Adebola Alabi
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As someone passionate about personal finance, I get asked a lot of questions about money management. I am creating this post to share my thoughts on the question: Should you pay off my mortgage or invest for retirement? This is a great question, and my goal with this post is to guide you so that you can make the best decision that works for your situation.
The way I want to respond to this question is to go over the advantages and disadvantages of each option.
Preconditions:
I hope this person does not have any other outstanding debt. The mortgage debt will be the last I would consider paying off because it’s mostly cheaper, and some tax benefits come with making the mortgage payment. So I will assume that he/she has paid off all other debts before considering paying off the mortgage loan. Plus, he must have his emergency funds in place, as well before asking the question “Should you pay off your Mortgage or invest for retirement?”
If you’re a homeowner and – you do not have any other debt, you are fully funding & you are on track with your retirement goals, it may make sense to consider paying off your Mortgage.
Retirement goal: You must have a retirement goal, in terms of how much you want to have saved in your retirement account by the time you are ready to retire. More importantly, you should be on track to meet your goals.
If you are behind on your retirement or you are still in other types of debts, then you shouldn’t focus solely on paying off your mortgage.
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Why you should pay off your Mortgage:
1. Peace of mind: Imagine never having to send thousands of dollars to your bank every month. You will be able to have more money at the end of each month. And this is money that you can invest in the way you choose. You eliminate the risk of foreclosure by not having any loan on your property. Think about it; your Mortgage takes anywhere from 20-30% of your income. In some cases, some people spend higher than that. So if you pay it off, that will create a lot of extra money for you.
2. Psychological benefits: I have never met anyone that regrets paying off their mortgage loan. If you are without any mortgage debt, it gives you some emotional and psychological satisfaction to know that you are debt-free. You can sleep better at night with no mortgage payment. They always say the grass on your lawn feels different when you stepped on it because you own the property.
3. Home Appreciation: Most properties do appreciate eventually. So let’s say you bought your house for $250k. After 15 years, it is possible that the property would have appreciated to about $400K, given the current trend of property appreciation. So, if you paid $250k, that’s an extra $150k that the property has generated for you.
4. Interest Savings: Depending on the value and the loan term of your mortgage, you may be paying anything between $500 to $2,000 in interest expense to your bank every month. The interest expense can cost you tens of thousands of dollars over the entire life of the mortgage. Paying off your mortgage earlier frees up that future money for other uses.
If your mortgage interest rate was 4%, and you have paid it off, that money now goes to your account, You will no longer need to pay any money to the bank, and you can then invest as you deemed appropriate.
Why you shouldn’t rush to pay off your Mortgage
1. Mortgage interest deduction: This point is a little controversial, as some people view the mortgage interest deduction as an advantage. Per the U.S. tax code, a homeowner can deduct your mortgage interest from your income during the tax season. This is a tax break for most people depending on where you live and your home value. Some people keep the mortgage for the purpose of getting the mortgage interest tax deduction, but the truth is that you are only getting a fraction of the interest you pay from the government. You get about 40 cents for every $1 interest that you paid to the bank. The question you need to ask yourself is this – would you put your money in an investment where you lose 60% of what you invest?
2. Lack of Cash: It is not of much benefits to having all your money tied to your home. If you lose your job, or you suddenly need money to take care of emergencies. There are only two ways to get cash out of the home:
Borrow against it
Sell it
Since you are trying to pay off the mortgage, it will be counterproductive to go back and borrow money against your home. But there is an additional complication if you lose your job: it’s unlikely that you will be able to obtain a loan against your home if you’re unemployed.
During a period of prolonged unemployment, your only choice may be to sell your house if cash is especially tight.
So if you are planning to pay off your mortgage early, don’t ignore the need to build up a fund that will see you through a time of prolonged unemployment. It’s not good to be cash poor, house rich.
3. Lost time in the market: Historically, the U.S. stock market has returned around 8-12% annually for over 80 years. So let’s assume that you can pay off a 30-year mortgage in 15 years. If you are making an extra $1,000 in your mortgage payment, and you complete the payment in 15 years. The alternative is if you instead invest the $1,000 every month in the stock market, and if you can get 10% per annum in return, in 15 years, you will have over $400K. It is highly unlikely that your property will appreciate by that much within the same period. Even if you are only getting 8% returns, you will still have about $350K in 15 years if you stay invested in the market.
4. You can’t run away from risk: Before the economic meltdown of 2007/2008, everyone will assume that your home price will always go up in value. The financial recession has taught us otherwise. There are some places in this country where property value declined by over 50%. Imagine you have paid off that Mortgage and a similar event occurred, and your property is now only worth half of what you paid? It’s true, many of those properties have recovered, but there are still some that are still underwater till today. Life is full of risk. Even if we don’t experience any housing bust anymore, look at the event going on in California, with the recent fire incident burning people’s properties (or Texas with flood events). I know insurance will cover them, but the insurance companies will only pay you what they considered fair, which may not be adequate for you.
Why you should invest in the market
1. Compound Interest: According to Einstein, “Compound interest is the eighth wonder of the world. He who understands it earns it … he who doesn’t… pays it.” The best way to gain that compound interest benefit is to invest your money into an investment vehicle that will generate returns for you, every year. Try not to harvest (cash out), the gains (or dividends). Re-invest the profits every year, and you will soon find yourself in a position where your investment can generate enough income to replace your active work. That is the stage where you can claim to have reached a financial freedom status. And you can do that by investing in the market and allowing your returns to stay in the market and ensure your money works hard for you.
2. Wealth Creation: If you learn how to invest properly, you can come out better than paying off your mortgage loan. What I mean by this is: Most home mortgage interest rates at this point are less than 5%. If you pay higher than 5%, you should consider refinancing your mortgage loan. Meanwhile, if you invest in the stock market, even if you generate a return of only 7%, you are still better off with the investing. Guess what, you are not earning any money from your paid-off home, but when you invest, you will make some money, whether monthly, quarterly, or annually, depending on the type of investment.
3. Liquidity: God forbid if you get into an emergency, and you quickly need to raise funds. Your investment in the stock market offers easy access to liquid cash better than your home. On the other hand, if you put most of your money on your Mortgage, then it becomes a risk too. If you need to move – for job-related purpose, and if it happened during a soft real estate market, you may end up losing money – or worse, you may not be able to sell as fast as you’d love to. If maintaining liquidity is essential to you, then you will do well to have some money in emergency funds and in the market. So it makes sense to have some of your net worth in liquid assets. Liquid assets are assets that can be converted into cash quickly, such as stocks, marketable securities, mutual funds, U.S. treasuries, and bonds. A house is considered a non-liquid asset because it can take months, or longer, for a homeowner to sell the property. Even if you need to collect some home equity line of credit from your home, it will take days to go through the process; meanwhile, you can sell any of your liquid investment and have cash deposited in your accounts in less than a day.
Why you should slow down on retirement investing:
1. Risk: Nobody can guarantee that the returns in the stock market will continue to be stellar. Anything can happen; the trajectory can change. In a world full of uncertainties, placing a bet on the returns of the stock market is a significant risk. But a paid-off home mortgage is a guarantee, there are no other risks on the property, you cannot be foreclosed, but of course, you must pay your property taxes, HOA, and insurance each year. The point is, there are lots of risks and volatility associated with the stock market. Your home value cannot fluctuate as much as the market does.
A Compromise
Paying off your Mortgage and investing are both responsible things to do. Determining which one should take priority can be tough. You have listened to the pros and cons, ultimately, I will say on the choice of investing or paying off your Mortgage, that you should do both. Yes, you should choose the middle ground. It does not have to be an either-or situation.
You can work towards paying off your mortgage and at the same time, stay invested in the market.
There are several factors you should consider before making that decision.
1. Age
2. Risk Tolerance
3. Priority
So here is my recommendation. If you do not have a prepayment penalty on your mortgage, and if you have extra money, you should consider chipping away at the principal by making any extra payment that you can afford every month.
This way, you can save a significant amount of interest and shorten the life of the loan while still investing and generating wealth in the market.
Let’s face it. Your home is not an investment. (At least not if you are living there). As a matter of fact, your home can be a liability, because you have to spend money to take care of your home.
Closing Thoughts:
So, Should you pay off your Mortgage or invest for retirement?
Paying off your Mortgage is a responsible thing to do financially, but you need to ask, is it in your best financial interest. You need to assess your situation. Are you 25 years or 60 years? Are you comfortable making mortgage payments at age 65 years?
According to financial experts, paying off your Mortgage early actually comes with its cost as well.
For investments to make more sense than paying off a mortgage early, the annualized rate of return over many years (say 10-20) would only need to be higher than the mortgage interest. For example, if your mortgage interest is 5%, your annualized rate of return on investment should be higher than 8% for it to make sense financially.
Paying off the mortgage loan may particularly be suitable for those people that are not comfortable with the volatility of the stock market. Because really, it is not unusual to see that your portfolio was worth $500K in January, and maybe by August in the same year, that $500 is worth just less than $450K, that’s if you have about 10% drop in the market. To do so, though, make sure you have some emergency funds saved as well. That is your 3-6 months of income.
