Paying Off Your Mortgage Early: Should You, or Shouldn’t You?

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If you don’t have enough money to do both, is it smarter to pay off your mortgage early or invest your money in the financial markets? For most working people, these are choices that need to be considered.

So, does it make more sense to own your home as soon as possible or make investments designed to fund your future lifestyle?

Opportunity Costs

Generally speaking, there is a short answer to this question—invest first. Why? The answer is relatively simple: opportunity costs.

Opportunity cost refers to a potential loss of value from other opportunities when you choose an alternative. In this case, most people these days have a mortgage with a relatively low interest rate, 3% or 4%, and that rate is locked in for 15 or 30 years. In contrast, a standard rate of return of a diversified portfolio from 12/31/2011 to 3/31/2018 is 7.6%1 (based on representative benchmarking) —greater than the borrowed mortgage rate.

The opportunity costs appear to be clear—choose the option that offers the higher rate of return. Unfortunately, like most things financially related, this simple answer comes with a few complications.

“Average” Can Be Deceiving

The first complication is that “average” annual return rate. The stock market does not deliver returns in a neat and tidy package. When you choose to enter the financial markets and how long you plan to stay are significant factors.

The market can be unpredictable, and this volatility is one of the variables investors must consider when weighing the benefits of paying off a mortgage or investing in the stock market. Some investors are simply too risk averse to tolerate market volatility. These people may elect to pay off their mortgage, foregoing any possible excess annual stock market returns, because of the peace of mind it brings. The same applies to those who simply cannot tolerate debt. Owning their home outright may mean more to the debt-averse than any potential benefits from higher stock market returns. Others may have stronger risk tolerance and will weather market cycles by maintaining a diverse and balanced portfolio. You can assess your risk tolerance by taking Personal Capital’s free interactive quiz by clicking here.

Taxes and Mortgage Structure

The new tax legislation throws additional tax-related variables into your decision. For instance, the law increases the standard deduction, which means fewer taxpayers are itemizing. If you are no longer itemizing, then your mortgage interest deduction has lost its traditional tax-return value, which may make paying off your mortgage early an attractive decision.

The structure of your mortgage is also a factor. If you have an older mortgage with an interest rate above 5.5%, you may want to investigate refinancing to take advantage of today’s lower interest rates. In other instances, hybrid mortgages—such as adjustable-rate mortgages or loans with balloon payments—could tip the scale toward paying off a mortgage.

While no one can predict interest rates, the U.S. Federal Reserve (Fed) recently commented that more increases may be on the horizon. For adjustable rate mortgages, these pending increases may have a significant impact on monthly housing payments. If you have a hybrid mortgage, you may want to consider refinancing your loan before rates rise significantly.

Age May Be More Than Just a Number

If you are in your 50s and want to retire in your 60s, it probably makes sense to begin paying your mortgage down, with the goal of being mortgage free the year you retire. Housing expenses are the largest budget line item for most Americans, so owning your home outright can go a long way toward helping you manage your retirement budget.

Our Take

Clearly, individual circumstances and personal preferences will play a significant role in your decision. However, if you have an average risk tolerance, you’re not unusually averse to debt, and you have some time before you plan to retire, the financial markets may provide the highest annual return on your money and, eventually, provide the most benefits.

Consulting a financial advisor can help you fully appreciate your personal circumstances and weigh your preferences before you make the decision to either pay off your mortgage or invest in the financial markets.

To learn more about the ins-and-outs of mortgages, read Personal Capital’s First-Time Home Buyer’s Guide.

Read the Free Guide


1. Representative Benchmark: 41.7% US Equities (VTI), 20.8% International Equities (VEU), 23.4% US Bonds (AGG), 4.1% International Bonds (IGOV), 10.0% Alternatives (equal split VNQ/IAU/DBC) from 12/31/2011 to 3/31/2018 [Inception Date 12/31/2011]

Disclaimer: This communication and all data are for informational purposes only and do not constitute a recommendation to buy or sell securities. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources believed to be reliable. However, PCAC cannot guarantee that data’s currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

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Paul Deer, CFP®

Paul Deer, CFP®

Paul is a Certified Financial Planner® and serves as both a Manager and Financial Advisor at Personal Capital. He has been educating and assisting clients with important investment decisions for nearly a decade.

2 comments

  1. Keith Gumbinger

    Paying off your mortgage or investing available funds doesn’t have to be an either/or situation, and there can be many ways to consider the issue. For example, and using the “”12/31/2011 to 3/31/2018 is 7.6%”” average return for the period, if you were invested in stocks over that time and achieved those returns, one idea might be to take some of your gains “”off the table”” and use the proceeds to retire a portion of your mortgage, essentially “”locking in”” a portion of those gains.

    For most homeowners, though, retiring your mortgage early doesn’t happen in one lump sum but rather by prepayment over time. Investing all your free funds in the market does provide the opportunity for gains, but “”investing”” in the retirement of your debt might be thought of a means of “”balancing”” your portfolio (reducing an outstanding liability), much as holding bonds might (both can provide known and guaranteed returns over time).

    A homeowner could, for example, take 80% of their free investable money and put that into the market and use the other 20% to pay down the mortgage. Admittedly, holdings of higher-rate and non-tax favored interest should be addressed first, but the cumulative gains of doing this over time can be considerable.

    You also mention a time-goal approach for prepayment (impending retirement) but depending on where you are in your mortgage, it might make sense to refinance to re-start a new longer mortgage term at a lower interest rate and use the cash-flow improvement to more fully fund retirement savings instead of using precious capital to retire the mortgage, where you might end up “”house rich but cash poor””.

    Reply
  2. Jerry

    Totally agree. Being able to borrow at such cheap rates allows one so many opportunities to use their extra cash to invest and earn much higher returns. If you consider inflation, the real rate many people are able to borrow at these days is so low that it’s almost silly to pay off.

    Reply

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