For the past few months there’s a question that I’ve been asking on Twitter that nobody can seem to answer. It’s related to paying down a mortgage early. Often people will say that paying down a mortgage early is a behavioral decision and not a mathematical one. While I agree with the tremendous benefits of being mortgage free from a behavioral standpoint, I’m here to argue that there is also a mathematical reason to do it.
In personal finance there are few topics more hotly debated than the age old mortgage pay down discussion. One side argues that you should never make extra payments on a mortgage. Those additional funds should instead be invested in something with a higher return on investment. The other side argues there are behavioral benefits to paying extra on a mortgage. These are the “it will help you sleep better at night” people.
Anyone that has followed my family’s story knows that in the end we decided to pay down our mortgage early. I’d argue that paying off a mortgage early can make complete sense from both a mathematical and behavioral perspective. This is a tough argument to make in today’s unprecedented twelve year bull market and record low interest rates, but I’m going to give it a try anyway. This article does not provide any investment advice though it does share our story and why we thought paying down the mortgage was the right decision behaviorally and mathematically.
First, A Story
My wife and I made a decision to improve our finances in 2011. I was approaching the age of 30 with a negative net worth and increasing amounts of debt. We had student loans, car payments, a mortgage, and had just spent a bunch of money to buy a vacation home with family.
We had two bathrooms leaking into our basement and weren’t sure how to pay for repairs. Credit cards were a possibility. We also had a bit of home equity available. So there we were taking out a home equity loan for about $13,000 (the max we could get) to help with home repairs. It was in that moment we knew we had to stop kicking the can down the road and start taking our finances seriously.
We were able to knock out our student loan debt ($50,000) and car loans ($20,000) in about two years. My wife started a teaching job and we lived off my income and used her new income to pay down the debt. The next three or four years were kind of a blur. We were met with unexpected home repairs, purchased a couple new to us vehicles, and in general found lots of reasons to spend the money we had pegged to either invest or pay down our mortgage.
In our case, we were neither investing or paying down the mortgage early. We were spending the money elsewhere. I believe this is the reality for most people. Not everyone (myself included) has the financial discipline of the personal finance community. Logic does not alway prevail. Often times, life happens. And life is expensive.
In our situation we were already putting a good chunk of money into the market and were exploring other lower risk investments for our money.
The Mathematical Reason for Paying Down a Mortgage
I’ve asked the question below in several venues and can’t seem to get a good answer. Maybe that’s because only a small percentage of Americans are in a situation where they have paid off all non-mortgage debt, have an emergency fund, and are already investing a decent amount into the stock market. I get it that this is an extremely fortunate position to be in. If you’re not in this position, I hope this blog inspires you to work towards it.
So for someone that does not want to be an active investor in real estate or a business, where is the best place to put your money if you are looking for a safe, low risk passive investment?
In the past, many would have invested their money into bonds, Treasury bills, or certificates of deposit. The former rule of thumb was to invest your age into these lower risk assets. For example, if you were 30-years-old you’d want to be 70% invested in stocks and 30% in bonds or other lower-risk assets.
In today’s market, where can you find a bond, Treasury bill, or certificate of deposit that matches the interest on your mortgage?
Without good alternative options out there for passive investing, many have gone all-in with stocks. While I’m a huge advocate for index fund investing, personally we’ve never felt comfortable being 100% invested in index funds.
While paying down a mortgage technically isn’t an investment, in our portfolio it has essentially replaced the money we would have previously put in bonds or other low-risk assets. It gives us exposure to another asset class (real estate) while providing a higher return than other alternative non-stock options.
Where Besides Stocks Do You Plan to Invest?
Paying down a mortgage is as close to a guaranteed return you can get today, and I’d argue that it’s the highest return you can get on your money at that low of a risk level. When someone says they could likely make a higher return investing in the stock market, my answer is that I completely agree. If you leave that money in stocks for 10 years or more it’s very likely you’ll have more money than by paying down a mortgage.
However, not everyone (including myself) feels comfortable investing 100% of their money into stocks, even less volatile index funds. Going all-in on any one investment strategy or asset class has more risk than what we are comfortable taking on.
The return you can get on any asset is based on return and risk. Contrary to what others believe, the reason for the higher return on stocks is due to the higher risk when investing in the stock market. The lower the risk, the lower the return in most situations. Risk is part of the mathematical equation that needs to be considered in our investments.
Paying down your mortgage early also doesn’t have to mean shoving all of your money in to pay it down. Paying one extra payment per year, for example, can save you years off the back of your loan. That means if your mortgage is $1,200 annually, adding $100 to each payment can shorten your mortgage by several years.
Why Paying Down the Mortgage Early Made Sense for Us
The mathematical reason for paying down the mortgage is a balance of risk and return, and not being able to find other low risk assets that have higher returns than most mortgage interest rates. With bonds, Treasury bills, and CDs offering extremely low returns, paying down the mortgage early has acted as a substitute for these other assets in our portfolio. It also provides exposure to a different asset class (real estate) for someone that doesn’t want to be a landlord.
It’s important to note while we were paying down our mortgage, we never stopped investing in the stock market. Including company matches, close to 20% of our income was going into the stock market.
Lots of people that were 100% invested in stocks prior to 2008 had their lives completely destroyed. Being old enough to see that unfold, I never want to be in that situation.
Shoving extra money into the mortgage and paying down other low interest debt gives us the confidence to continue to put a higher percentage of our income into stocks going forward, and potentially even riskier assets such as (gulp) cryptocurrency. Paying down a low interest rate mortgage may seem restricting at first, but with a strong financial foundation of being completely debt free, it allows us to take bigger risks in other areas.