Prioritizing your goals is an important part of financial planning, but it often poses a tricky balance. And it turns out, we may not be wired to negotiate this balance particularly well. The Wall Street Journal recently highlighted a study out of the University of Chicago that showed that people were willing to borrow money at expensive rates to keep savings goals intact. Why? Saving makes us feel financially responsible. And it’s usually a good goal to have. But you have to carefully compare what you are gaining by saving with the costs you are incurring elsewhere in your financial life.
The General Rule
This strikes at the heart of the question regarding paying off a mortgage: How does your mortgage interest rate compare with what you can reasonably expect to earn in your investments? If you believe you can earn more as an investor than you pay in interest as a borrower, it generally makes sense to invest rather than pay down debt.
A quick illustration with some numbers: Assume you have a $100 mortgage loan balance at 4%. Let’s keep the math simple and say your interest payments are $4. You expect to earn 6% per year in your investment portfolio based on a prudent risk allocation.
Scenario 1: Pay down mortgage. You use $20 in excess cash to pay down your mortgage at the beginning of the year. Your mortgage balance drops to $80, and you spend $3.20 to service the 4% debt.
Scenario 2: Invest. You invest the $20 and earn your 6% return, or $1.20, for the year. Your mortgage interest expense remains $4. Netting the two, you spend $2.80 and come out ahead 40 cents over Scenario 1.
With mortgage rates near historical lows, many people have found that it makes more sense to invest rather than pay down debt. But it isn’t always so black-and-white. There are a lot of caveats to the simple rule above. I will cover some of them below, but—as always—it’s best to discuss your particular circumstances with your advisor.
The Common Caveats
How comfortable are you with risk? The more risk-averse readers have probably already noted this imbalance: The return on your investments isn’t guaranteed, but your debt obligations are set in stone. You may expect to earn a 6% investment return over the long run, but there will probably be periods where you earn less than 6% and periods where you make quite a bit more. Over a sufficiently long time span—say 10 years—your rate of return is more likely to average out, and the General Rule above is more likely to hold. But you have to be willing to stomach years where you may be worse off, perhaps even losing money on your investments while you continue to pay interest on debt. This is one of the reasons, among others, that I believe some people are drawn toward aggressively paying off debts. And provided their financial plan looks OK, that may be the best path for them. On the flip side, borrowing money so you can invest in more lucrative opportunities is how most successful businesses thrive!
Do you have enough liquid assets? While I always preach that you shouldn’t invest any money into stocks that you might need in the next five years, stock and bond investments are usually fairly liquid if emergencies arise. In other words, you can convert these investments into cash within a couple of days. This is not true of equity in your house. Once you pay down your mortgage, it becomes more challenging to get that money back if you find yourself in need of cold, hard cash. If you don’t have a lot of liquid assets on your balance sheet, it may make sense to delay paying down your mortgage or look into getting a home equity line of credit (HELOC) in place first.
What does your mortgage look like? It’s possible that you apply the General Rule test and decide to invest because you have a very low mortgage rate, but that rate is locked in for only a short window of time. Variable rate mortgages were very popular in the real estate boom leading up to 2007, and have been attractive recently because the rates are so cheap. But you have to tread carefully when you finance long-term assets with short-term debt—particularly when you live in that long-term asset! If you plan to stay in your house for longer than the interest rate lock on your loan, I would strongly consider the costs and benefits of refinancing into a longer-term, fixed-rate loan. Another option would be adjusting the risk in your investment portfolio so that you are in a better position to pay off your mortgage down the road if rates get too high. Of course, adjusting the risk may reduce your expected return and, in turn, change the results of your General Rule test.
Are you accounting for taxes? Often clients are reluctant to pay down mortgage debt because they don’t want to lose the tax deduction. It’s an understandable sentiment, but no one is in the 100% tax bracket. Therefore, it’s always better to have no expense rather than have a deductible expense.
There are some tax considerations to take into account, though. For starters, primary mortgage interest is generally only deductible for debt balances up to $1.1 million. If your mortgage is above that, you may be better off getting it down closer to that threshold before you invest. You should also look at the tax characteristics of your investment returns to make sure you are comparing apples to apples. If your investment returns are largely ordinary income and your mortgage interest is fully deductible, then comparing the numbers like I did in the General Rule section above should give you the right answer. But if your investments are more tax efficient, you may need to make some adjustments to your math. Best to consult a tax advisor to be sure.