Is It Better To Pay Off A Mortgage Or Invest?

pay-off-mortgage-or-invest

Is It Better To Pay Off Mortgage Or Invest?

One of the biggest debates in the financial world has to do with the question….Is it better to pay off mortgage or invest?

As someone who has followed Dave Ramsey’s 7 Baby Steps, let’s take a look at what he’s recently had to say about this to callers on his show.

Is It Better To Pay Off Mortgage Or Invest?

Caller #1

The first caller (35-yr-old) was debt-free except for his mortgage and had managed to save up quite a bit of cash in his savings.

He owed $180,000 on his mortgage with a 3.25% 30-year fix rate and was having a difficult time convincing himself to pay it off with such a low rate.

His home was worth about $520,000 and household income was $140,000.

His savings included:

  • $90,000 in non-retirement accounts
  • $150,000 in a 401k retirement savings
  • $75,000 in 529 plans

Step 4 in Dave’s Baby Steps is to invest 15% into a retirement account which he was doing (roughly $25,000 per year).

He also was funding 529 plans for his 5 and 8 year old kids so now he was up to Step 6, paying off the home early.

Dave’s recommendation:

Take the $90,000 in savings and throw it at the remaining mortgage. Why? Because of lowering risk giving him a better peace of mind.

Dave quoted several studies and books he’s read about millionaires. He claimed they got to their 7-figure net worth status because of their habits and what they did with their money.

And the two primary financial decisions that those habits caused them to be successful was this:

  1. The first million or two in their 401k
  2. A paid for house.

The millionaires that were studied never said anything about borrowing money at 3.25% so that they can invest it and make a better rate of return. In essence, he was saying they paid off their homes aggressively even though their interest rate was low.

Some people will state that because their interest rate is low (i.e. 3.25%) they’ll forgo paying off the house aggressively to invest. Most millionaires, according to Dave, don’t operate in that fashion.

Once they get the house paid off, they then use the increased cash flow of not having a house payment to start heavily investing mainly in index funds that track the stock market.

Dave states, “100% of the foreclosures occur on a house with a mortgage.”

He’s all about setting financial goals of lowering risk and getting out of debt. He’s built his empire on this strategy.

Caller #2

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The second caller had a different scenario as he wasn’t yet putting Dave’s recommendation of 15% into retirement yet.

Here’s his personal finance stats:

  • $105,000 left on the mortgage
  • $10,000 in savings
  • $50,000 household income

After paying his monthly bills, he had $1,800 left over.

He asked Dave, “Would it be a good idea to start investing $1,000 a month now or just use that extra money to pay on my mortgage?”

Because he wasn’t yet investing 15% of his income or $7,500/yr, Dave recommended that he started doing that first before paying any extra on the house.

We all know that Dave recommends, no matter what the question a caller has, that the Baby Steps are followed in the EXACT order presented.

Now, I realize that mostly Dave Ramsey is for the average income earner. But for me, I felt like early on when I had student loans and a mortgage, I could do both:

Pay aggressively on all debt (including the house) AND invest.

I didn’t want to miss out on the compounding interest.

Let’s take a look at what another money expert has to say about: Is it better to pay off mortgage or invest….

The Money Guy

Brian Preston over at The Money Guy Show also answers this question frequently from people that either:

  • are debt-free but not much saved up for retirement
  • want to know is it better to pay off mortgage or invest with interest rates so low

Here’s how he recently answered it from a caller:

Dear Brian,

Help please. We have a house and plan on paying it off in five years. There’s no other debt, but we have no retirement fund.

My husband isn’t worried about it.

I am.

He has wealthy parents but I want money I can hold, not hope for. We are in our 40’s and the house is worth between $800,000 and $950,000.

My question is, “Can I simply count on the house to act as our retirement fund?”

Brian loves questions like this as he doesn’t see a lot of people talking about in the financial press that the two things you got to unpack is that, “Can you have too much of a good thing with paying off your debt too fast?”

Meaning there’s an opportunity cost that you had, had the debt been paid off instead of letting that money work for you.

And then the second thing is you can go on the other side of the coin where people are worried about, “Why would I ever pay off the debt because interest rates are so low?”

Opportunity Costs

Brian has covered, in detail, financial mistakes people make by age. I’m not going to go into all of the calculations but here’s some of his results….

He discovered the power of a dollar bill, if you start saving when:

  • you’re 20 years of age, by the time you’re retiring at 65, can be worth $88.
  • a person starts at 30 years of age, that $1 can be worth $23.
  • a person who’s 40, it’s $7.
  • somebody who’s 50, it drops down right below $3.

So you can see that those people who are saving early and often when they’re in their 20’s, it’s a dynamic growth multiplier on your assets, that’s the power of compounding interest.

Brian recommends that we aggressively pay down high-interest debt such as credit card debt and car loans.

But his fear is someone that doesn’t take advantage of the process of compounding interest.

He says that if you’re in your 20’s and 30’s, while you have a multiplier that’s double digits, you need to be investing that money.

He doesn’t recommend that you do too much of a good thing by trying to get completely out of debt because he worries when you’re older (40’s or 50’s), you’ll have a paid for house with no retirement.

He calls this….Too much of a good thing on paying off debt.

When you pay that mortgage off, all you’re essentially doing is just locking down that interest rate savings.


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Army of dollar bills

When this interest rate savings is locked down, he states that we furlough our army of dollar bills.

When someone pays their debt off too early, Brian starts to get nervous.

Why?

Think about it.

Essentially every dollar that you prepay on the mortgage, that army is going into your house and they’re all looking at each other going:

What are we doing here? I could be out there working. I could be bringing more money back to the army, but we’re stuck here. We’re all furloughed, hanging out, wondering why we’re not growing.”

The person that originally asked Brian, “Can I simply count on the house to act as our retirement fund?” wanted liquidity.

Last time I checked, you can’t retire off your house assets until you sell it. If she has a paid for house with no savings, things could go south in a hurry (i.e. another Coronavirus pandemic).

Also, you can’t go to the grocery store and buy food based on the value of a house, right?

Here’s another thing to thing about. If you love where you live and love your house, you’re not going to want to move.

Follow up question

Brian also answered this follow up question:

Is there a time when it does make sense or should you ever prepay your mortgage especially when interest rates are low?

Brian disagrees with those that say we should NEVER pay off the mortgage. His thoughts are that as we near retirement in our 50’s and 60’s, he wants us to reach financial independence.

This means that we have no obligations to anyone and that obligations extends out to debt.

For many people, the emotional benefit of being debt-free can outweigh the analytics of the calculation.

Plus don’t forget on that calculation discussed earlier, by the time you’re in your 50’s, it’s less than a three times multiplier.

So the opportunity cost of what you’re missing out for decreases as you age. If you think about, if you pay off your house completely when you’re in your mid fifties or in your sixties, your opportunity cost is not that bad.

Let the emotional benefit as well as the true financial independence weigh the scale of decision making at that point versus trying to always have money working and having that risk of what’s going on out there in the world of finance. (It seems to be that it’s going to come down to personal preference, especially risk tolerance.)

Further Analysis To Consider

My good friend over at ESI Money also addressed this issue with an article titled, “Pay Down Mortgage Or Invest.”

Many different scenarios were looked at plus other things to consider such as:

1. Inflation. Those who advocate for the pay off mortgage early, rarely consider the effect of inflation. Why pay off the mortgage quickly using today’s dollars when you can pay off the mortgage using your dollars 20 years from now?

If inflation were to rise at a rate of 2.5% for the next 30 years, your $1 today, will only be worth 50 cents or less in 30 years. By delaying extra payments, our future money will go much further than our current money on our current mortgage debt.

Our income will generally rise, with our mortgage repayments staying the same.

Bottom-line: Mortgage payments get EASIER with time.

2. Maybe you don’t like risk. If you’re risk tolerance is low, it’s best to pay down the mortgage, which is a guaranteed return on investment.

If you prefer moderate risk, consider BOTH investing and paying down the mortgage. (This is the route we chose to do with our current home.)

Many people will argue that paying down your mortgage is risk free. I disagree with this. Yes, it is less risky than investing, but definitely not risk free. By putting all your spare cash into paying down the mortgage, you are limiting your exposure to other assets, thus increasing your exposure to risk.

3. You must also consider your personality. Like me, maybe you hate having debt. Student loan debt, mortgage debt, you want it gone. You like the feeling of being free from debt, even if it means missing out on better financial returns.

It would be silly to recommend investing to someone like this. On the flip side, how bad would you feel missing out on high investment returns should the market explode?

4. What is the mortgage interest rate? If the rate is 10% or higher then it may be better to pay down the mortgage with ALL of your spare cash. What about an 8% mortgage rate? Then maybe 80% of your spare cash on the mortgage and 20% on other investments. A 5% interest rate may see you put 50% of your cash on the mortgage and 50% in investments.

You can come up with your own rule of thumb, depending on the current mortgage interest rate. The higher it is, the better off you will be paying down the mortgage.

Investment returns are unknown, but mortgage rates (when fixed), can be guaranteed. This makes it much easier to use this as the benchmark return, instead of using a hypothetical investment return rate.

5. Do you need the cash? It may not be a good idea to use all your spare cash on paying down the mortgage if you don’t carry any in the form of emergency savings.

6. Are you a good saver? Mortgages are great for poor savers because they act as a forced savings plan.

As a poor saver, if you don’t pay down extra on the mortgage you may not end up investing the difference. Which strategy will you be able to implement with the greatest ease?

7. What are your goals? Do you want to retire in a nice house with not a lot of cash invested? Or an average house with more cash invested? There is no right or wrong answer, as you may be able to do both. But if you had to make a choice, which one most closely aligns with your retirement goals.

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My Thoughts

When people ask me questions, I usually answer them if I were in there shoes….what would I do.

When we started our financial journey, I was a die-hard Dave Ramsey follower. I was 100% focused on becoming debt-free, including the mortgage.

That was then, and this is now.

Back then, I knew nothing about what keeping hundreds of thousands of dollars tied up in equity of a home could potentially do to wealth building.

Also, I didn’t know anything about investing in passive real estate which could have paid my mortgage off all while building wealth simultaneously.

Again, I believe it all boils down to personal preference. For me, I’d continue to max out our practice’s retirement account, save any extra money and then invest in passive real estate syndications.

That way, as I continue building new streams of passive income, that could be used to pay extra on the mortgage.

What do you think?

Should you pay off the mortgage or invest?

jeff@debtfreedr.com
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