Volume 92 No. 8 - August 2021
The investment portfolio is often one of the largest assets of a person’s net worth. For most Americans, the primary residence is another large portion of overall wealth. Roughly 75% of homebuyers utilize a mortgage for some portion of the purchase price. When people start to amass wealth, they also begin looking at ways to pay down debt, including mortgages.
In most cases, from an economic standpoint, investing excess cash in the stock market instead of paying down a mortgage will build more wealth over the long-term. Over the past forty years, the S&P 500 has had an annualized total return of 9%, while the long-term average increase in housing prices is 4% annually. The benefit to paying off a mortgage early is largely psychological, rather than economical.
There are several factors that may cause a person to want to pay their mortgage off early. The desire to pay off all debt, eliminate monthly mortgage payments, or own the home outright are all common reasons. While the motivations and background may differ, each generation, from the silent generation to boomers to millennials value a paid-for home. When deciding if paying off a mortgage early is right for you, here are some points to consider:
What are the terms of the mortgage?
Interest rates represent the cost of borrowing money, in this case, money to purchase a house. A 6% interest rate means a much higher cost of borrowing than, say, a 2% interest rate. When you are considering paying off a mortgage, consider the price you are paying to borrow that money (its interest rate). There is a greater potential savings in interest payments in paying down a higher interest rate mortgage as compared to a lower interest rate mortgage. It may also make sense to evaluate refinancing that higher interest mortgage than paying it off.
Consider other debts
When deciding to pay down debt, it is important to consider all debts and the interest rates assigned to each. Consumer debt such as credit card debt, auto loans, and student loan debt all have different interest rates and are often higher than average mortgage rates. Generally, the debts with the highest interest rates should be paid down first, as these debts cost more in interest.
Remember the importance of an emergency fund
Before paying off a mortgage, it is important to save an emergency fund, which will provide the ability to cover unforeseen expenses. A general guideline for the size of an emergency fund is to calculate your average monthly living expenses and save three to six times that amount. In the case of a broken appliance, car repair, or other unplanned circumstance, the emergency fund will provide the money to cover the expense, without having to use other sources of funds. In addition to the financial capacity and stability the emergency fund brings, it also gives a peace of mind and relieves the mental strain of unforeseen expenses. The emergency fund is a key aspect of financial wellbeing and should be fully funded prior to paying off a mortgage.
Compare fixed income asset returns to your mortgage’s interest rate
If your investment portfolio contains fixed-income securities, it is possible that they may yield a rate of return that is less than the interest rate you are paying on your mortgage. If a person has fixed-income investments that earn roughly 2% to 3% annually, it may make sense for them to pay down the mortgage, if that mortgage rate is higher. For example, if the mortgage rate is 4% and the fixed-income portion of the portfolio returns 2% annually, it would be beneficial to pay off the mortgage as its interest costs more than the return of the fixed-income securities.
Consider the tax implications
Generally, money should not be taken out of an IRA to pay off a mortgage. Stocks should not be sold in a taxable account either. Both of these actions will cause taxable events. In most cases, selling stock to pay off a mortgage does not add to overall wealth, especially in light of the earlier statement that stocks have had a total return of 9% over the last forty years.
Conclusion
The decision to pay off a mortgage is unique to each person’s circumstances. Other factors that are more difficult to quantify, including personal preference and goals, also play a role in the decision process. Paying off a mortgage represents a significant financial decision and should not be made without diligent analysis. Investment Counsel is here to help.
We are here to help with life’s complex financial decisions and guide you toward realizing your long-term investment goals and objectives. Our years of experience have given us perspective through numerous examples. We can assist in the decision of paying off a mortgage, while keeping in mind your goals, risk appetite, and liquidity needs.
Investment Counsel Inc., a Division of LaFleur & Godfrey, is a registered investment adviser. Information presented is for educational purposes only. It should not be considered specific investment advice, does not take into consideration your specific situation, and does not intend to make an offer or solicitation for the sale or purchase of any securities or investment strategies. Investments involve risk and are not guaranteed. Be sure to consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.