It’s October, which means the neighbors are putting cobwebs around their front doors and jack-o-lanterns on their porches. The spooky season can quickly turn the cheery and inviting home on the corner into a haunted house that you walk quickly past. And while your home may have skeletons guarding your front door, many homeowners will still look at their home and see something far scarier – a great, large, looming MORTGAGE *cue werewolves howling at the moon.*
A home can be one of the most valuable assets you ever own, but a mortgage on that home can easily be one of the biggest drags on your ability to build wealth. Naturally, most people want to pay off their debt as soon as possible, and for good reason. The peace of mind of being debt-free plays a major role in our financial and personal decisions, and rightfully so. Many people use a cash windfall to pay it down. Whether it’s an inheritance, the sale of a business, or another means of incursion, a large cash inflow can have the ability to diminish a mortgage and allow you to live without the weight of debt. But in many cases, the option of investing the cash instead of paying off the liability can be an attractive option. While there are several great reasons to relieve yourself of debt as soon as possible, which is the right option?
The right answer is “there is no right option.” Each person has distinct considerations that make the decision itself unique. Whether it's liquidity needs, the size of the loan relative to your total net worth, or the presence of other outstanding liabilities, there are a myriad of factors that play into this decision. Furthermore, everyone has different goals that help determine which choice is best. Some people want to be debt-free by the time they retire. Some care strictly about how the math works out. Some just want financial simplicity. Regardless, matching your goals and values for debt and financial independence is the key to navigating these complex and important decisions.
Paying off your mortgage is something you may think about from the moment you sign the paperwork, and for good reason too. It allows you to save on interest payments, realize the full equity in your home, and sometimes even alleviate the need for excess insurance. But more than anything, it can give you peace of mind. If something were to happen to you or to your spouse, mortgage payments could spell considerable stress and often a financial concern for the survivor. Not to mention, it can free up cash flow. While the rewards can be substantial, what are the missed benefits of investing the cash and keeping the mortgage?
The Market Opportunity Cost
The main opportunity cost is not having the cash utilized in the market. For example, by paying off a mortgage with a 3.5% interest rate, you are effectively getting a return of 3.5% on your cash. Compare that to deploying the cash in a diversified and prudently invested portfolio, and you may find that your money would have had a larger impact if it were invested. With interest rates so low, your stock portfolio would hopefully outperform the 3.5% effective return over 30 years.
For many taxpayers, mortgage interest plays a large part in their ability to take the itemized deduction on their tax returns. Because they can deduct the interest payments they made, their effective rate is even lower than the stated rate. While the high MFJ standard deduction often eliminates couples from taking the itemized deduction, mortgage interest can help single homeowners, the charitably inclined, and can help save big bucks on your state tax return, especially in Georgia where the standard deduction is much lower than the federal standard deduction. It is important to remember to not let the tax tail wag the dog, but it still is an important consideration.
Another pro of investing the sum is the high degree of liquidity. Using $300,000 to pay off a mortgage may alleviate your debt, but it’s $300,000 you cannot put in your pocket without taking on more debt. By investing it, you retain increased flexibility by keeping the ability to make withdrawals. Again, depending on your situation, this may not be a need. But for others, the lack of liquidity that comes with paying off your mortgage can be a major drawback.
Investing does come with potential disadvantages. You will gain exposure to volatility by participating in the stock market, which can be unattractive compared to the guaranteed effective return of paying off your mortgage. Furthermore, the risk associated with keeping debt on the books can be costly. The freedoms of financial and personal security as well as increased flexibility have a price tag that, to some, a market return simply does not provide. Additionally, some investors may find themselves withdrawing and spending an invested windfall that they wouldn’t have the option to spend if they’d paid off the mortgage.
So, when deciding, ask first what matters most to you, and then count the costs and the rewards of acting on that decision. If you find yourself somewhere between, there are middle-way options as well. Some people find they can alleviate some of their stress by refinancing their mortgage. Others may make extra loan payments. In fact, by making a “13th” payment, you can significantly reduce the duration of your mortgage payments. So, while there is no right choice to be made, there are certainly options that can fit your individual goals and keep the scariness to a minimum.