Should I Pay Off My Mortgage or Invest?
Given the current environment of historically low interest rates, we have received a lot of questions about whether to pay off one’s mortgage or consider refinancing. We actively track the mortgage market vis-à-vis our client records, and reach out to them when we see potential savings that a re-finance might bring.
As with many decisions, there is not a single right answer. Accordingly, we thought we'd share some of the variables that should be considered when making this choice. We often tell clients that there are often two components to a given financial decision: equations (what do the numbers tell us?), and emotions (what are the non-financial factors to consider?) Note: The financially optimal choice isn’t always the “right” choice.
Owning a home and/or vacation home is a dream that many Americans share. A mortgage often accompanies the realization of this dream. The basic question is how to balance this debt with savings needs for retirement, children's education, saving for other goals, and "living for today", etc. We generally recommend that mortgages be paid off by the time you begin your "financial freedom" years; however, there is no one-size-fits-all answer.
The cost of borrowing today is at historic lows. If you have debt, it is a good time to consider re-financing that debt. If you are taking on new debt, consideration should be made to locking in fixed, rather than variable rates. Key determining factors in making these choices are the costs of the transaction, the resulting cash flow need, and your “financial freedom.” Being debt free offers the most flexibility and is a component of “financial freedom.” As a general rule, we like to see debt (to include mortgage debt) paid off as early as possible to provide the most flexibility. Those that are moving into the later stages of their lives often find that reducing or eliminating their debt enables them to meet the increasingly high medical costs they face in their later years.
While many point to the mortgage interest deduction on their taxes (this deduction is listed on possible items to be eliminated when next year’s tax debate ensues), the benefit really isn’t all that large, especially when you take into account that your itemized deductions really only provide economic value to you once they exceed the “free” standard deduction the government provides.
Evaluating the opportunity cost Deciding among prepaying your mortgage, refinancing, and investing your extra cash isn't easy, because each option has advantages and disadvantages. You can start by weighing what you'll gain financially by choosing one option against what you'll give up (the opportunity cost).
As an example, let's assume that you have a $300,000 balance and 20 years remaining on your 30-year mortgage, and you're paying 6.25% interest. If you were to put an extra $400 toward your mortgage each month, you would save approximately $62,000 in interest, and pay off your loan almost 6 years early.
By making extra payments and saving all of that interest, you’ll clearly be gaining a lot of financial ground. But before you opt to prepay your mortgage, you still have to consider what you might be giving up by doing so--the opportunity to potentially profit even more from investing.
To determine if you would come out ahead if you invested your extra cash, start by looking at the after-tax rate of return you can expect from prepaying your mortgage – that’s a guaranteed rate of return and compare it to the after-tax return you may receive by investing your extra cash. This enables you to compare apples to apples. Keep in mind that, while paying off your debt is a guaranteed rate of return, your investment return may not be.
If you’re considering refinancing, one of the key components is how long it is before you recover the costs of the refinance transaction itself. If the refinance costs $3,000 and it reduces your payments $300/month, you will be ahead after only 10 months of payments.
Another key factor in refinancing is recognizing when you want to be through with making payments. Again, we recommend you not extend your payments into your “financial freedom” years. Instead, you may want to look at refinancing to a 15- or 10-year mortgage. The analysis here is more complex, as you are dealing with different length loans. So, the best way to compare is through a present value analysis of the cash flows associated with each loan option. Your lender should be able to assist; or, we are happy to do so.
Other points to consider · What's your mortgage interest rate? The lower the rate on your mortgage, the greater the potential to receive a better return through investing.
·Does your mortgage have a prepayment penalty? Most mortgages don't, but check before making extra payments.
·How long do you plan to stay in your home? The main benefit of prepaying your mortgage is the amount of interest you save over the long term; if you plan to move soon, there's less value in putting more money toward reducing your mortgage.
·Will you have the discipline to invest your extra cash rather than spend it? If not, you might be better off making extra mortgage payments.
·Do you have an emergency account to cover unexpected expenses? It doesn't make sense to make extra mortgage payments now if you'll be forced to borrow money at a higher interest rate later. How comfortable are you with debt? If you worry endlessly about it, give the emotional benefits of paying off your mortgage extra consideration.
·Are you saddled with high balances on credit cards or personal loans? If so, it's often better to pay off those debts first. The interest rate on consumer debt isn't tax deductible, and is often far higher than either your mortgage interest rate or the rate of return you're likely to receive on your investments.
·Are you currently paying mortgage insurance? If you are, putting extra toward your mortgage until you've gained at least 20% equity in your home may make sense.
·How will prepaying your mortgage affect your overall tax situation? For example, prepaying your mortgage could affect your ability to itemize deductions (this is especially true in the early years of your mortgage, when you're likely to be paying more in interest).
·Have you saved enough for retirement? If you haven't, consider contributing the maximum allowable each year to tax-advantaged retirement accounts before prepaying your mortgage. This is especially important if you are receiving a generous employer match. For example, if you save 6% of your income, an employer match of 50% of what you contribute (i.e., 3% of your income) could potentially add thousands of extra dollars to your retirement account each year. Prepaying your mortgage may not be the savviest financial move if it means forgoing that match or shortchanging your retirement fund.
·How much time do you have before you reach retirement or until your children go off to college? The longer your timeframe, the more time you have to potentially grow your money by investing. Alternatively, if paying off your mortgage before reaching a financial goal will make you feel much more secure, factor that into your decision.
The Middle Ground?
As you save and invest to satisfy your goals, you may also choose to work toward paying down your mortgage (or, other debt). Even small adjustments can make a difference. For example, you could potentially shave years off your mortgage by consistently making biweekly, instead of monthly, mortgage payments, or by putting any year-end bonuses or tax refunds toward your mortgage principal.
And remember, no matter what you decide now, we understand that "life happens" and that reprioritization of goals to match changes to your circumstances, market conditions and interest rates is a normal and on-going process. We stand by ready to assist with the analysis of your options should you be pondering these questions as well.