You Should Definitely (Not?) Pay Down Your Mortgage Early If . . .
As financial advisors to high-net-worth clients, those with extra cash to deploy frequently ask us whether they are better off pre-paying part of their home mortgage or putting that money into long-term investments.
Spoiler alert! There is no blanket correct answer to that question. It is, however, a question a good financial advisor can help you answer within the context of your overall financial situation. Getting the answer right can make a meaningful difference in your financial well-being.
First Things First
Before getting to why pre-paying a mortgage or investing might be better, here are three essential things to consider first.
1. See if refinancing your mortgage makes sense.
Mortgage rates are near historic lows. If you haven't refinanced recently (or your mortgage interest rate is more than 3.25%), shop around to see if refinancing your mortgage to a lower rate makes sense.
2. Make sure you don't have other, higher-cost debt.
If you have any high-cost debt, such as credit card debt, a car loan, or possibly student loans, you should strongly consider paying off that debt first. Since your mortgage will typically be your lowest cost debt, paying off higher interest debt will give you more bang for your buck.
3. Make sure you have enough cash set aside for emergencies.
You should always have ready access to enough cash to cover unexpected costs such as a health emergency, home or car repair, or a temporary loss of income. We generally recommend an emergency fund to cover 3 - 6 months of living expenses.
Top 3 Reasons to Consider Pre-Paying Your Mortgage
1. Lowering your expenses in retirement.
The lure of paying off a mortgage early is powerful for those approaching retirement. The idea of a hefty monthly payment hanging over your head after you've lost your primary source of income can seem very daunting. Depending on the amount and timing, pre-paying your mortgage could help to pay it off early and achieve a better balance between income and spending in retirement. Remember, though, that pre-payments on their own don't usually lower your monthly payment; they just bring the final payoff closer.
2. Better peace of mind.
Even if a mortgage payment is manageable, many people just can't stand being in debt, and the sooner they are debt-free, the better. This benefit may be non-monetary, but that doesn't mean it isn't valuable.
3. A predictable "return."
In today’s low-interest-rate environment, where the highest quality bonds pay less than 2% in annual interest, pre-paying a mortgage costing you 3% or more may be a favorable tradeoff. Keep in mind that the mortgage interest may provide you with a tax benefit, so the after-tax benefit of your pre-payment may be less than the total interest saved.
Avoid this mistake!
One mistake many people make when considering pre-paying their mortgage is assessing the level of home price appreciation. We've often heard something along the lines of: "Well, my house is growing in value by 10% a year, so shouldn't I want to invest more in that?" The amount of principal you pay down has no impact on your home’s appreciation. Counter-intuitively, adding more principal lowers your rate of return! Think about it: you've increased your investment in your home without increasing its value.
Top 3 Reasons to Prioritize Long-term Investing
1. Better returns are possible (but not guaranteed).
It is too simplistic, as above, to compare the mortgage interest rate to available bond returns. If the money you have available to pre-pay is for the long-term, a better comparison might be what is available from a diversified, long-term portfolio of stocks and bonds.
A diversified, balanced portfolio of stock and bond investments has handily outperformed mortgage costs over the last decade. We'd be the first to caution that this is no guarantee it will do so in the future, especially in any given short-term period. The tradeoff is one of a low, assured return (from pre-paying your mortgage) vs. a potentially higher but not guaranteed rate of return (from long-term market investments). We call this tradeoff your opportunity cost, and we can help you better understand your particular opportunity cost.
2. Protect yourself against inflation.
Owning a home offers good protection against inflation. Owning a home with a (fixed rate) mortgage offers even better protection. Your monthly payment is set in nominal dollars, so as inflation erodes the value of your dollars, you'll be paying back less and less in real terms.
A simple exercise to illustrate this is to look at your mortgage expense as a percentage of your Social Security benefit (which adjusts each year to account for inflation). If you had a monthly Social Security benefit of $3,000 in 2017 and an equal $3,000 monthly mortgage payment, you'd have spent 100% of your Social Security benefit on your mortgage. Beginning in 2022, just through inflation adjustments, your Social Security benefit would rise to $3,430, meaning your fixed mortgage payment would only take up 87% of your monthly benefit.
3. More liquidity means more flexibility.
Once you have paid principal on your mortgage, it's not so simple to take the money back out again if you need it. You do have options, of course. You could re-finance the mortgage or take out a home equity loan, but these take time and may not always be available (or advantageous). Money invested in a diversified portfolio of stocks and bonds will generate regular income, plus it's much easier and faster to sell an investment to get access to cash.
One more advantage - mortgage interest can still be tax-deductible. The 2017 tax law changes reduced the benefit of the mortgage interest deduction for many people. But not for all, and maybe not for all time. Many taxpayers still benefit, and there is regular talk of restoring some or all the interest deductibility. We suggest asking your tax advisor about your specific situation.
What Should You Do?
To repeat - there is no blanket correct answer to this question. You should talk with a knowledgeable financial advisor to think through the options with a full understanding of your particular financial picture.
For example, a smart, holistic approach that considers your overall financial picture might involve adjusting your investment balance between stocks and bonds to effectively source any pre-payment amounts from lower earning fixed income investments.
NEED HELP ADDRESSING THIS QUESTION?
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