Classic Debate: Should You Pay Off Your Mortgage or Invest That Extra Money?

by Kevin on July 2, 2010

Oh man. I’m excited. I love these types of posts.

One of my favorite personal finance bloggers, JD Roth of Get Rich Slowly, has posed this question to his readers: Should I Invest or Prepay My Mortgage?

There’s a great discussion brewing over there, but I wanted to post my thoughts here.

Experts Disagree on Mortgage Payoff — As They Should

In JD’s post he linked to multiple high profile authors and bloggers with quotes of their thoughts. As you might expect they differed greatly.

Some said to absolutely invest the money and ride the mortgage for as long as possible. Others said do a little bit of both. Others yet said it would depend on your personal situation.

And that makes sense, right? They are experts in different niches. Some are investing gurus, some are debt reduction gurus. They should have different opinions.

But what does that mean for you? What should you really do?

You Should Pay Off Your Mortgage

The bottom line: you can’t live in a retirement account.

If you pay off the house you can live in it assuming you pay your property taxes (otherwise the government would put a tax lien on it and eventually kick you out).

This is a huge psychological factor for many people. Imagine if you didn’t have a mortgage payment! If you lost your job and had an emergency fund it will stretch much further without having to pay a mortgage.

Also consider the last 10 years of investing returns. Up, down, up, down, up, market crash, up… there were people that literally saw their portfolios get cut in half in a very short period of time.

Now some may say, “Yea, but your home’s value can get cut in half, too! Look at Las Vegas, look at Miami, look at how those condo values have disappeared over night!”

While this is true — the home’s value can go down, the home’s utility (use) doesn’t. You can still live in the house even if it ends up being worthless. This only becomes a problem if you ever hope to sell the home and use the proceeds to pay for retirement.

You Should Invest for Retirement

The flip side of the coin is this: historically speaking investing your extra money will net you more money.

Investment returns have outpaced the growth of the value of real estate when you take inflation into account. Real estate, historically, has an inflation adjusted return of 1-2% per year. Compare that to the stock market returns that fall into the 9 to 10% range.

Again, historically speaking, you would be losing anywhere from 7 to 9% on every dollar that you use to pay down your mortgage. I promise you that will add up over time!

I’ve also heard it put this way: let’s say you get laid off. Would you rather have $150,000 in equity in your home or $150,000 in liquid assets that you could cash out?

What Percentage of Your Net Worth Would Your Your Home Represent?

At the end of the day there is no cookie cutter formula to determine on whether or not you should pay off your mortgage early. Every situation is different and there are just too many variables to take into account to get an easy yes or no answer.

But let’s consider one variable: the value of your home in contrast to your net worth.

For example, let’s say you own your home out right and the value of the home is $150,000.

  • If your net worth is $200,000, then 75% of your net worth is tied to an illiquid asset. You would have $50,000 in assets to use during hard times. (Meaning you would have to get a home equity line of credit to tap that $150,000, or you would have to sell it.)
  • If your net worth is $500,000, then 30% of your net worth is tied to an illiquid asset. You have other assets of $350,000 that you could use during hard times.
  • If your net worth is $1,000,000, then 15% of your net worth is tied to an illiquid asset. You should have no problem weathering hard times.

Again, it depends on your situation. I wouldn’t want 100% of my net worth tied up into a house made of brick, mortar, wood, and cement. It’s not moving. I can’t do anything with it other than live in it, rent it out, or sell it. Getting to the money “inside” the home is extremely difficult.

Other Questions to Consider Before Making a Decision to Pay Off Your Mortgage

The value of your home compared to your net worth, discussed above, is one question to consider. Here are some others that can help you make a decision to either pay off your mortgage or invest the money elsewhere.

  • Do you plan to live in the same home for a long time (30+ years)?
  • What is the interest rate on the mortgage?
  • What is your tax bracket?
  • What is your risk tolerance? That is, can you not sleep at night because you are so worried about your mortgage payment?
  • How long do you have until retirement? (If you are about to retire then investing in the stock market may be too risky of a proposition to you.)

In my next article I will focus on the interest rate of your mortgage and your tax bracket. Many folks who recommend investing over paying down your mortgage point to the reduction in the cost of your mortgage thanks to tax deductions.

We’ll see if that is really true in my next post. Stay tuned via RSS or e-mail updates.

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Loan One Lender July 2, 2010 at 10:49 am

You asked some good questions in this article. You’re right that it’s not an easy black-and-white answer to tell someone whether it is best to pay off a mortgage or invest their money in the stock market. I’m glad that you tell people to take into consideration their interest rate, risk tolerance, and other factors. It may be wise to advise people with these financial questions to meet with a financial planner, although he or she may be biased too!

Golfing Girl July 3, 2010 at 1:04 pm

“you would be losing anywhere from 7 to 9% on every dollar that you use to pay down your mortgage”
Check your numbers–you have to subtract out the interest you’re paying in the mortgage (minus the standard deduction for interest on your taxes). That will be a lot less than 7 to 9%. In our case, we pay 5.5% in interest so that number is now down to 1.5% to 3.5% (minus tax deduction). The risk isn’t worth it for a POSSIBLE 1.5% return to me. I’d rather have the FREEDOM of no debts, a guaranteed return of 5.5% and a much lower emergency fund if a mortgage payment weren’t needed.
That being said, we opted for a 15 year mortgage (saved us $90K in interest over the 30 year rate we were offered) and are paying an extra $100 per month even though I’m now staying at home with our second child. However, we have a full 6 months in our emergency fund and are still contributing 25% to retirement, otherwise we wouldn’t be putting extra money into the mortgage. Half of any windfalls usually end up in the mortgage as well.
I know this scenario isn’t realistic for most people, as they buy at the top of their price range for homes. This is a real issue–people are just not willing to “settle” for something in the middle or lower end of their price range.

Budgeting in the Fun Stuff July 14, 2010 at 1:00 pm

I’m with Golfing Girl. We got a 15 year mortgage at 5.375%, which boiled down to $740 a month. We’ve paid $900 a month since the beginning and also hit all of our other savings goals (including a 401(k), Roth IRA, and $2500 annually to pure high dividend stock investments) before throwing any extra towards debt. We almost have our last car loan ever paid off…happens at the end of the month…then we can put that extra towards the house. We’re currently on track to have our mortgage paid off in 11.33 years total, but after the car is paid off, it will probably be more like 9-10 years total. WOOT!

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