Oftentimes people say, “I really want to pay off my house.” I ask them what their mortgage interest rate is. These days, the answer is usually in the 6% to 7% range.
I then show them an investment return analysis covering ninety years. From 1900 to 1990 a nicely diversified portfolio of 60% stocks and 40% bonds would have earned a 7.75% rate of return. And a portfolio allocated 60/40 stocks to bonds is rather conservative. A higher allocation of stocks would have earned a higher rate of return. And as everybody knows, over the last sixteen years, we have earned returns from stocks and bonds greater than 7.75%.
To pay off a mortgage requires coming up with a healthy chunk of money all at once, or making larger mortgage payments than required each month. Instead of using that money to pay off their mortgage, I suggest to my clients that they invest it. If past history holds true, they will probably earn a return at least equal to their mortgage rate. Even if they earn the same percentage as they are paying in interest, they will come out ahead by keeping their mortgage because they receive a tax deduction for the interest paid on the mortgage.
If instead of applying $100 a month toward early payoff of your mortgage, you took that same $100 and invested it for thirty years at 8%, it would grow to $140,855. If you made your regular house payments during that same thirty years, you would then own your house free and clear, and have a pretty good investment account to use for other purposes.
Yet some people will read the simple analysis above and start to sweat. All their life they have had this goal of paying off their mortgage early. Even though, from a rational economic standpoint, they might earn more in the long run by investing the money in stocks and bonds, they feel better paying off their mortgage instead.
And to them I say: Pay off your mortgage.
Every financial decision involves a blend of analytical and emotional factors. We are told that emotion doesn’t belong in business or in financial decisions. But, in fact our decisions are often primarily based in them. To deny our emotional needs in financial decisions is to deny ourselves—the part of us that needs to feel good about what we are doing and to feel safe.
Remember that financial planning is usually based 80% on fact and 20% on emotion—except when the decision is based 100% on emotion.
I often work with couples where one spouse is very analytical. Stereotypically, the husband arrives with all the mortgage amortization schedules and has all the proof to show his wife why they shouldn’t pay off their mortgage. He listens to me reinforce his position and smiles.
Then I tell them that emotional factors should sometimes take precedence over analytical results and the wife lights up. If one spouse has strong emotional reasons to pay off the home, I may support doing that over what the strict financial analysis might show. The emotional drain of not having the mortgage paid off may actually be more costly than the amount of money they are bypassing by not investing in the market. Some people find that the peace of mind that comes from living in a house that is paid for is priceless.
One client worked for a company that was bought by another company. As a result of the buy-out, his stock options increased in value by 35% percent. His net worth increased to over five million dollars. Do he and his wife have enough money? Shouldn’t that amount of money give them peace of mind? Not in this case. His wife will not be comfortable until their mortgage is paid off.
But he didn’t want to pay off the entire mortgage immediately. In the end, they compromised. They made an agreement that 25% of everything from the old company stock that is sold would be diverted and will go toward paying off the house. The other 75% can be invested in the market. This accomplishes what the wife needs and, at the same time, takes advantage of the higher potential returns they can make in the market.
Paying off a mortgage early may give you peace of mind. Who cares about a few percentage points one way or another if you sleep better at night? Go ahead and pay off your mortgage. Just be clear why you are doing so.
But if optimizing your long-term financial return is important to you, then begin to see your mortgage interest in a different light. You could take the money you would otherwise be using to pay off your mortgage early and invest it in a diversified portfolio. Over a time period of ten years or longer, your portfolio could potentially earn you a higher return than your mortgage interest rate. In the long run, you would probably come out ahead.