Here's the latest post in the Rockstar Finance Money Match-Up series where two money bloggers argue opposite sides of an issue. Today's issue features a debate we've covered previously but wanted to revisit because it's so good -- which is better, paying off all debt (including a mortgage) or using excess funds to invest? We'll begin with the blogger from Financial Pilgrimage who favors paying off all debt first, even a mortgage...
Why Did We Decide to Pay off the Mortgage?
In 2011 we were at a crossroads. Approaching $200,000 in total debt we were sitting in a bank lobby getting ready to take out a home equity line of credit because two bathrooms in our home were leaking into the basement. We didn't have enough money in savings to cover the repairs. It was one of those rare moments of complete clarity. In that moment I realized then that we could either continue going down this road of taking on more debt, or go on the attack against it. I immediately started reading up on strategies for paying off debt, investing, and financial independence. I quickly realized before financial independence could be achieved first I had to pay down all of our non-mortgage debt. Next we'd need to build an emergency fund. Finally, we'd ensure we were investing 15 percent in our work sponsored retirement funds.
Enter Dave Ramsey
For those of you familiar with Dave Ramsey, you probably already guessed that we were following his plan. The baby steps listed below lay out the plan that thousands of people have followed to become completely debt free.
- Step 1: $1,000 in an Emergency Fund
- Step 2: Pay Off All Debt With Debt Snowball
- Step 3: 3 to 6 Months Expenses in Savings
- Step 4: Invest 15% Of Income into Roth IRAs and Pre-Tax Retirement Plans
- Step 5: College Funding
- Step 6: Pay Off Your Home Early
- Step 7: Build Wealth and Give!
I was onboard with this approach until baby step 6 to pay off the mortgage. Why would we pay down a 4 percent interest rate mortgage loan when we could invest the extra money in the stock market, real estate, or a business with potential returns of greater than 10 percent? Even someone who isn't financially savvy can do the math here. To top it off, what about the tax deduction on mortgage interest!? It only took us a couple years to move through baby step 2 to pay off all our non-mortgage debt. Though that was primarily because we ended up refinancing our personal residence to get a lower interest rate (good move) and also rolled in our remaining $30,000 in student loans (bad move).
Preparing to Invest
By 2016 we had built up more than $50,000 in savings and were ready to invest in buy and hold rental property. In order to get the best deals we made a decision to buy with "cash". By cash what I really mean is we took out a home equity loan on our primary residence to purchase the property and planned to use our savings to fund the rehab. After careful deliberation we ended up backing out of the contract. In the end, I knew the house was probably a good deal but couldn't get over going further into debt to buy this property, especially using home equity. If something were to go wrong with the property, it could mean running out of money or even worse losing our personal residence. I was starting to think that Dave Ramsey was right after all about paying off the mortgage. In another moment of clarity it was evident that by taking on more debt to invest we weren't making any real progress to get out of debt. In the past 8 years we had refinanced our mortgage twice, used money that was pegged for real estate to purchase two nearly new cars, and were now getting ready to go further into debt to invest in real estate. Where would it end? We realized that if we wanted to achieve financial independence, it was time to ditch the debt completely.
Paying off the Mortgage
Two years ago we made the decision to go all in to pay off our mortgage. We had worked the balance of the mortgage back down to $93,000 by making extra payments over the years. While we continued to live below our means, we didn't have any focus or a real plan. We then went into full attack mode against the mortgage. We immediately pulled $30,000 out of savings to pay down the mortgage and have since been paying about $3,000 extra per month. As of the drafting of this post we have $14,500 remaining on the balance. I share this story so you understand how we moved from one side of this argument to the other. Below are additional thoughts on why we moved to the dark side to (gasp) pay off the mortgage early.
The Behavioral Aspect
Earlier this week I was listening to a podcast from BiggerPockets. Co-host Brandan Turner was discussing how financial independence unlocks a freedom and creativity inside us to truly pursue our purpose in life. There is a similar effect when paying off debt, though maybe to a smaller extent. There is a real freedom in not being shackled by debt or owing another person or institution a dime. I've talked to several people about this and never met anyone who has regretted paying off their mortgage. Almost everyone says the freedom that comes with being debt free is something you can't put a price tag on. The behavioral benefits of being debt free spill over into all aspects of life. There is less stress and worry by eliminating the largest bill in most households. I also believe there is power in knowing that a bank can't call my loan if I miss a payment or two. While life may be good now, the next recession, unexpected death in the family, job loss, or a number of other events could change our financial situation in a flash. Personal finance is a behavioral game more than a numbers game. Good luck putting a price tag or projection on the incredible feeling that comes with a paid for home.
Guaranteed Return on Investment
The low interest rate environment we've been in during the past 10 years has its pros and cons. On the pro side many of us have been able to secure fixed mortgages between 3 and 5 percent. On the con side, it has been challenging to find low risk investments above 2 percent. By paying down your mortgage you are getting a guaranteed return in the amount of your interest rate. While stocks result in higher returns long-term, you never know when the next 30 percent drop will happen. If you are already putting 15 percent into a retirement account heavily invested in stocks, then getting a guaranteed 4 percent return on your money from paying down the mortgage doesn't sound so bad.
Decreases Monthly Expenses
For those of us in pursuit of financial independence, the goal is to have passive income that exceeds monthly expenses. By eliminating the mortgage payment you will need less monthly passive income to achieve financial independence. Housing expenses can amount to 30 to 40 percent of your budget, with most accounted for in the mortgage. Achieving financial independence is a relatively simple equation. Earn more than you spend and invest the difference. While you can certainly increase the earning side, there is also significant benefit to lowering the expense side. There is a balance between the two, but if you're able to knock out your largest payment every month it will accelerate your chances of achieving financial independence. After paying off the mortgage your monthly cash flow will go through the roof and you'll be able to quickly ramp up your investments.
Remember 2008? The further we get away from the great recession, the more people seem to forget about how rough of a time that was. Being in my mid-30s, I can recall hearing about families falling apart due to the housing bubble. By aggressively paying off mortgage debt we make ourselves more resilient during a recession. Another recession is coming, and probably soon, so hopefully people don't make the same mistakes as last time. Having a paid for house will significantly reduce the amount of stress in the next downturn.
Are You Really Going to Invest the Extra Money?
Humans are irrational creatures and the toughest part of personal finance is the discipline. If you have a significant amount of money sitting in an investment account you'll continually be tempted to use it. Maybe you have more discipline than I do, but I was constantly pulling money out of my investment account to buy new vehicles or to fix up our house. I've had this discussion in person with several individuals who tell me how you need to have a mortgage because of the tax benefits (which have been greatly diminished in the new tax law). When I find out what they're doing with the extra money it's usually contributing to some factor of lifestyle inflation. Given my personal experience, I really question if that extra money will go towards investments. Again, personal finance is more of a behavioral game than anything and many of us will find reasons to spend that extra money on something that will not lead to financial independence.
Of Course You Should Pay Off the Mortgage! (Maybe)
I fully concede that from purely a numbers standpoint investing excess funds in stocks, real estate, or a business makes more sense than paying off your mortgage with a low interest rate. However, personal finance is behavioral and there are many other benefits to paying off the mortgage compared to investing above the 15 percent you should already be putting into retirement accounts. It's hard to put a price tag on being able to sleep well at night or not fearing the possibility of losing your home. Knowing you'll have a roof over your head regardless of just about anything that can happen is almost impossible to duplicate in an investment. Personal finance is just that, personal. In the end, if you are fortunate enough to be in position to either pay extra on your mortgage or maximize your investments, you're way ahead of most people and you should give yourself a high five. I've been on both sides of this argument and decided to go the behavioral route instead of following the numbers. ------------------------------------------------------------------ Now let's hear from XYZ at Our Financial Path who thinks investing is the better option...
Why Investing Out-Performs Paying Off Debt
Sure, paying off your mortgage as soon as possible is a noble cause but not to the detriment of your retirement plan. To summarize, if you are a conservative investor, in a low tax bracket with a high mortgage interest rate, it might be good to pay off your mortgage. However, if you are an aggressive investor, in a high tax bracket with a low, 30-year, fixed mortgage interest rate, then it is better to keep your mortgage. Let's dig a bit deeper.
False Sense of Security
Paying off your mortgage completely only gives you a false sense of security. You will never be completely payment-free. There is always taxes to pay and bills to cover. It will not be the end of the world if you miss a payment or two but if you accumulate a negative balance on your tax bill, not only will interest and penalties accrue but, at some point, the city or your county government might take action. They have some incredibly powerful collection tools, including selling your home. Actually, having your money tied up in your property makes it even harder to cover these obligations in times of need.
Your Money is Locked In
If you pay off your mortgage, your money is locked in your home. You might be house-rich but you lose the flexibility. If your money is in your home, you will either need to sell your house or remortgage if you need funds. The first options might take months, cost upwards of 5%-6% in transaction fees, and you will then need to find a new place to live. The latter option will take a few weeks, depending on the lender, you might incur home evaluation fees, lawyer or notary fees, and the mortgage rates might have moved up from where they are now. Keeping a mortgage and investing instead keeps your assets very liquid. With index funds, for example, you can easily sell your investments and get your money out in only a few days. Some brokers even offer same-day withdrawals.
Lowest Rates Possible
Mortgage rates are very low right now but even when rates were higher, it was always the cheapest money to borrow. Because of the collateral in your house, your mortgage is the lowest borrowing rate you can find. This low-cost interest financing on an inflation adjusting asset is a great tool to build your wealth. If you have other loans outstanding, you are better off paying these high-interest debts before even considering paying off your mortgage.
Mortgage Interest is Deductible
Not only are the rates low but the interest is also deductible. This lowers the net interest rate and makes the argument against paying off your mortgage even more tempting. For example, if your average tax rate is 20%, and you get an interest deduction, which many people do, then a 4% interest rate is really only 3.2% because of the tax deduction. As of 2018, the standard deduction is $24,000 for married couples and $12,000 for individuals with a $750,000 cap on the mortgage interest deduction.
Keeping a mortgage is also an inflation hedge. A long-term fixed-rate mortgage such as a 30-year fixed rate, is an inflation hedge, with the inflation risk is all assumed by the bank. With the rise of cost of living, your interest rate stays the same. Due to inflation, the bank effectively gets payments that are less valuable over time. Assuming a 3% inflation rate and a home appreciation rate at 4%, the house only appreciates at 1% in actuality, which makes the payoff your mortgage even less attractive. The home appreciation in your area might be outstanding but this happens whether you have a mortgage or not. When you pay off your mortgage completely, the actual return is only the cost of borrowing, not the home appreciation. If you are paying off a 4% 30-year fixed, your return will be 4% less any tax deduction you might be missing on.
The Stock Market has a Higher Potential
Investing your money instead has, historically, had much greater returns. Paying off your mortgage might be better than holding all of your money in savings account or in treasury bonds but a balanced portfolio of index funds would have, historically, handsomely over-performed. Paying off your home is exactly like investing in a secure, interest-bearing, taxable account paying the rate of your mortgage. When you pay off your 4% mortgage, it is just like you are investing in a 4% CD in a taxable account. If you are a very conservative investor, then this might actually be a good option. However, looking back at historical data from 1926 to 2016, the average annual return on a balanced 60%/40% portfolio is 8.7% whereas a 100% stock portfolio averaged at 10.2% annual return (Source: Vanguard portfolio allocation models). Taking on a bit of equity in your portfolio seems to greatly over-perform paying off your mortgage.
Guaranteed 50% Return
Even better, many employers offer 401(k) retirement plans that include employer matches, often 50% of every dollar you put in up to 6% of annual pay. You just cannot beat a guaranteed 50% return on investment, so it usually makes sense to make sure you are maxing out this account before even thinking of paying off your mortgage. Even if your company does not offer a 401(k) plan, it may make sense to maximize tax-deferred and tax-free retirement savings accounts before paying off your mortgage.
With all the chatter about total market funds and world diversification, why would you put a huge sum into a single asset? Your home is a very local, single-asset, and illiquid. Your house is the ultimate home-bias. Keeping a mortgage allows you to invest your funds elsewhere to benefit from diversification. For us, it is a no-brainer. Keeping a mortgage as long as possible is the way to go. If you are a conservative investor, in a low tax bracket with a high mortgage interest rate, it might be good to pay off your mortgage. However, if you are an aggressive investor like us, in a high tax bracket with a low, 30-year, fixed mortgage interest rate, then it is better to keep your mortgage. ------------------------------------------------------------------ So, those are the two sides of the issue. What do you think?