This is a question I have heard discussed quite frequently… especially recently. I’ve heard it from both family members and co-workers.
It’s a good question and one I love to hear. Often times I believe the people have reached the wrong conclusion, but the important thing is that they are thinking about their financial situation.
If you do the wrong thing but had the right intention, I couldn’t give you more credit. In the end, we can educate you to make the right decision for the right reasons.
A typical question might be framed as:
My husband and I owe another $60,000 on our house (mortgage) which has a fixed-rate interest rate of 5.25%. We have about the same amount of money invested in mutual/index funds in a taxable account. With the current economic crisis, the taxable account is down about 25-30% from its peak. Wouldn’t it be wise to sell of those funds and pay off the house? That will ensure we keep our house if we get laid off and have money problems.
Like I said earlier, I give you insane amounts of credit for thinking about your financial situation and trying to guard yourself against a possible financial catastrophe.
However, I think you’re going about preparing for your worst case scenario in the wrong way. What could you do better?
First off, let’s assume you have more than 10 years left on your mortgage. With that being said, you’ll likely earn a better return on your investment in the market. The 5.25% interest rate on your mortgage probably only costs you closer to 4% once you itemize for deductions and itemize your mortgage interest. Remember, that’s one of the advantages of mortgages.
Do you think you could get better than an annualized 5% return (which after capital gains tax would be close to the 4% cost of the mortgage)?
If you can get more than a 5% return on an investment, it does not pay to get rid of your mortgage. And with prices as depressed as they are now (just look at your taxable account), that shouldn’t be too difficult. When looking at index funds of the market, this is especially true in the near-term of five years or more. Even CD’s had an average return of over 5% in the 90s.
So all in all, I would keep your money in the taxable account and keep paying off your mortgage as normal.
What Am I Overlooking?
I am overlooking the psychological impact of the mortgage hanging over your head.
I am not swayed much by the psychology of debt or investments, I am swayed by the actual math and rationale of the situation.
So, with that being said, some of you may read this and say “MLR, you’re an idiot!” And what it probably boils down to is a difference of opinion.
You could combine both the mathematical and psychological approaches by keeping your money in the taxable account but investing at a slower rate. You could use the extra money to make extra payments each month. Each extra payment will go towards the principle and shorten the life of the mortgage.
In the end, if you only care about the psychological effects of debt, pay off your mortgage early! I wouldn’t, but it may be the best solution for you!
So a quick recap:
- It is great that you are thinking of your financial situation and coming up with ways to avoid potential problems.
- Don’t make decisions emotionally, make sure to run the numbers. Unless of course you are someone who cares more about the psychological impact, as I mentioned.
- Your decision depends on how long you expect to stay in the market.
- This is a perfect example of how you can leverage your debt to get an investment return. This isn’t always true, but don’t fall into the trap of believing that debt is always bad.
Good luck, feel free to add on to my advice!