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To Pay or Not To Pay Thumbnail

To Pay or Not To Pay

Written By Andrew Roth

One of the more common questions we run across with clients of all ages is whether they should accelerate paying down their mortgage or invest. This is a question that my wife and I have wrestled with personally. These questions typically arise after a pay raise, re-evaluation of lifestyle and budgeting, or during times of stress as people consider their goals and try to crunch the numbers. People wonder how to best use their money. Fundamentally, this is a question about alternatives and opportunity cost.

Looking at this academically, it seems like a simple question. For example, suppose you have $200 left in the budget each month, your mortgage rate is 4%, and you assume that your investments can return 7%. It’s a no-brainier in this case, just put your $200 into your investments and take that extra 3%! Unfortunately, this is an over-simplification of the question. The question is more complex because financial planning and individual psychology can’t always be simplified into a math problem.

There is a myriad of factors that might affect how we could address this question. Firstly, we have concrete details like age (and time horizon), mortgage and tax rates, and how long one might expect to be in their home. On top of this, we have some basic hurdles like whether a person already has an emergency fund and is contributing to retirement savings in tax-deferred accounts. We then have variables like expected rate of return on investments, risk tolerance, future tax and interest rates, and even inflation. Finally, we have the most complex consideration—the human variable. Some people are “allergic” to debt, while other people don’t mind it as much. It’s difficult to quantify the relief or pride someone might get by being mortgage free.

For younger individuals with a higher appetite for risk, we might recommend investing excess cash instead of paying down the mortgage—especially if they don’t plan on being in their home forever. Long term it might be easier to assume that their investment portfolio could out-perform their mortgage interest rate and they will see the benefits as time marches on. Additionally, the liquidity provided by the invested assets could help in the future.

To muddy the waters a little, what about a risk-averse younger couple? Maybe they’re fine taking risk in their retirement portfolios, but are much more conservative in their taxable and liquid “non-retirement” accounts. In this case the opportunity cost of expected returns might be much closer to their mortgage rate. This risk-averse couple may also argue that no one knows what the health of the economy will be in five or ten years or what markets will do, but their mortgage payments will stay the same. This argument supports the idea of paying off a mortgage more aggressively. I see the validity in this argument too—debts don’t care about employment status or portfolio returns.

For couples with retirement on the horizon, we might more closely consider their expected income in retirement. There could be scenarios where we recommend paying down a mortgage aggressively while still employed, because that burden can be harder to manage in retirement on a fixed income from pensions and social security.

Conversely, maybe we have a couple who aspires to retire in their mid-fifties (meaning they can’t access IRA monies without penalty) who are considering either investing in a taxable and more liquid account, or paying down their mortgage. While we understand the attraction of being mortgage free, we might recommend investing rather than paying down the mortgage because that liquidity will be a valuable tool as we try to achieve their goals of an early retirement. In this case it’s about maximizing alternatives. Being mortgage free is wonderful, but that money is not accessible once it’s locked up in the equity of your home.

These are just a few examples of the multitude of scenarios and variables to consider. This is before we even throw in the idea of re-financing! The allure of “the market” outperforming your mortgage rate is appealing, but the idea of accumulated interest on a 30-year mortgage can also be eye-watering. Both sides of the coin are understandable. Keep these few examples in mind as you consider your situation. The solution may be different than the assumed “best thinking,” and that’s okay. Everyone has different priorities.