Nothing quite gets people fired up in the personal finance community, like the debate on whether pay off the mortgage early or invest with extra cash. Debt brings out a range of emotions in people, and many find themselves firmly on either the payoff early side or the invest more side. While I have a general dislike for debt, I can see both sides of the argument.
I'm a firm believer in the idea that many personal finance decisions are not black and white, but rather personal. I prefer a pragmatic approach to these decisions by considering the different factors involved and making a decision based on the information. The decision to invest or payoff the mortgage with extra funds is one of those decisions that comes down to personal preferences and trade-offs.
Rather than write a post in favor of one or the other, I’m going to walk you through all the factors I considered when making my decision. Spoiler alert! I went with investing rather than paying off the mortgage (as if the headline didn't already give that way).
Even though I made the decision to invest, and hold off on paying my mortgage off early, my decision isn’t the right one for everyone. By walking through all the factors below, you can decide what works best for you.
Despite the fact I listed a number of factors, it doesn't mean that each factor has an equal weight. You decide how to weight the factors however you’d like (told you this was personal). For example, if peace of mind is the only thing you care about, you can ignore all the other factors, and make your decision based on what will give you the most peace of mind.
Before we dive into the factors I considered, I want to make one thing very clear. I don’t think you can go wrong either way. Whether you choose to payoff the mortgage early or invest, you should be commended for your financial position. In a world where many are just scraping by to make ends meet, consider yourself lucky or blessed to be able to decide between these two great options.
Now let’s look at the factors I considered, with an explanation on why I made the decision I did.
Peace of Mind
For those of you who despise debt, the thought of no longer having to make a mortgage payment can bring about a huge sense of relief. Not all financial decisions are strictly about the money. In the payoff or invest decision, the emotional benefit of a paid off mortgage can cause people to ignore the numbers. I know many people who have paid off their mortgage, and would not trade their peace of mind for a higher investment balance. No regrets, right?
Personally, I would love it if my mortgage were paid off, but I’m comfortable having a very reasonable mortgage payment during my working years. Paying off my mortgage would bring peace of mind, but as you’ll read, other factors were more important to me.
How much peace of mind would you get from not having to make a mortgage payment every month?
Risk Tolerance: Interest Rate vs. Investment Returns
Paying extra on your mortgage gives you a guaranteed rate of return on your money. The guaranteed rate of return on your money is your mortgage rate (you could adjust for tax deductibility, if you want to get fancy.) While the historical long-term average of the stock market (hopefully) far exceeds the current interest rate on your mortgage, investment returns are far from guaranteed going forward.
I don't know if my investments will exceed my mortgage interest rate, but I have a lot of time on my side. The stock market can be very volatile from year-to-year but I believe the long-term trend in the market will continue to be positive. Sure, I may be wrong, but that's a risk I'm willing to take.
Do you think you can get returns in the stock market that exceed your interest rate? Are you willing to take the risk?
Investing at All-Time Stock Market Highs
One factor that could've given me pause is the fact that I'm choosing to invest with the stock market at all-time highs. Is it ideal? Who knows? I'd have a lot more confidence in my future returns, if I were investing after a big market sell-off. However, I'm of the belief the long-term trend in the stock market is positive, so I'm willing to keep investing at these elevated levels. I have a long time until retirement, so I don't need to make a prediction on what the market will do over the next year or two. I'm in it for the long run.
How do you feel about investing with the stock market at all-time highs? Does concern about a big drop make you feel safer putting the money towards your mortgage?
My wife and I are aggressively saving for retirement. We currently don’t have kids, so we would like to get as much saved as possible, before we become parents. We’ve made a decision to prioritize investing at the moment, and, since we don’t have infinite resources, we can’t afford to aggressively pay down the mortgage at the same time.
Take some time to reflect on your own financial priorities. Try to get to the "why" behind your priorities. What is most important to you?
I’m a big believer in doing whatever motivates you the most at the moment. When we have a tailwind of motivation behind us, we can usually surprise ourselves, by what we can accomplish. Motivation comes and goes, and you can’t expect it to last forever. Harness the motivation you currently have to aggressively go after your goal.
Setting smaller goals, or goals with shorter time frames, can give you an extra burst of motivation. For my wife and I, maxing out our 401ks and IRAs is a huge motivating factor for us at the moment. Simply put, we're more motivated to invest right now than pay off the mortgage early, and that's what we are going to do.
Which goal gives you the most motivation?
Tax-deductible Mortgage Interest
One popular reason for keeping a mortgage is the mortgage interest being tax-deductible. This wasn't a major factor in my decision, but since I'll be paying interest, the fact that it's deductible doesn't hurt.
(I'm definitely not a tax advisor so take everything I say here with a grain of salt, and consult a tax advisor for advice on your specific situation.) If getting a tax deduction on the interest is a priority for you, be sure you aren't overstating your tax benefit. The IRS already gives you a standard deduction, and so you should only itemize if your deductions exceed the standard deduction amount.
Let's look at a (highly oversimplified) example of how it's easy to overstate the benefit of tax-deductible mortgage interest. In 2016, the standard deduction for married couples filing jointly was $12,600. Eric and Jennifer paid $13,000 in mortgage interest (they had no other deductions for the year). Since they are in the 25% tax bracket, they think they saved $3,250 ($13,000 x 25%) in taxes by paying mortgage interest. Are they right? Kinda, sorta, but they are overstating the tax benefit. Why do I think they are overstating the tax benefit? With a $12,600 standard deduction they would already see $3,150 ($12,600 x 25%) in tax savings if they paid no mortgage interest. The entire $13,000 they paid in mortgage interest only saved them $100 in taxes ($3,250 - $3,150).
How much is your mortgage interest really saving you in taxes? How important is this benefit to your decision?
Time to Payoff Mortgage
One very useful exercise everyone making this decision should do is calculate how fast you can pay off your mortgage. I did this by looking at how much I could afford in extra payments each month, and then I plugged the amount into an amortization calculator.
Since my wife and I are prioritizing retirement savings, it doesn’t give us a whole lot extra to put towards the mortgage each month. With the extra we can apply to our mortgage, it would allow us to pay it off in 12.5 years.
A lot can happen over 12.5 years. If I knew I could pay off the mortgage in, say, three years or less, I might be more motivated to pay extra. Unfortunately, money is a finite resource in our household and we have other goals that have priority. (I thought about planting a money tree, but we don't have a yard. Sad day.)
Remember, the longer the early payoff will take, the higher the likelihood life will get in the way and derail your plan.
How long will it take you to payoff your mortgage early if you factor in your extra payments?
Coming Up Short on Mortgage Payoff
When you decide you want to aggressively pay down your mortgage, it becomes an all or nothing proposition. While there are benefits to reducing the principal amount you owe on the loan, your monthly mortgage payment remains the same until the entire thing is paid off. Make sure you take this into account because refinancing is the only way to reduce your mortgage payment if you come up short.
If you do end up coming up short on your mortgage payoff, would you rather have the money tied up in your home equity or in your investments?
Unclear Exit Strategy
Another driving factor for not paying off the mortgage early is being unclear on the exit strategy for our condo. We may sell the condo when we move out, or we may rent it out. Our preference is to rent it out, but we aren’t 100% sure we’ll go the rental route. We aren't confident in our HOAs competence, and we may end up selling due to fears of mismanagement potentially costing us a lot in the long run. I'd have more motivation to pay the mortgage off, if I planned on holding on to it forever.
How long do you plan on staying in your current home? Do you plan on selling it or renting it out when you move out?
Saving For Another Downpayment
If we do decide to rent out our condo, it means we’ll need to come up with our down-payment entirely out of pocket, instead of relying on our equity. (We could use the equity in our condo, but we don’t want to. That’s a topic for a whole different debate.) The potential cash need for a down-payment is another reason I want to build up my investments.
Do you have another down-payment you need to save up for? How does that impact your plan?
Putting all your extra money towards your mortgage reduces your liquidity, since outside a home equity loan or selling the home, the money isn't very accessible. If you instead put the money in investments, you should be able to access the money a lot easier.
How important is liquidity to you? If you received a check today for an amount equal to your mortgage payoff, would you put it towards your mortgage or invest it?
Avoiding PMI/ >20% Equity
Outside of paying off the mortgage entirely, getting your mortgage balance below 80% of the home's value can help you avoid private mortgage insurance (PMI). A few years ago, I paid extra on my principal for this exact reason. Now that I've gotten rid of PMI, I'm not as motivated to pay extra on the mortgage.
Are you paying PMI? How much would you have to pay your mortgage down to get rid of PMI?
Not In My “Forever” Home
My wife and I are currently living in a condo, and we expect to move into a house one day when we have kids. The fact that we aren't in our “forever” home, means that even if we pay off our condo, we would have to start over again one day when we buy a house.
What do I mean by a “forever” home? The easy answer is a home you plan on being in forever. Another "forever" home definition I'll accept is, a forever home is the most expensive home you'll ever live in. For instance, if your planning to move from New York to Texas, you might still be in your forever home. Chances are your home in New York is more expensive than what you'll buy in Texas, so you'll never need to come up with additional funds to upgrade. Now, if you're planning to move from Texas to New York, it's an entirely different story. You'll most likely need to sell an arm and a leg if you want to pay off your place in New York. Are we clear now on what a "forever" home is?
Why is this a factor? Paying off your mortgage is great, but I don't want you to make a habit of it. If you keep upgrading homes, after they are paid off, you could be devoting many precious years and dollars to your home, instead of building up your investment balances. That's not to say you shouldn't pay off your mortgage (if you'll eventually upgrade), but do be mindful of how many years of investing you might be missing out on, if you are going to be aggressively paying down multiple mortgages.
Are you in your "forever" home? Does being/ not being in your "forever" home impact your decision to pay off your mortgage early?
Paying Off Mortgage Before Retirement
I’m a big fan of having the mortgage paid off prior to retirement. At the moment, I have no plans to retire early. Being in my early 30s means, even if I took out a new 30-year mortgage, I'd have our place paid off by age 65.
If I were older or considering an early retirement, I would have more motivation to pay off the mortgage earlier. I'm confident I'll have my mortgage paid off before I retire, even if I'm not in the house I'll be in when I retire.
Are you on track to have your mortgage paid off by retirement? Is having your mortgage paid off prior to retirement an important goal for you?
Freedom to Change My Mind
One of the things that makes me feel better about my decision to invest, instead of paying off the mortgage, is the freedom to change my mind. If I wake up tomorrow, and someone convinces me I should payoff my mortgage early, I could sell my investments and put it towards the mortgage. Either way you can change your mind, but I’d argue having the money in liquid investments, gives you greater flexibility.
Part of my goal with this post is for me to over-analyze the decision so you don't have to. If you’ve been spending way too much time trying to figure out what to do, I want you to relax. Remember, you can always change your mind. Feel free to try out both approaches for a few months each, and determine what makes you feel better. If you think you’ve made the wrong decision, don’t be afraid to change your mind. Either way you go, you're making good financial progress.
Whatever you decide, I hope you consider these factors when making your decision. The beauty in personal finance decisions is you can decide what works best for you personally. Remember, you don't have to equally weight the factors. Go with what is important to you!
Did I miss any factors that helped in your decision-making process? What factor(s) do you feel is/are most important to you?