With the market down double digits in 2022, a common question on many people’s minds is Should I just pay extra on my mortgage instead of investing in a losing market? This is appealing to many people in many ways. Instead of diving into all the facts and figures, let’s start by first exploring the psychology of why paying extra on your mortgage instead of investing it seems so attractive.
The Psychology Behind Preferring Extra Mortgage Payments Over Investing
First, it is a guaranteed return. You know you will “earn” the equivalent of your mortgage interest rate by putting the extra towards your mortgage principal. Guarantees are a rarity these days, and it’s hard to pass one up when you see it. Our natural bias with anything in this life is to take something that’s freely given to you, so why not pass up the free “gift” of a guaranteed return?
Second, it is hard to stay invested. Thanks to the media, we live in a world of instant global news, whether it’s good or bad, near or far. We find out immediately if there is a new restaurant going in down the street or a change in political leadership in the Middle East. The problem with all of this news is, how do we understand everything that is going on, and much less, how do we decide what to do in light of the situations we hear about? For many, this can lead to a paralyzing fear of not knowing what to do. In most cases, staying invested, aka doing nothing, is the best course of action. Why? We don’t like not being in control or not knowing when something will change, so we need to do something, right? Unfortunately this is not the case. For example, by simply staying invested in a low cost index S&P 500 fund during any market downturn, you would have recovered(and much more) 100% of the time.
Third, we live in a FOMO society. For those that don’t keep up with all of the current acronyms, FOMO is the Fear Of Missing Out. Whether it’s your brother-in-law who is “killing it” on his latest crypto trade, the new boat your neighbor just bought, or the vacation your best friend just took and posted to social media, our society tells us explicitly that everyone else has it better than we do. We have to do something about this FOMO, which again means we need to take action, right? Why not cash in your 401k to buy that new truck you deserve or double down on the new penny stock that’s going to the moon? We could go on and on. The point is, we’re led to believe that the grass is always greener on the other side. But is it really? The short answer is that(spoiler alert) we stay content no matter where we’re at. But, without giving away the rest of this post, let’s get into the meat of this topic.
Due to the specific circumstances that surround each individual and family’s situation, it is impossible to fully cover every single scenario that could arise when deciding whether to allocate funds towards paying off a mortgage or investing. However, perhaps the easiest way is to discuss many of the common factors that go into the decision making process. It is with that hope that I’ll lay out the reasons for and against.
As always, it is best to consult your fee-only financial planner, tax advisor, or attorney for an in-depth recommendation. If you don’t have a financial planner, schedule a discovery call, we are taking on new clients.
Why pay off your mortgage
Cash Flow/Budget Concerns
If you have an expected decrease in income, eliminating a mortgage payment can be potentially one of the most freeing actions you can take. The most common ways a planned income decrease occurs is in your employment. Retirement, a job change, or a decrease in hours can all lead to decreased income. If this decrease happens without a decrease in your mortgage payment, paying off your mortgage can make sense.
The key word in italics here is expected. This is by no means saying that paying off your mortgage should happen if you find yourself losing a job, becoming disabled, or in a situation where you didn’t expect to see a decrease in income. Those situations require a completely different strategy altogether.
Planned Lifestyle Changes
These can be various in nature, but some common examples are extended absences including sabbaticals, multi-year travel, or decreasing hours to help raise new grandchildren. If you are in a financial position to be able to spend more than a year away from your job, consider if the long-term benefit of working a few years longer towards a paid off mortgage is greater than the short term benefits of travel or time off. Now, I’m not saying that you should simply look at this from a mathematical perspective. If you feel that now is the time to enjoy the sabbatical or extended travel that you’ve always wanted to do, I think you should evaluate the decision with that in mind. However, I am a firm believer in keeping a balanced perspective with any major decision, and many times there is a very healthy middle ground that is good from both a financial and personal perspective. Consulting wise counsel from several well-known, trusted advisors in big decisions like these can add great third-party perspective that you may not have considered previously.
High Mortgage and No Refinancing Options
A third scenario that makes sense to pay off your mortgage is if your current mortgage rate is high and refinancing is not available. There are multiple facets to this which I will explain. A “high” mortgage rate is a pretty ambiguous definition. A “high” mortgage rate in 2021 would have been 5%. Now in mid-2023, a 5% mortgage rate is almost unattainable, with the majority of current homes at a very low mortgage rate. Keeping this in mind, for the purposes of this post, let’s simply assume a “high” rate is at least 2 percentage points higher than the current average rate. If you have a current high mortgage rate that you aren’t able to refinance to a lower rate, paying extra towards your mortgage makes sense. Again, if you’ve taken out a mortgage between 2010-2021, you probably won’t be needing to worry about this in the near future. However, this will become more pertinent once rates normalize.
In terms of not being able to refinance, this could involve a few different factors. If your credit is bad or you have less than 20% equity, a larger amount towards your mortgage principal is a prudent move. A built-in bonus to this is that with all of those extra payments, you will likely not miss a payment. This shows more on-time payments on your credit report, which helps to improve your credit score.
While these scenarios don’t represent an exhaustive list, they do illustrate many of the common cases for putting extra payments towards your mortgage principal. Next, let’s cover the reasons for investing the extra and not paying any extra.
As mentioned above in this post, all big decisions surrounding your financial life and assets should be reviewed carefully and with a balanced perspective, along with the help of outside trusted advisors. However, you may have guessed based on the tone of this post that I have a slight bent to the “not paying off” approach.
Before I go into the scenarios for investing extra and not paying off your mortgage, let me present a concept to you. More often than not, your home mortgage is actually one of your greatest assets if utilized correctly. In the world of finance, the application of leverage can be a powerful tool, especially when used in the form of a mortgage. Leverage is defined as, “to use (a quality or advantage) to obtain a desired effect or result.”
There are some very helpful and very harmful ways to use leverage. Leverage does not have a morality in itself. Just like money, it is merely a financial tool. Leverage in the form of a margin loan can add unnecessary risk to a portfolio, which can increase returns, but more often increases losses. However, when used conservatively, leverage can allow the positive side of the equation to work in your favor.
I’m not saying that the debt associated with a mortgage is an asset in and of itself, but the opportunities a mortgage unlocks create the ability to accelerate growth in other avenues which might not be available otherwise. In terms of risk, a fixed, low-rate mortgage is usually one of the most conservative ways to gain this valuable leverage. By freeing up the capital that would normally be allocated to a fixed rate of return, the funds can then be directed into avenues that provide more potential for growth, tax advantages, and greater liquidity.
Top reasons for investing extra funds and not paying off your mortgage early
Long Timeframe
While a fairly simple concept, time is the most underrated factor of investing success. If you have a long investing timeframe, the historical returns of the stock market have drastically outpaced mortgage rates. Instead of capping your upside by putting extra down on your mortgage, you can “unlock” the long-term potential of the stock market with low-cost leverage. Not only do you stack the odds in your favor for getting better expected returns, you increase the liquidity and diversification of your portfolio by putting your money to work in other areas.
While liquidity is often viewed as simply cash, it is more than that. Liquidity involves diversifying your investments into different vehicles that can be converted into cash more quickly than illiquid assets. Since real estate is an illiquid asset class, having funds set aside in an investment account can help to increase your overall liquidity and mitigate the risk of having too much locked up in your home.
An Individual, Joint, or Living Trust brokerage account are all examples of investment accounts that provide liquidity and could be easily accessible should the need arise for a large amount of cash.
Maximizing Investments During Peak Earning Years Instead of Early Mortgage Payoff
A successful career is something to be proud of, and peak earning years are a great time to celebrate the fruits of many years of labor. However, with higher earnings come higher tax rates. If you are earning more than you ever have, there are elements of a mortgage that can help to offset the increased tax liability. The first and major tax advantage is through the mortgage interest deduction. Being able to write off the interest paid on your mortgage creates an added case for paying the standard payments and investing any extra.
This again is simply an example of maximizing the best value of multiple benefits. Paying mortgage interest itself is not necessarily a good thing. However, taking advantage of any offset in taxes, especially at high tax brackets, can be very valuable.
Income is Stable and the Payment is Not a Strain
Housing is never going to be free, and we know that we will always have some sort of expense to provide a comfortable place for our family to live. Budgeting for the right housing cost is important to providing a sustainable cash flow to cover all of our ongoing expenses. If your income is sufficient and stable to cover your housing costs, this extra room in your budget should be going towards investing in your future.
Again, discretionary income provides the ability to pursue higher-yielding, tax-advantaged accounts and investments. This is a good spot to be in and should be taken advantage of!
Current Interest Rate is Low
The opposite of the “high” interest rate discussion in the first section, a low current interest rate is about the best scenario you could ask for. If you’ve locked in a great rate and don’t have a need to relocate, the reasons for not paying down your mortgage in this case are the greatest of any of the other scenarios. You can unlock tax advantaged investments, higher savings opportunities, and other goals such as education and retirement. You can have a greater focus on long-term goals and allow the power of the market to work in your favor knowing your mortgage isn’t costing you an exorbitant amount of interest.
Home is Only Significant Asset
This scenario isn’t meant to cause judgment or belittlement if this is the reality you face. If your situation is that your home is your only significant asset or source of equity, you are simply over concentrated in one area and creating additional risk. As discussed in the scenarios above, this creates the likelihood of not being able to invest in other asset classes, explore tax advantaged investments, or maintain additional liquidity in case of emergencies. The easy way to begin remedying this is to diversify into other investments. Using any additional money that may otherwise go towards additional mortgage principal is the best way to start diversifying.
Deciding whether to put extra towards your mortgage or invest should be considered carefully and with the help of outside trusted advisors. As mentioned above, the main goal with deciding on the best route to take should be with this in mind: contentment. Paul writes in Philippians 4:11-12(MSG), “actually, I don’t have a sense of needing anything personally. I’ve learned by now to be quite content whatever my circumstances. I’m just as happy with little as with much, with much as with little.
It is with this lens of contentment that I believe we should evaluate financial decisions, such as paying down a mortgage or investing it. Ultimately, we have a responsibility to steward what God has given us, and being content with what God is leading us to do will guide us into his best for us.
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