Danny Newman, Wealth of Geeks
Should you pay off your mortgage or invest? It’s a good question and one that’s particularly relevant to the estimated 82.8 million owner-occupied households in the US. After all, their mortgage is the single most significant debt that the majority of Americans will ever have to pay.
Paying off your mortgage and investing your hard-earned money are both commendable goals. But is one better than the other? Which pursuit makes more sound financial sense?
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The conflict
Common sense suggests paying off debt should be the priority. Why?
In part because it simply doesn’t feel good to owe money. It’s called a burden of debt for a reason. Indeed, approximately 40% of individuals with bad credit card debt say it impacts their happiness, and 20% say it harms their health. In addition, interest makes debt more expensive as time passes, and there’s always the risk of defaulting if you go through a difficult financial period.
Furthermore, when paying interest on the loan, is investing with a little money even worthwhile? For the bank balance to benefit, the return on investment (ROI) must exceed the mortgage rate over time.
That seems probable in periods of economic growth, but with rising inflation, the war in Ukraine, and an economy reeling from years of COVID-19, it may seem less likely in the current climate.
On the other hand, it’s common knowledge that wealthy people invest. To paraphrase a famous saying, “the poor spend their money, the middle class save it, and the rich invest.” With financial pundits heralding the virtues of investing (for a good reason), it’s natural to assume it eclipses the virtues of paying off your mortgage instead.
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The first impression
After a quick look at the current interest rates and the average return of the S&P 500 Index, it seems like the answer’s a no-brainer.
Although mortgage rates climbed to 5% recently (for the first time in 10 years), they remain incredibly low from a historical perspective. At the same time, the S&P 500 Index, which acts as a benchmark for the US stock market, has delivered an average annual return of 10.7% over the last 65 years.
Most people would take that extra 5.7% in a heartbeat. Surely, then, savvy homeowners are better off paying the minimum on their mortgages and investing whatever’s left in stocks?
Perhaps. This could be the best approach in many, if not most, cases.
Yet first impressions can be misleading, and nothing is straightforward, especially in the complicated field of finance. In reality, there are other factors to consider that may determine the right approach for you.
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The considerations
If you’re struggling to decide whether to pay off your mortgage or invest, taking the following factors into account should help:
• Retirement
Investing tends to be the right call for people who are decades away from retirement. The more time you have between now and your golden years, the easier the decision becomes.
This is because of the opportunity cost involved with servicing debt. Remember, the stock market has delivered enviable average returns throughout history. So while it may deliver less than your mortgage rate over a matter of weeks, it’s almost guaranteed to outperform it over 10+ years.
In essence, you leave money on the table by paying off your mortgage, assuming the interest rate is manageable. And make no mistake, it’s no small sum either.
Thanks to the magic of compound interest, an initial investment of $10,000, plus a monthly contribution of $500, can turn into $284,669.80 over 20 years, assuming a relatively conservative average return of 7%.
• Liquidity
Access to capital is another important consideration here. Needless to say, you can’t eat your house. While paying off the mortgage sooner will alleviate the stressful nature of having debt, it risks tying up potentially available cash in the property.
Although renting it to tenants, selling it, or taking out a loan against equity are viable options, accessing that money becomes a challenge.
Despite the fees and tax implications, invested money has much higher liquidity. Whenever spendable cash is wanted, sell as much or as little holdings as required.
• Rates and risk tolerance
Investing isn’t right for everyone, though. For instance, while the average interest rates in the US remain low, older mortgages may have expensive high-interest rates still. Not only would this detract from stock market returns, but it may also dominate monthly cash flow, leaving very little left to invest.
Then, of course, there’s the risk to consider. Younger people have time on their side, which allows for market corrections and minimizes the risk of downturns. But, unfortunately, the same can’t be said for folks with shorter time frames.
Ultimately, the closer one is to retirement age, the weaker the argument to invest becomes. Less time in the market makes you a) more susceptible to variation and b) unlikely to recover from a bear market.
That’s not all, either. Having to repay a mortgage on a post-retirement fixed income is far from ideal. In the lead-up to retirement, it’s often sensible to devote more excess cash to the mortgage.
Deciding whether to pay off the mortgage or invest is a common conundrum faced by homeowners everywhere. In general, the higher returns offered by the stock market trump the money you’ll save from repaying your mortgage sooner.
There are pros and cons on both sides, with individual circumstances featuring heavily in what constitutes the “right” decision.
