This question always brings out the punches, kicks and jabs. People have STRONG emotions about debt, even low-interest mortgage debt.
Through Afford Anything lens of “Stop Shouting, Start Thinking,” let’s walk through the potential consequences. You decide.
Everything Has Risk. Period.
Most people want to pay off their mortgage for three reasons:
#1: Emotion: Peace-of-mind
#2: Risk-Management: Reduce the chance of a foreclosure
#3: Savings: Lower their interest payments
These are all great reasons. But nothing is the “best” choice in a vacuum. It has to be compared to an alternative.
Alternative #1: Spend the money on champagne and strippers. Obviously a terrible choice.
Alternative #2: Invest the money. Okay, this could be a valid option. Let’s explore it.
Stocks, historically, have yielded an 8 percent long-term annualized return over the past few decades. Legendary investor Warren Buffet predicts that number will be closer to 7 percent in the coming years. For the sake of argument, let’s assume Buffet is right.
Now let’s rephase the question. Are you willing to pay extra to get rid of your mortgage faster?
That’s not a rhetorical question. Missed opportunity has its price. If you’re willing to pay the opportunity cost for the sake of reducing your risk — Great! Go for it! You might be leaving money on the table. If you’re okay with that, then you have your answer.
Notice I asked if you’re willing to pay the opportunity cost. That doesn’t mean you will. No one knows what the future holds. If the markets perform as they historically have done, you’ll miss opportunity. But if stocks tank, you’ll come out ahead.
There’s risk in every decision, even the decision to become debt-free.
Should you save or pay off debt? Or invest? Each option has pro’s and con’s.
Paying off your mortgage has:
- Guaranteed interest savings
- Limited upside
- Unknown missed opportunities
- Greater potential for upside
- Stronger chance to capitalize on opportunity
You have $100,000 in cash. (Congrats!) You also have a brand-new 15-year mortgage with a balance of $100,000, at 4 percent. (For simplicity sake, I’m leaving taxes out of the equation.)
Scenario A: You pay off your mortgage. You save $33,143 in interest payments. You invest $739 per month, the amount that would’ve been your mortgage payment. You contribute every month for 15 years and it grows at 7 percent. At the end of the term, your portfolio is worth $237,706. Hooray!
Scenario B: You invest the entire lump sum in the market. You make no additional contributions. In 15 years, your portfolio is worth $284,894. You’ve also paid $33,143 in mortgage interest, which you subtract out. Your net gain is $251,751. Wahoo!
Under this scenario, you’ve lost the opportunity to make $14,045 by paying down your mortgage early. Boo! That’s a strong argument for investing.
On the other hand, you’ve enjoyed peace-of-mind, which DOES have a value. You have less risk, higher liquidity and more flexibility.
Is that peace-of-mind worth $14,045? You decide.
Scenario C: You invest the money. The market tanks. You lose your job. Your house gets foreclosed on. Your spouse leaves you, your dog bites you, and even your goldfish won’t look at you anymore.
It’s a worst-case scenario, but it’s possible. Now the $14,045 looks like cheap insurance.
(What about borrowing to invest in real estate? Here’s my take.)
Quit Being Ideological
You know what’s funny about being a personal finance blogger AND a real estate investor? I hear ideologues on both sides of the aisle.
Finance bloggers, as a group, tend to have knee-jerk reactions to the word “debt.” Debt bad! Debt bad!
Real estate enthusiasts tend to have the opposite reaction. Gimme leverage! More and more and more leverage!
Half the emails I receive about this topic come from people who say, “Are you going to pay off your houses as fast as possible?” The other half ask, “Why aren’t you borrowing more?!”
Don’t make decisions based on ideology. Everything financial, even debt payoff, comes at a price. Everything carries risk. Risk wears different costumes, appears in different forms. But it’s there.
Avoid knee-jerk reactions and zombie ideology. Weigh the risks. Make a spreadsheet. Calculate missed opportunities. Imagine the worst-case scenario and ask yourself if it’s something you can live with.
Make choices based on information, not ideology.
Then decide for yourself.