Most of our clients will at some point ask if paying off—or more aggressively paying down—their mortgage is a prudent financial decision. The answer to this question, like most complex financial decisions, is that it depends. Several factors should be considered with the help of a financial advisor to determine if it makes sense to pay off your mortgage or use your financial assets elsewhere. For the purposes of this article, we are seeking to help answer this question for one’s primary residence versus an investment, or rental property.
Cash Flow Planning
One of the first steps in determining if paying off your mortgage is the right financial decision is to look at your current cash flow in the context of your overall financial goals. You need to determine if you have excess cash flow after prioritizing savings goals related to your overarching financial objectives. For example:
- Do you have appropriate emergency cash reserves?
- Are you participating in and maxing out any potential 401(k) programs available to you? In 2019, the maximum 401(k) contribution rate increased to $19,000. The individual retirement account (IRA) limit was bumped up to $6,000 per person.
- If education funding is a goal, do you have an education savings strategy in place, such as contributions to a 529 college savings plan?
- Do you have other spending goals (i.e. vehicle purchase, vacation) toward which you are adequately saving?
If you are well on your way to meeting your financial goals and have excess cash, one of the next steps is to evaluate other outstanding debt you may have, such as credit card or student loan debt. This debt should be paid off first before paying down your mortgage because it typically carries a higher interest rate and is never tax deductible
If you have other loans—for example a car loan or home equity line of credit (HELOC), you will want to evaluate the interest rate and tax deductibility of those loans. For example, you’d likely want to start by paying down your car loan because it is typically not tax-deductible. After that, you would look at your HELOC, which may or may not be tax deductible (see side bar for more information).
One of the most helpful ways to frame the question as to whether you should pay off your mortgage or invest excess cash is to consider the best use of—and return on—your money. In other words, you need to assess the risk of the mortgage versus the risk of potential investments. Based on the average annual inflation-adjusted return of the stock market (about 7%) compared to the current 30-year fixed rate mortgage (about 4%), you are “technically” better off investing your money. However, the decision is not this clear cut. We all know that markets are never really “average.” While you know what the “return” on your mortgage is, there’s no way of knowing what the return on your investment will be and timing won’t always be in your favor. Therefore, your risk tolerance, investment time horizon and other risk factors should be taken into consideration. Consider the following questions:
- What is your risk tolerance? If you are a conservative investor and the “expected” return on your investments is less than or equal to your mortgage (plus interest), it would make sense to pay down your mortgage. The more you pay down, the less interest you pay.
- What is your investment time horizon? Going hand in hand with your risk tolerance, it’s also important to consider your investment time horizon. Will you be invested long enough that you can stand to weather a potential market downturn? Someone looking to invest for a longer time period with a higher risk tolerance may be more comfortable investing their excess cash versus someone who intends to retire in the next couple of years.
- How long will you stay in the property? If you’re currently in your “forever home” where you intend to live for many more years, paying down or paying off your mortgage makes more sense than if you are in a home you may be looking to sell in the next few years.
- Do you owe more on your mortgage than what your home is worth? While most homeowners anticipate the value of their property appreciating over time, some people find themselves in a situation where they’re underwater on their mortgage. If you’re in this situation and can afford to pay off your mortgage, you’re likely better off doing so.
As with many financial decisions, it’s not always about the numbers. For some individuals, especially those nearing retirement, the thought of carrying a mortgage payment causes anxiety. There are homeowners who can’t stomach the idea of having a mortgage payment in retirement even though they could afford it and would have likely been better off investing their excess money. The same holds true for younger individuals who have said they feel a sense of liberation and personal achievement knowing their home is paid off. The decision that helps you sleep at night is frequently the best decision for you.
If you’re considering paying off or paying down your mortgage, we encourage you to walk through these steps and talk to a financial advisor to ensure you’re factoring your personal financial goals and unique financial circumstances into the decision. The decision that’s right for your next-door neighbor may not be the right decision for you.