One of the most debated questions in personal finance is whether you are better off paying down your mortgage or investing in the stock market instead. Many, many authors and bloggers have tackled this question and yet almost all of the content has a serious flaw. The question is the wrong one to begin with. They are comparing stock market returns with mortgage rates, trying to compare the numbers and make the most rational choice.
Knowledgable investors know that you can only compare investment options apples to apples if they have a similar risk profile. You cannot say stocks are always superior to bonds because over long periods of time they tend to provide a higher return. It depends on your time horizon, risk tolerance, and how well you want to diversify your portfolio. The returns are not directly comparable. Because stock investments are more volatile, there is an extra “risk premium” investors demand on stock return expectations vs relatively safe bond investments. Investors do you demand the same return for both types of investments because they have a different risk profile. More certain investment returns are what everyone wants, so the more certain, the lower the return tends to be.
This is why the mortgage question is completely wrong. The stock market is very volatile and has much higher risk. The return you get by paying down your mortgage is a sure thing. You should expect (no guarantee) that stocks provide a higher return vs this sure thing but that doesn’t mean you should keep your mortgage and invest in stocks. What you need to do is compare paying down your mortgage to an equally “safe” type of investment. If that investment pays you more, then invest in it. If not, you are better off paying down your mortgage.
Since your bank is sure to insist on regular mortgage payments, paying down your mortgage is a pretty sure thing in terms of investment return, which means the only relevant comparison is a similar maturity length treasury. Currently, 30 year treasury rates are about 2.5%. So if planned to keep your mortgage for a full 30 year term, this is the rate to compare. The 15 year rate is 1.3% so this is your comparison rate.Of course, the income on your bond (or stock) investment is taxed as well, so if we assume a 20% rate on these gains, 30 year treasuries are returning 2% and 15 year treasuries about 1.0%. Let’s be generous to the mortgage holders and assume a 33% marginal tax rate through the life of the mortgage (though in reality as you pay down your home, less of each payment is interest and this tax break shrinks over time). With the tax benefits on mortgage interest, this means your effective mortgage rate actually needs to be 2.7% or lower before it makes sense to put your money into a 30 year t-bill instead. If you have a 15 year mortgage, your rate needs to be 1.4% or lower to break even. These are much, much lower return numbers than the 6-10% values discussed for stock investments.
Did you think that banks provided mortgages because they were nice? They make good money off mortgages. They charge more on mortgages than they have to pay to get the money and pocket the spread with near certainty. If it was so easy to make more money in the stock market, why wouldn’t they just invest their money directly in the stock market and not offer mortgages at all? Investment banks do this, and sometimes make a lot of money. But they also sometimes lose a lot of money (remember 2008?)
Let me provide another way to think about this. Do you own any bonds? Most people have some bond component as part of a diversified set of investments. Do those bond investments yield more than your mortgage rate? If not, you are wasting money holding those bonds and not using the money to pay down your mortgage instead. You are taking out a high interest loan and putting it into a low return investment!
Are you a fully committed stock market investor instead? Then keeping a mortgage is the same as investing on a margin account. If your house were paid off, would you take out a loan on the house and invest it all in the stock market? Does this feel risky to you? If you have a mortgage and invest in stocks, this is what you are already doing!
At this point, hopefully the rational analysis is swaying you to the benefit of paying down your mortgage more than many of the mainstream financial planners would advocate. But we’re not done yet. We all know that humans aren’t completely rational. So where do the arguments based on human psychology land us? Actually they further strengthen the case.
Money Psychology Point #1
Most people that decide to invest instead of pay off their mortgage faster do not actually invest all of that money. They tend to spend some of it. Setting up extra mortgage payments on a regular basis is a more reliable way to create an effective extra saving habit. Taking that money on a monthly basis, moving it to your online brokerage, deciding what investments to make, and then doing it, takes a lot more mental effort so it just doesn’t happen as effectively.
Money Psychology Point #2
Peace of mind. Many people get a great deal of satisfaction and peace of mind when they no longer have a mortgage payment. This is typically the last debt they pay and so now they are completely debt free! It’s a nice feeling.
Money Psychology Point #3
Cash Flow. This is somewhat psychology and somewhat math. Without a mortgage payment, you need quite a bit less cash flow coming in from your investments to pay your expenses. You could argue that your higher level of assets (because you didn’t use that money to pay down your mortgage and instead invested it right?), would cover these additional investment withdrawals. But you have to make those withdrawals and do more work managing things like taxes. If you have lower expenses with a paid off house, then it makes managing withdrawals from your savings easier and often helps you be in a lower tax bracket because you need to withdrawal less.
In additional, from an emotional standpoint, it’s generally painful for people to withdrawal from their investments as well. In fact many studies have confirmed that humans judge the pain of loss (in this case cashing out and withdrawing gains) to be weighted 2x higher than the equivalent gain. This means an investment gain of $100,000 is needed to compensate for withdrawing $50,000. This extensively verified tidbit of human psychology means that it’s better to lower your expenses by paying down debt to minimize your withdrawals. So while the math may be more equivalent, the effect on your happiness is not. These types of aspects are rarely cited in the “invest or pay off the mortgage” argument, but they are important if your overall goal is to be happier.
In my case, I started firmly in the standard camp of believing a home was a good investment. Better than “throwing money away on rent”. I’ve now owned three homes in two different states and have learned a lot more about the cost of owning a home. There are many good articles out there analyzing your primary residence as an investment but my favorite is from Mr. Collins.
When you run the numbers, including property taxes, maintenance costs, repair costs, utilities, HOA fees, upgrades and changes, and buying/selling transaction fees, you find that any actual gains on your house from the time you bought it to the time you sold, are much, much lower than they appear by just looking at the purchase price and sale price. When you add in inflation, it often turns into a loss. In fact, across America, housing just about keeps up with inflation over long periods. Adding in the significant ongoing costs of owning a home and you end up with an investment that lags inflation.
So why do I mention this? Because you need to view your house as a lifestyle expense, not as investment. Do not rationalize yourself into buying a more expensive house on the grounds that it’s an “investment”. If you decide to purchase a home, and you view it rationally in this way, you will be strongly biased towards a much lower cost home than the banks will say you can “afford”. Note the banks qualify you for the maximum amount they predict you will be able to bear without going bankrupt and defaulting. This runs counter to my value of freedom and makes me think of the long term financial burden, not the fancier kitchen or neighborhood.
If you think this way too, and purchase a home that costs much less than you qualify for, you will be able to accelerate your mortgage payments significantly. If you can do it, targeting a 10 year mortgage payoff is a great goal.
By increasingly viewing our own home investment this way, we limited the amount we spent on housing. My wife and I really like the lifestyle benefits of a house so we’ve made a conscious choice to spend money there, but we are not fooled into thinking this is a key part of our financial freedom plan.
From a portfolio view, I view our home equity like TIPS with a 0% rate of return. In other words, it’s a bond that only returns the inflation rate as yield. Even though this is an extremely low yield, one nice advantage is that I pay no taxes on this yield because of how house gains are taxed. Importantly, there is also no interest rate risk like you have with a normal bond. We paid off our mortgage at age 36 (8 years from starting our first mortgage payments) and have been mortgage-free ever since (except for one payment after a relocation before we quickly decided to go back to our preferred mortgage free status). With our house paid off, the equity accounts for about 20% of our total net worth, and I view this as the “bond” component of our portfolio. This makes me comfortable being very aggressive with the rest of our investments, using the remainder of our net worth to purchase businesses that working hard to make us more money every day (i.e. stocks).
Despite the relatively poor stock market returns over the last 15 years, by continuing to invest over these years, and benefiting from dollar cost averaging, we have made a much higher return on our stock investments than we have with our houses, which haven’t done much for us at all (which is typical for housing).
While you do sacrifice investing more while you are paying down your mortgage, you should still be investing at least some. At a minimum, getting the matching contribution from your 401K and ideally maxing it out. Once your mortgage is paid off, you’ll be surprised at how quickly your investments grown as you redirect your savings to investments. Ours certainly built surprisingly fast once we didn’t have a mortgage payment and we never regretted this path. When the markets tanked, having a paid off house gave some peace of mind as we continued investing throughout the downturns. When markets did well, we enjoyed the gains but never really felt the loss of additional gains we could have made by investing our home equity. I was never tempted to take out a new mortgage on the house and invest it, despite having a very high risk tolerance.
We simply enjoyed not having the obligation of sending a large check from our savings to a bank every month. Here at IBFree, we like freedom, and having debt, even “good” debt, is fundamentally at odds with the pursuit of freedom.