Mortgages are often referred to as good debt. However, when faced with the opportunity to pay off your mortgage early or invest your money in the financial markets, which option should you choose?
To help answer this question, I have provided both a short and simple answer, as well important additional considerations.
No, don’t pay off your mortgage early.
Generally speaking, you’re better off investing your excess cash in a well-diversified portfolio than paying off a low interest mortgage early. A diversified portfolio consisting of 60% stocks and 40% bonds, if held and rebalanced annually, would have returned an average of 9.34% over the past 30 years.
Therefore, if your current mortgage interest rate is significantly lower than the historical rates of return on our model balanced portfolio, you’ll have done better by investing your excess money using a similar diversified approach. Overall, in a low mortgage rate environment like today, it rarely makes sense to pay off your mortgage.
For a simple example:
Let's say you get a $200,000 mortgage with a 4% fixed interest rate, which results in a $955 monthly payment. If you pay it off over 30 years, you'll end up paying nearly $145,000 in interest. That's a lot of money, so it's natural to think that any extra cash should go toward paying down your principal. However, if you stick to your 30-year payment schedule and invest $250 each month—just one-quarter of your mortgage payment—and earn an average 8.34% return, based on the trailing 30-year returns of our model portfolio, your portfolio would grow to $375,000 by the time you've paid off your mortgage. Therefore, if you have a relatively low interest rate, then it may make sense to hold the mortgage, benefit from the deductibility of mortgage interest paid, and invest your spare cash in a diversified portfolio.
5 Other Key Considerations
1. Weigh Cash Flow Needs
Aside from doing the math, it’s important to weigh cash flow needs. If you’re having difficulty making your monthly mortgage payment and you have a lump sum available too, it may make sense to pay the mortgage down to a more reasonable amount you can afford. In general, maintain a monthly mortgage payment that is less than 30 percent of your gross monthly income. Also, if you’re sitting on cash, then it’s better to pay down your mortgage, rather than have it sit in a no-interest cash account. However, keep in mind that the more cash you put into your home, the less liquidity you have. Also, remember that a mortgage is an investment. If you put too much cash in your home, then you may leave yourself under diversified.
2. Measure Risk Tolerance
There are investors who simply need to pay off their mortgage for their own peace of mind. If you have substantial retirement savings, then this approach may make sense. However, if you redirect cash toward paying down your mortgage and leave yourself without a substantial retirement principal from which to draw retirement income, then you’ll have very little peace of mind as a retiree. Being mortgage free can create deep feelings of emotional stability, but at what long-term costs? Risk is often unavoidable if you haven’t saved enough for retirement.
3. Consider Long-Term Financial Plans
Paying off your mortgage is just one element in your overall financial plan. Be sure to consider as many elements of your financial life as possible when determining where to redistribute your cash. For example, is there a possibility that you may want or need to move in the future? If so, the savings you see now may not ultimately come to be, given closing and moving costs as well as unexpected expenses when setting up your new residence.
4. Acknowledge Automatic Savings Impact
Homeowners often forget that by making monthly mortgage payments, they’re actually saving money by paying down the principal balance of the mortgage. Sure, in the early years of a mortgage, a large portion of payments go toward paying down the interest.
Still, you are saving money every time you make a mortgage payment. If you didn’t have to make a mortgage payment, would you save the same amount of money each month? If you lack good savings habits, then you’re probably better off maintaining your mortgage, so that you are accumulating assets.
5. Calculate Risk-Free Return Versus Investment Risks
So far, under many circumstances we’ve leaned toward not paying off a mortgage; instead, use your extra cash to invest using a diversified approach. However, be aware of this fact: When you pay off your mortgage, specifically eliminating the mortgage’s interest costs, this is a guaranteed risk-free return. There is no such thing in the stock market.
The key when evaluating guaranteed risk-free return is to consider the opportunity cost of not having invested this same cash in financial markets. Only a detailed financial analysis can provide the break-even data for you to make an informed decision.
In general, there are two reasons to consider paying off your mortgage early rather than investing the extra cash.
- One, if you have a high interest mortgage. Whenever possible, it almost always makes sense to pay off high interest loans or credit cards versus allocating savings to lower earning investments.
- Two, if you’re closing in on retirement and want to pay down debt. You have a fair amount of retirement savings that will continue to grow during retirement, enabling you to draw needed income to financially sustain your retirement needs.
At GW & Wade, we encourage all of our clients to have no less than six months of savings set aside for emergency purposes. You simply don’t know what curveballs life will throw your way on any given day. Finally, although it’s been said before, it can’t be said enough; you can’t borrow money to fund your retirement. Financially secure retirements are built on prudently investing savings.
If you have questions pertaining to your financial situation, please contact us. We welcome the opportunity to help you achieve your long-term financial goals.
A Note About the Author
Timothy Pinch was recently recognized as a 2018 Boston Magazine FIVE STAR Wealth Manager. This honor is awarded to wealth managers who excel in client retention and satisfaction. To learn more, read the full details here.
 Based on GW & Wade’s internal calculation of a model portfolio consisting of 60% S&P 500 Index and 40% Bloomberg Barclays US Aggregate Bond Index, with interest and dividends reinvested and annual portfolio rebalancing, from January 1988 through December 2017. Please note that these are model results that do not reflect actual trading or the impact that any material economic and market factors may have had on our decision making had GW & Wade actually managed these assets. Some GW & Wade clients had investment results materially different from the results presented in our model.
 See GW & Wade’s analysis of the new tax bill which details the amount of mortgage interest you can deduct.
The information provided above is general in nature and is not intended to represent specific investment or professional advice. No client or prospective client should assume that the above information serves as the receipt of, or a substitute for, personalized individual advice from GW & Wade, LLC, which can only be provided through a formal advisory relationship.
Clients of the firm who have specific questions should contact their GW & Wade Counselor. All other inquiries, including a potential advisory relationship with GW & Wade, should be directed to:
Laurie Wexler Gerber, Client Development
GW & Wade, LLC