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
Given the choice of investing 1 extra payment per year vs putting it toward the principal of a 30 year mortgage, I can see one possible reason. Time value of money.
A few extra payments toward principal in the first years of a mortgage affect the interest calculations for every payment every month for the rest of it. That shaves multiple *years* off the end of it because it reduces the interest over time so much.
If you buy now and will pay it off in 2054, but you want to retire in 2050 or before, then having it already paid off by then just because you put in a couple extra payments up front could be pretty nice. Beats having to work several more years. Likewise if you don’t think you’ll make it until then, having it paid off when your family inherits it could be nice.
You could also cover those cases with investments and life insurance. But some people might prefer to just have it already taken care of. And not have to worry about losing on their investments at that time or having lapsed or otherwise lost their insurance (due to health problems or whatever).
Personally I’m still going with investing instead, but different people have different preferences for that kind of thing.
It’s a perfectly valid strategy to only pay the interest on a mortgage and instead invest the equivalent equity payments elsewhere. The last 30 years have been a very stable period of peace and prosperity with fairly dependable growth. 2008 was a blip as was COVID and baring the Ukraine and Middle east conflicts expanding there’s good reason to believe the next 30 years will be generally prosperous too. But it is possible there will be disasters that tank the markets and owning your home is real peace of mind if the markets falter. If you’ve never had the wolves at the door it might be hard to appreciate that though.
Please note that your “conservative” investment return is above the average consumer investor annual return.
Also investing leaves you with “JUST” money. Buying a house also means you have somewhere to live.
Personal finance is just that, personal. There are a lot of things on paper that makes sense that we as people avoid. One example is merging, if a lane is closed and you have to merge it is best to wait to last second to merge but the irrational side of us hate seeing people do it. Paying off your mortgage will make you feel much re secure even though you’d have more money invested that you can withdraw and pay the house off and taxes on capital gains if needed but we are an irrational race.
First, I think it’s helpful to point out that there is a minimum payment you need to make monthly on a mortgage. If you don’t make that payment you start getting charged extra fees. So you definitely want to make that minimum payment no matter what else you invest in.
After that though, it’s better to get a better rate. If you can get a 6% return on your investment in the stock market and your mortgage is only 4.5%, feel free to put your money into the better rate!
Another angle you may not have considered is that there is an emotional aspect of debt. People often feel relieved or less stressed when they don’t owe any money. It’s also less stressful to have safer investments a lot of the time. Paying down a mortgage is safe and helps get you closer to not having debt. So it can possibly be a better choice emotionally, even if it isn’t as efficient financially. It all depends on the person.
If you think of your house as a pure investment, the smart money is to keep a mortgage of 4.5% and invest your extra money in a higher yield vehicle. You may also derive an income tax deduction which will be in your favor. Of course, some investments are taxable each year and others are tax deferred, so there is that to consider, as well.
If you think of your house as a place to live, then you may want to pay off your house as soon as feasible so your family will have a place to live no matter what happens in your financial life.
There is not a “right” choice, but rather a preference based on your goals and risk tolerance.
Also, unless you specifically have an interest only a mortgage payment plan, that is not an option. Most traditional mortgages require an interest plus principal payment each month for a set term. Usually 30 years. You don’t have the option of just not paying off the principal.
You answered your own question. The returns are theoretical, average, tentative.
How much would I have to pay you, guaranteed, in a year for you to loan me a dollar? How much would I have to pay you, theoretically, for that same dollar if there was a possibility you wouldn’t get it?
Everyone answers that question differently. Only gamblers value them equally or prefer the second. The first scenario is like paying down debt or putting money in an FDIC insured account. The second is a risky investment.
To get more into the math, not only is paying down your mortgage risk free, it’s also tax free. So if your marginal tax rate is 30% you have to divide your mortgage rate by .7 to find the minimum risk free rate of return that would be equivalent. If your mortgage is 3.5% you would have to get 5% on a savings account to break even because interest is taxable. You’d have to get a significantly higher expected rate of return on a risky equity investment to compensate you for the risk of loss.
I have a graduate degree in finance and an undergraduate degree in economics. I aggressively paid down debt my entire life and was still a millionaire by 35. (Also don’t use Motley Fool, they’re predatory.)
Not everyone is good at the math.
Generally, you want to put down enough to not pay an extra PMI payment. This is typically 20%. If you have a good enough rate, putting down less and accepting the PMI is worth it.
You also generally want to put down enough to have a mortgage payment that you are comfortable paying.
Where I live, home insurance is about $5,000 a year that I’m required to spend while I’m paying the mortgage. If I pay off the house now instead of 20 years from now, that’s at least $100k saved.
Latest Answers