Should you invest with your spare cash or pay off your mortgage early? As with most financial planning decisions, the answer is not black and white.
One of the most common questions facing families is whether to accelerate mortgage payments or to borrow as much as possible, make minimum debt payments and save for retirement.
In a world without emotional or behavioral biases where we all rationally evaluate the economics and make choices based on probability-weighted outcomes, the math points to investing over debt elimination.
Yet, the mortgage decision is rarely ever this simple. It depends on your specific situation—your tax rate, portfolio allocation, credit history, propensity to save and risk tolerance.
From a purely quantitative standpoint, the economic benefit to maintaining a mortgage and investing the difference is significant for most homeowners over the past several decades.
To help understand the economics of the mortgage decision, we test two scenarios: 1) a family uses $200,000 of savings for a home, and invests each month an amount that would otherwise be the mortgage payment (less the tax deduction), and 2) a family invests $200,000 in stocks and bonds while borrowing the same amount on a 30-year mortgage.
Over the course of 42 years, the family that borrows sees a positive outcome 97% of the time. The only period when paying cash would be better was between May and December 1981, when the mortgage rates ranged between 16.4% and 18.5%. If we allowed for refinancing, the mortgage-and-invest approach would be favorable at all times.
Assuming that history is a useful guide and ignoring behavioral biases, the analysis provides a compelling argument for keeping a mortgage. However, we would be remiss to ignore some of the important factors.
1. Tax rate. Generally, the tax benefit of the mortgage interest deduction is most meaningful for families with high income and significant other itemized deductions. Otherwise, there’s often little or no true tax savings from the mortgage interest.
2. Investment allocation. In the above scenario, we assume the $200,000 is invested in a portfolio of 70% stocks (Standard & Poor's 500 Index) and 30% bonds (Barclays Capital U.S. Government/Credit Bond Index) and rebalanced annually back to these targets. The more aggressive the investment allocation is, the better the mortgage and invest approach compares.
3. Credit history. In the analysis, we use the 30-year Freddie Mac mortgage rates. Borrowers with weak credit would obviously find the math of borrowing less attractive than the numbers above. Such borrowers may be better served to reduce the mortgage rather than invest.
4. Propensity to save. Maintaining a mortgage creates a form of forced savings. For those who lack a strong savings discipline and tend to spend what is available, the behavioral element favors a mortgage.
5. Risk tolerance. Investing in a portfolio of stocks and bonds is more risky than using the same funds to reduce a mortgage, and therefore, should have a higher expected return. But nothing is guaranteed with investing.
Paying off debt, on the other hand, is risk-free, which provides a substantial emotional benefit that is not measurable in dollars and cents. Some people prefer the peace of mind than a few hundred thousand dollars of potential economic gain.
The decision ultimately comes down to three paramount words of financial planning: avoid unnecessary risk. Without a definitive need to assume additional risk, it is hard to justify the mortgage and invest approach even if the potential, but uncertain, economic benefit is significant.