I’ll preface this with the disclaimer I may be missing something obvious but considering these assumptions:
– a person has a mortgage (at say 4.5% today) and they choose to pay that off monthly (not interest only)
– the opportunity cost of this investment would be a conservative 6%/year in ETFs or REITs (of course this is tentative and an average over the long run)
(See for return references: https://www.fool.com/research/reits-vs-stocks/)
Why would a person choose to pay down their mortgage rather than invest in the markets? The pros of greater liquidity in the markets and greater diversification in REITs seem to make it the preferable choice?
For context, I am a 24M considering the best route to financial independence for myself and future family.
Thanks in advance.
In: Economics
You can’t live in the stock market.
You need a house for your family, much like food. Only question is will you rent (and let that money evaporate) or pay a mortgage and keep the asset (your house).
Time will pass, you will for something. May as well have something to own after 20 years
Although the maths is correct at 6% return being higher than 4.5% cost, the preference could be psychological. Your mortgage is a known debt that you reduce over time. Provided you have an income which covers it, your position will improve with the reduction of the debt.
Entering into an investment programme might yield returns, but you’re sacrificing a known financial improvement for a speculative one.
Also, not sure where you are in the world but in the UK, property ownership has historically been the most reliable investment strategy (particularly in and around London) because prices have increased consistently and healthily over the period, so it’s also a stable return on investment, just unrealised until you sell. There are periods where homeowners have technically had greater wealth creation from the increase in value of their home compared to their salary. Sucks to get on the ladder in the first place of course.
Personal finance is about behavior, not math. For example, the debt avalanche is mathematically superior to the debt snowball. So paying off interest based on interest rate will save money. But in the real world, the debt snowball leads to a higher chance of success and performs closer than the math would have you believe:
https://commons.lib.jmu.edu/cgi/viewcontent.cgi?article=1672&context=honors201019
Paying off your home is a risk free return. As you mention, your 6% is average over the long run, so it’s not guaranteed.
There is no right answer. Personal finance is PERSONAL. I would not pay off a 4% or lower mortgage early. But one of my best friends could not understand why you would not want to accelerate being out of debt to everyone and enjoy the freedom of being able to own your own house.
A lot of people actually don’t pay down their mortgage if they get those interest rates. You still need to pay the interest on the mortgage but it is much better to invest in the market then in your mortgage. The problem with this is that it does come with some risk. In a market crash you can lose quite a bit of money in a short while. This is also when people are at higher risk of losing their job. So you might end up with a big mortgage, having lost your savings and your job. It is therefore safer to pay down your mortgage so you can handle a market crash with less worries. Or even just a market stagnation.
Purely financially, I can think of two.
1. Returns on stocks, whether they be Dividends or Capital Gains, get taxed while the ‘return’ of being charged less interest on your smaller mortgage is not. So you have to factor taxes into your stock market returns which closes the gap between the two.
2. Stock market returns are volatile while your mortgage is not. If your investing for the long term, buy and hold some index ETF’s until your old and grey, then you dont care if the graph looks like a rollercoaster so long as it goes up. But if you are relying on returns to make short-medium term cashflow then the volatility matters. Investment options that have similar volatility to a mortgage usually dont perform nearly as well.
This assumes you have **more** disposable income than your *financial commitments*, for the duration of your mortgage. I.E. on a [$400,000 mortgage at %4.5, you’ll owe 2,223.33 every month for the next 25 years](https://www.calculator.net/mortgage-payoff-calculator.html?cloanamount=400%2C000&cloanterm=25&cinterestrate=4.5&cremainingyear=25&cremainingmonth=0&cpayoffoption=extra&cadditionalmonth=0&cadditionalyear=0&cadditionalonetime=20%2C000&type=1&x=Calculate#loanterm). You must make that + living expenses in income overall. That’s a risk susceptible to life changes:
* Family – kids on the way, wedding, divorce
* Health – injury, mental break, time off OR expenses to care for a dependent
* Repairs – House maintenance, seasonal damage, car repairs, etc
* Market – Interest rate changes,
* Employment – downsizing, relocations
General wisdom points to paying down debt [high cost credit card/car loans > low cost/mortgage]; building a reserve fund; and taking advantage of incentives [stock/retirement matching, etc]. Reducing expenses & having a reserve fund will make your family more resilient to downturns, and position you to be ready and able to take advantage of opportunities when they come knocking.
Another thought – follow the money: The bank thinks it is a sounds, savvy investment to earn $266,998.97 over 25 years on your choice to get a mortgage. Paying down your mortgage faster minimizes that massive life-long expense out of your pocket. While you’re investing small amounts at 6%/year, the bank will be cashing 4.5%/year on a LARGE amount. The only way out of the LARGE payments to the bank, is paying down principal sooner. This frees up disposable income to invest as you see fit.
Consider simulating the scenarios yourself! Enter a few values into the calculator link above, and see how the situation can change. A one-time gift of $20,000 applied to your mortgage can shave off 2 years 2 months, and save 13% of your total interest costs. OR you could keep the 25 year duration and get significantly lower monthly mortgage costs.
It’s a matter of risk management. Imagine if you took a 25-year interest-only mortgage in 1983, meaning it matured in 2008. There’s a real chance you’d have found yourself wiped out, in a market where you couldn’t even sell your home.
Assuming you’re still putting money towards your savings/investments, you can think of paying down your mortgage as a way of mitigating risk by diversifying your portfolio.
Cause you don’t have the money. You’re borrowing for your mortgage. If you borrow the same amount to invest in the stock market, how high do you think the interest will be? Plus, you’ll need to pay rent
I like how on the one hand you use really specific terminology, giving the impression you know a little something about the topic. On the other hand you are asking this in ELI5.
If you pay down your mortgage you own a house. Put your money into the market and you might get a better return or you might pick bad investments or hit unfavourable market fluctuations and see the money wiped out.
Different people have different personal circumstances and risk tolerances, but for many the security of home ownership beats profit maybe.
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