When I was a $hitty Financial Advisor, the thought of paying down a sub-5% mortgage was ludicrous.
The logic was simple:
Why payoff a loan at 5% (or less) when I can invest and earn 7% (or more)?
But, as I’ve gotten older and realized that money management is more about psychology than math, my stance has changed and I’ve started to see the benefits of paying off a mortgage early. That’s why my wife and I are happily paying down our 2.875% mortgage.
If you are thinking about paying off your mortgage early, but find yourself confused because so many people speak out against it – then here are several reasons why you’re not crazy (and neither am I).
#1 – Individual Investors Earn Lower Returns Than the Market
Everyone loves to throw around the fact that the stock market has averaged between 7-10% returns throughout history. What most people fail to realize is that individual investor’s do much worse than the market average.
According to research from the last 30 years, individual investors have earned an average return of 4% while the S&P 500 has returned 10%.
This happens because we are irrational human beings who continually fall victim to two powerful forces: fear and greed.
We want to invest when markets are high (i.e. Bitcoin 2017) and we’re hesitant to invest when markets are low (i.e. 2009).
So, if you’re debating between paying down your mortgage or investing excess cash – do you think you have the discipline to continue pouring money into the stock market even as stock prices are falling?
#2 – Paying Off Your Mortgage is Risk-Free, Investing in Stocks is Not
When you’re paying down your mortgage, you’re earning a guaranteed “return” equal to your mortgage rate. When you’re investing in the stock market, you’re expecting to earn a positive return – but, it’s far from a guarantee.
In other words, it’s not an apples-to-apples comparison.
To get an accurate comparison, you would need to compare your mortgage rate to a risk-free investment like the 10-year treasury or a 5 year CD. As of today, the rates of each hover around 2.45%.
According to Michael Kitces (one of the most well-respected Financial Advisors), “clients should prepay their mortgages unless they expect a full 9%-10%+ return on equities in the current environment that sufficiently rewards them for the excess risk.” This is because investors have historically demanded a 4-5% premium above risk-free returns.
So, the question is, what returns do you expect going forward? And are you being compensated for the additional risk?
#3 – Future Returns are Expected to Be Low
I am an optimist and I believe our world is getting exponentially better every year. Technology is disrupting every industry and it’s making the impossible possible.
Now, even though I’m extremely bullish about the future, I recognize that technological progress doesn’t always translate into predictable, positive returns.
Here’s a few other things to consider:
- All assets look expensive right now: stocks, bonds, real estate, bitcoin, etc.
- As an example, the Shiller P/E Ratio measures how expensive stocks are based on price to earnings ratios. The historical average is 16.8. We’re currently sitting at 33.4 (99% higher than normal).
- We have had a 9 year bull market with most years delivering double-digit returns. While much of this was rebounding from a massive drop in 2008, it has been fueled by artificially low interest rates and an unprecedented monetary stimulus.
- A 1 year CD is paying 2% right now while the 10 year treasury is only slightly higher at 2.47%. You would think that going out 10 years would warrant a much higher return; however, it’s only .47% more. A flattening yield curve like this has historically been a predictor of recessions to come.
I hope I’m wrong.
#4 – People are More Risk-Averse Than They Think
Let’s say you inherited a paid off house. Would you pull all of the equity out of the home and invest that money in the stock market?
Or, let’s say you owe $200k on your mortgage and your house is worth $300k; so you have $100k in equity. Would you increase your mortgage to $250k so that you could invest $50k?
Or, as a final example, let’s say you have a paid off car that’s worth $30k. Would you take a loan out against your car and invest that if the interest rate was 5%? What about 4%? Or 3%, 2%, etc.?
Most people answer “no” to the scenarios above because the thought of taking out new debt in order to invest feels risky. But, it’s the same risky decision that people make every day when they choose to invest instead of paying down their existing debt.
For some reason, people don’t see the risk of holding existing debt, but they do see the risk in taking out new debt.
New debt and existing debt are the same, people.
#5 – The Mortgage Interest Tax Deduction is No More…for Most
People LOVE to point to the mortgage interest tax deduction as a reason to keep a mortgage around.
But, think about this logic:
Pay $8,000 to a bank each year in interest, so that you can avoid paying the government $3,000 a year in taxes.
It doesn’t make sense.
Add on top of that the fact that only 30% of Americans itemize and it’s clear that this benefit is overstated.
In 2018, the percentage of Americans who itemize will drop even more as the standard deduction increases from $12k to $24k.
So, the mortgage interest tax deduction will disappear for many.
In Closing, Some Necessary Asterisks
*It’s important to note that both paying down debt and investing are smart financial moves that will increase your net worth.
**Don’t for a second think that I don’t invest. We consistently max out tax-advantaged accounts (401k’s, IRAs and 529 plans) and invest in regular brokerage accounts as well. We pay down our mortgage with cash leftover after these contributions.
***If you choose to aggressively pay down your mortgage, it’s important to maintain liquidity. You can achieve this by keeping a large cash reserve or opening up a home equity line of credit (HELOC).
****This article was written to highlight the key aspects of this debate that most people do not consider.
