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In my financial planning discussions, a question that universally comes up with clients, young and old, is whether they should pay more on their mortgages each month or take the extra money and invest it. The answer is not always straightforward. Getting out of debt is a crucial financial goal for all families, but not all debt is created equal. Mortgages certainly have their benefits compared to other debt like credit cards.
The first step is taking stock of your current financial situation. If you have other debt outstanding, it is smarter to pay it off first. Credit cards, student loans and other loans may carry higher interest rates than your mortgage. Pay off your higher-interest debt first before tackling the mortgage-versus-investing question.
Another item to consider is whether you are taking full advantage of your workplace retirement plan. If your employer offers a company match, you should be contributing to receive the matching contribution before paying off your mortgage. You are essentially giving up free money by leaving this benefit on the table. Once you are receiving a full matching contribution, then you should max out your contribution to meet your retirement goal.
The last item to consider before weighing the pros and cons of the mortgage-versus-investing dilemma is your emergency fund. Your emergency fund should have three to six months of expenses saved in checking, savings, money market funds or CDs. If you work in a cyclical business, your emergency fund should have more than six months of expenses socked away. If your emergency fund needs some work, make this a priority before addressing the mortgage-investing question.
The pros of paying off your mortgage
Save on interest: If you pay additional principal, each month or annually, you will save yourself thousands of dollars in interest over the life of your mortgage. For example, on a $250,000, 30-year mortgage with a 5% interest rate, adding $100 a month to your payment will save over $38,000 in interest. You will also pay your mortgage off four years sooner.
Peace of mind: Paying off your mortgage will give you comfort that in an emergency such as a job loss or other family crisis, you won’t have to worry about housing costs, usually your biggest monthly expense. This is more of a benefit for people in their 50s and older.
More cash flow: For parents in their 30s and 40s, paying off your mortgage quickly is great because it will free up money to pay for expenses like your children’s college education and catching up on retirement contributions. Many families I meet like this benefit because they can rest easy knowing they own their home and will focus on retirement and college later. This ignores some of the benefits of compounding, but the psychological benefit of being debt-free trumps the math for some people.
Retirement Planning: You will have lower expenses in retirement because your home is paid off. For Gen Xers and older millennials, this may seem like a long way off, but by eliminating your largest expense, you can spend your retirement dollars differently such as on traveling, health care or early gifting to your children.
The cons of paying off your mortgage
Lower return profile: Your home is usually one of your largest investments, but it does not offer the most optimal return. Over the past decade the S&P 500 has returned 109.5% with dividends, while home prices nationwide have declined 2.1% over the same period. If you are looking to accumulate wealth, your home is not necessarily the best investment. If you pay 5% on your mortgage and are in the 28% tax bracket, your loan is more like having an interest rate under 4%. If you pay your home off and there is a bull market, you may wish that you had invested your extra cash because it will compound more quickly.
Real estate is hard to sell: Homes are a very different asset than stocks, bonds or mutual funds. They are illiquid, which means they are difficult to sell quickly. In addition, it is expensive to sell, with commissions running as high as 7%. You can certainly take out another mortgage or get a home equity loan to take advantage of the equity in your home. If you ever need money in a hurry, though, your home is not necessarily an easy source.
Interest rates are attractive considering inflation: The current interest rates on mortgages are historically low. Most homeowners have locked in low rates by moving or refinancing over the past few years. Because mortgages last between 10 and 30 years, there is a strong chance that inflation will be higher along with interest rates in the future. By paying off your mortgage sooner, you are not taking advantage of inflation, which lowers the real value of your loan. If you pay off your mortgage quicker, you are missing out on the opportunity to benefit from both cheap interest rates and inflation making the real value of your mortgage lower.
Lose your biggest tax break: This is the most commonly cited benefit of having a mortgage. If you itemize your deductions, your interest is a tax-deductible item. If you are in your 30s or 40s, you are still in the early years of your mortgage, your interest payments are high and you’re likely reaping this benefit. It carries more weight if you are in a higher tax bracket. This item is very specific to each case because some people may find the standard deduction works in their favor.
There is no easy answer to this question. I lean toward investing over paying off your mortgage quicker, but the right choice really comes down to your situation. For some people, being debt-free is more important than accumulating the most wealth. Others are looking to optimize their after-tax returns, and for them, investing is the better path. But if you choose to invest, you have to invest. I have seen people decide to invest but did not set up an automatic investment plan and ended up spending the extra money instead.