The thought of being debt free sounds like a dream come true for most of us. Many folks are wrapped up in credit card debt, car payments, mortgage payments, etc. However, there’s one debt freeing yourself from could do more harm than good, from a mathematical standpoint. That is your mortgage debt. Honestly, it’s often not a good idea to pay it off or even pay extra on it before age 50.
I know individuals in their 30s who received big inheritances, went out and paid cash for a house to avoid a mortgage payment. To them, it was a good idea. I also know individuals that decided they wanted to pay their home off as fast as possible. I have some friends that are also clients that ended up in this exact scenario. They bought a house in another state during the downturn of the market. Recently, they sold it and made $100k, to which they planned to pay off the mortgage on their current home making them debt free.
I said to him, “You know that sounds good and I understand, but you‘re dealing with about a million dollar decision right now. And I think you probably need to look at the math to know the consequences of what you are about to do.”
He replied, “I know what to do. We’re going to pay our house off, then take the monthly payments and save it.”
While I wish that were true, I pointed out, “No, you won’t. Human nature says you won’t do it. Human nature says you’ll upgrade your lifestyle; not save it.”
Usually, those individuals that plan to do this hate debt, and are just dead set on reaching this goal with an all or nothing mentality. Often, they go with this approach. “Well, I am going to pay this mortgage debt, and then I will start saving.”
To be clear, I am not targeting them or anyone directly, but again the chances are they are not going to save the money. It’s just human instinct. On the off chance that we get extra income, people tend to upgrade their lifestyle. Which means they won’t toss the additional funds into savings, even if they have the best intentions.
Albert Einstein once said, “Compound interest is the eighth wonder of the world. Those who understand it earn it, those who don’t, pay it.” His analogy could not be more precise. Let me explain what Einstein meant with this synopsis.
Here are the assumptions for our example. The average middle-class family dwelling at this point is $250k, so we’ll go with a $250,000 house with a mortgage. The rate on the mortgage is 4%. Home appreciation rates (how much the house will go up in value) vary between 3-5%, so for this scenario, we will go with 4%. Let’s assume an 8% market return. That is how much the money will return if it’s invested in the stock market rather than paying off mortgage debt. Our individual’s tax rate is 20%, and we’ll assume inflation at 3%. Now, let’s break all this down to see why making those extra payments or even paying the home off isn’t always the best option.
At $250k, the payment is going to be in the low thousands, maybe around $1200 or $1500 once you add the PITI or principal, interest, taxes, and insurance altogether. Now, this payment is just for an average home value. Some parts of the country may be higher or lower, but again we’re looking at an average. So, if we have a house for $250k, over time, regardless of if there is mortgage debt or not, the house should appreciate in value.
Again, we’re looking at a stock market return of 8%. Keep in mind this an arbitrary number. There is no guarantee of that type of performance. Some will say less, while others say more. However, there is a lot of data out there showing 30-year track numbers, and I believe 8% is a somewhat conservative number for this illustration. However, we’re going to assume the money is invested in equities or a reasonably aggressive portfolio.
Now as for tax rates, those vary by state and person. I’m using the assumption that our homeowner has a 20% tax rate including state and local governments. That is about the average rate nationally for somebody buying a $250,000 house. So that means if they make $100,000; roughly, $20,000 of their income is going to go to the state and federal government. Also, we have to deal with inflation, which we are using 3%. The Federal Reserve indicates a target inflation rate of just 2%, so I’m slightly over-inflated for my example.
So, looking at the math for only the house and plugging in those numbers, here’s what we get. In 30 years time, with or without a mortgage, a $250k house should be worth roughly $810,000. That’s according to the home appreciation rate of 4%. So that’s not a bad investment. We went from $250,000 to $800,000 on this asset. Now again, if you’re in a part of the country where the houses appreciate more rapidly and let’s say you’re at a 5% return then obviously your return would be greater than $810k. Or if you’re in Smalltown, USA or middle America, you may not get a 4% ROI. You may be significantly below. So,30 years from now instead of $800k, your home may only be worth $500,000 in value 30 years from now. Again, I am using an average.
At this point, let’s look at investing that $250k in the stock market instead of a home. If we took that cash, invested it in the stock market, earning 8% a year compound interest for the next 30 years, we’d get $2,515,664. The reason it is significantly higher is the stock market is returning double what the home is appreciating at. One thing to remember is there’s always an imbalance in both the real estate market and the stock market. It’s not going to earn a constant rate. It may make 10% one year, then -6% the next. The only constant you can count on is always is never always.
So in this apples-to-apples comparison of no debt, no mortgages, no cash flow issues, no inflation issues, no tax issues, pure analysis on the data, the $250k invested in the stock market compared to the $250k house—the stock market wins, hands down! But here’s the reality, most of us don’t have $250k in cash sitting around that we can just invest in the stock market or even outright buy a house.
So if we have extra money what should we do with it? Pay off debt or invest? Well, let’s take this same scenario and run the numbers in a more realistic way. Let’s say we have an extra $1000 per month and we’re trying to decide if we should pay extra toward mortgage debt or invest it.
A $250k home on a 30-year mortgage with an interest rate of 4% gives us a payment of $1193.54 per month. That doesn’t include taxes and insurance, just straight principal and interest. Make that payment 12 times a year, and we’ve spent $14,322.48 of your income on our mortgage payments. So we’ll say we got a raise at work and we’re bringing home an extra $1000 a month. There’s no other debt, so we are going to add it to our mortgage payment to get the house paid off in 12 years. We’ve gone from paying $14,322.48 to $26,321.76 a year and knocking 18 years off this mortgage mess. For the remaining 18 years, we’re going to invest that same $26,321.76 in the stock market. At the end of 18 years, earning 8% (that’s our constant in this analogy), we would have $1,027,745 in our investment account. Couple that with the $810,849 our home is worth and our assets are valued at $1,838,594 after 30 years.
Alright, now let’s run the numbers a little differently and see what our total net worth is at the end of 30 years by investing the extra money in the stock market. We’re still buying the $250k home at 4%. This time we’re paying just the payment for 30 years. Nothing extra. We’re taking that $1000 from our raise investing in the stock market for 30 years with our 8% return rate. We already know at the end of that period according to our early calculations that the value of the house is $810k. What we need to know is the value of our stock at this point. Running those numbers, you end up with $1,417,613. That means our stock is worth around $500k more at the end of 30 years than it would’ve been in the 18 years we invested it after paying off the house. So now instead of $1.8 million, we’re now worth $2,217,614. Not bad considering we DID NOT pay our house off early.
However, it doesn’t stop there with the calculation. It actually gets more cumbersome because, in reality, we’re not dealing with just principal and interest payments. We still have inflation and tax rates. Remember earlier I said, we’re going with a 3% inflation rate. So if the home appreciates at 4%, that’s just above the inflation rate. Therefore making the house only appreciate 1% in actuality. So, here is what is interesting though. Those people who choose to make extra payments on their mortgage do a couple of different things.
First of all, remember the house is going to appreciate regardless of the mortgage debt or no mortgage debt. So by paying extra payments toward the mortgage, you limit your cash flow by investing your extra cash into an asset, you have to sell or borrow money on it to get the cash back. I consider that a dead asset. Even though it’s an asset on your financial statement, it’s not one you can typically use very quickly if you’re in a pinch. Even if we put all this extra money toward it, the asset won’t grow any faster.
This is where inflation comes into play. There are several inflation calculators out there, and I use the CPI inflation calculator. So I ran the inflation scenarios. I took our mortgage payment of $1193.54, plugged it in to see what it would be in 10 years and based off their calculations the $1193.54 would inflate to about $1457. I also wanted to know what it was worth ten years ago. At that time in history, $1193 was only $970. What’s the point in all of this? Well, basically not only does the price of goods and services increase but so does our income.
By the time the mortgage is paid off in 30 years the payment would be about equal to $537 coming out of your pocket today.Click to tweet
So as our income increases over the next 30 years, the dollars we are using today for our mortgage are fixed at today’s value. What does that mean? That means that $1193 would be equivalent to $970 in 10 years. In 20 years, that same $1193 would “feel” more like $758. By the time the mortgage is paid off in 30 years the payment would be about equal to $537 coming out of your pocket today. What I’m saying is we are sinking our most expensive and valued dollars into an asset that isn’t going to grow to be worth any more than the $810k we’re projecting it to be in 30 years. It’s not going to help us grow our net worth any more than we already calculated. However, if we put the $1000 a month into an investment account, we end up with a net worth that is about $500k greater than if we just used to pay our outstanding mortgage debt.
Someone reading this may be thinking, “well what about interest?” So let’s figure that in our synopsis too. If the average tax rate is 20%, and we get an interest deduction, which many people do, then that 4% is really only 3.2% because of the tax deduction. Obviously, that’s not the case for all, but many claim this deduction on their Schedule A tax return, (which is why you hire a good CPA). So, if you have a tax deduction and your house is appreciating at 4 percent regardless of the interest, you’re going to make a 0.8 percent growth on that asset.
We already know that if we have this house paid for with cash with no interest whatsoever, it’s worth $810k some 30 years down the road. If we have this house paid for with interest in 30 years, it’s still worth $810k. So, what am I getting at?
Look, I’m not telling you what to do, but I can show you is the math for this scenario. Run the numbers and talk with your financial planner consistently to figure out what’s best for your particular situation. Don’t get it in your head that you have to pay your house off. There are plenty of mathematical reasons why you wouldn’t want to do that. Not to mention that most people only live in their house for seven years. What I do believe though is many times, we can go in and make a compromise. Instead of it being all or nothing, we do a little of both, more of a 50/50 attack. We get a little more aggressive on the mortgage, and we invest a little extra to pad the retirement account. Sure paying the house off as soon as possible is a noble cause but not to the detriment of our retirement plan.
Some will argue it gives them peace to tackle the mortgage because they have no debt. That’s awesome! However, you need to realize you also have an asset that you can’t get to quickly if you need it. It is simply tied down. As with anything, there are pros and cons. To say you’re making the wrong choice by paying the house, I can’t do to that. Neither can I say you’re making the wrong decision by investing and paying your fixed mortgage payment. I know very successful people who’ve chosen both paths.
I’ll sum it up this way. Work with your CERTIFIED FINANCIAL PLANNER™ to build your custom plan and throw as much money as possible into your investments. For me, the numbers speak for themselves. I personally won’t throw all my extra money into a debt asset. That makes no sense if you’re in your 20s or 30s. However, maybe you’re in your 50s. Then that’s a different story. That’s the time to start hunkering down and gearing up for retirement in about ten years. Why? You are now at the point (because of inflation) where you are paying your cheapest dollars toward the interest. So, throw as much money toward the principal in the latter part of that note! You certainly don’t want to retire with debt.
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Keep in mind the above circumstance is just one variation on the numbers. Your specific situation may differ by geographical location, interest rate, tax rate, investment return, etc. Always speak with your advisor to decipher what’s best for your particular financial position.