To Pay or Not to Pay?... Off Your Mortgage Early
A friend of mine emailed the other day and was curious about my thoughts on paying down his mortgage as quickly as possible vs. investing that additional money into his portfolio. This is a great example of how the science of numbers and the pull of emotions lead very similar people to very different conclusions. Our industry just doesn’t have “one-size fits all” solutions. In this post, we will explore the math behind the question and weigh the pros and cons.
To explore this concept fully, let’s look at a simple example. Let’s say Bill recently executed a 30-year mortgage of $400,000 with a fixed interest rate of 3%. In doing the math, this results in his monthly principal and interest payments being $1,686. That means Bill will end up spending $606,960 paying off his $400,000 mortgage ($1,686*12*30). The interest alone will end up costing him $206,960! In this example, Bill has an additional $1,000 per month that he can use to either pay down this mortgage debt or invest in the stock market.
Scenario A: Paying down the mortgage
By increasing his mortgage payment an extra $1,000 per month Bill will be able to pay down the mortgage in roughly 15.5 years. In this scenario, Bill will spend $499,596 over the life of the mortgage saving $107,364 in interest payments on the loan.
Scenario B: Investing at a theoretical 6% rate of return
Bill could also decide to invest the additional $1,000 per month into the stock market. Let’s assume if he chooses this option, he will invest it into a portfolio that has an average annual rate of return of 6%. A quick time value of money calculation will show that a portfolio of $1,000 monthly contributions made over 15.5 years (how long it took Bill to pay off his mortgage) earning a 6% rate of return will be worth $305,729 at the end of the timeline. In this scenario, Bill will also have 14.5 years left on his mortgage which would be worth approximately $237,705.
By investing his $1,000/month into the stock market, Bill could theoretically completely pay off his mortgage at the end of 15.5 years with the investment account and still have $68,024 remaining!
So, you’re probably wondering, why would you ever pay down your mortgage instead of just investing that money in the stock market? This is where the art and science of finance needs to be analyzed. Mathematically, investing in a security that earns more than the mortgage interest rate will always beat paying down a mortgage in the theoretical world. However, there are other factors to consider in reality.
The pros and cons of paying down your mortgage:
- Peace of Mind
Many clients hate the idea of carrying debt. By paying down debt quickly, you are getting closer to financial independence and that can give certain people a great sense of security.
Paying down a mortgage is great because you can guarantee your X% interest rate savings on your money. One of the cons of investing is that the 6% theoretical return is just an assumption. The stock market doesn’t perform as consistently as finance academia would like. By paying down your mortgage quicker than necessary, you are guaranteeing you will pay less in interest payments over the life of the loan.
It is often easier for someone to simply increase their monthly mortgage payment than it would be to keep track of an investment portfolio.
- Opportunity Cost
Using additional money to pay down debt means you are potentially losing out on a better investment opportunity. The S&P 500 (since its inception in 1926 through 2018) on average earns 10% annually**. While that does not happen every year, if given a long enough timeline, that could be a realistic expectation for the performance of an index fund invested in the S&P 500.
The money you pay down on your mortgage is now in the ground as home equity. In an emergency it could be difficult and time-consuming trying to access these funds by way of a Home Equity Line of Credit.
In the current low-interest rate environment we find ourselves in, it is important to consider all the options we have available to us. Finance will never have one-size fits all solutions, because each client’s situation is unique. If you have further questions, please don’t hesitate to reach out!