Pay Down Mortgage or Invest?

Pay Down Mortgage or Invest?

Ah, the age-old question, do I overpay my mortgage or do I invest those extra dollars?  A tale as old as time, I’d say.  I get this question maybe more than any other financial planning question.  Especially these days when new mortgage rates can be in the 6% or 7% range. 

Now, like most everything with finances, the question is very situational and nuanced.  That said, I certainly have my heavy proclivities here, and since you asked happy to share them.  Let’s start by giving a very simple real-life example.

A Real Life Example

Ex: Mr. and Mrs. Client own an $800,000 home with $400,000 owed on the mortgage at let’s say 5% for 30 years.  Meanwhile, the Client has $1,000,000 in retirement savings. 

We will use this lovely couple as a reference point for the rest of this blog.  Now, truthfully the interest rate is not my driving logic for what my preference usually tends to be.  Generally, I am a fan of investing those extra dollars rather than pay off the mortgage. 

Of course, you are Andrew, you deal with investments for a living. 

This is true but let me let you in on my logic.  Yes, for starters I 100% think that over the course of your mortgage term, regardless of length, your investments will fare better than the interest you are paying on your home mortgage.  However, let us take this a little bit further and remove the simple equation, albeit a critical one of investments do better than mortgages.  Rather, why don’t we focus on a few other critical pieces of financial logic for today?

Heck, let us completely remove the rate of return and assume that the investment returns and mortgage rates are identical.  With all things being equal it is important to remember that they actually aren’t equal.  You see if both mortgage rates and investment rates were the exact same you still get a deduction for the interest you are paying on the mortgage while you don’t get a deduction when it comes to investing (in non-retirement investments). This alone gives a slight edge to investing vs. mortgage paydown.

I can tell you aren’t convinced quite yet, so I will continue.  If you took out a $400k mortgage at 5% you would have paid a total of $373,023 in interest over those 30 years.  I know staggering right?  You would have also paid $400,000 back in principal the bank let you borrow for those 30 years as well for a total of $773,023 in total payments.

Now, what would happen if you invested that same amount of dollars monthly at a 5% rate of return for the same time period?  Bebop boo be-bop boo boo ding dang (this is the noise of me computing by the way) boom!  In this scenario, you would have paid the same $773,023 but instead assumed the benefit of compound interest on your money.  In this scenario, you would have had $1,757,774 in total dollars.  That comes out to 2.5x your net if instead, you put those resources towards the mortgage.

The Math

I know this is oversimplifying the math, but it holds true at 7% and it holds true at 3% mortgage and ROR.  The other key element here remember when you pay off your mortgage it doesn’t mean your home is worth it anymore.  Rather, you simply owe less to the bank.  Said differently, your house continues to appreciate regardless of if you owe anything on it, which by the way is the only way you make money in real estate. 

You don’t make money if you buy a $500k home and pay it off only to be worth $500k.  You make money when that home goes to $700k for example, and the cool thing about that is you get all the appreciation, and the bank gets all the debt. 

The math also works the same if you are talking about overpaying $1,000 or putting $1,000 toward your investment portfolio.  Quite simply, you would need terrible returns for 30 years and an extraordinarily high-interest rate, in my opinion, to justify the math.  You can borrow for a home too, which you can’t do for retirement.  Oh and remember all these extreme examples are assuming investment and interest rates are identical, which if properly invested should not be the case. 

I recognize there are certainly non-financial and more emotional reasons to pay down one’s mortgage, which I am totally fine with.  But, if asked what makes more sense financially as you can see if is generally investing.  As always we are here to help you cope with this and many other financial planning questions.

Stay wealthy, healthy, and happy.