the end, it’s important to understand the pros and cons of each decision as it relates to your overall financial plan. Generally, and historically speaking, I am pro investing and NOT making double payments. With rates so low, I’m confident that I can invest my clients’ funds and beat the mortgage interest rate long term. LONG TERM being the key phrase from that sentence. This isn’t a short-term strategy to consider. This is a long-term commitment you need to make, considering the volatility investments can bring. You need to be prepared for the ups and downs investing brings.