Assume you have money set aside to cover emergencies, and you have money in a savings account as well. Or perhaps you just received some money through an inheritance. Should you use any of these sources to pay off your mortgage or take that money and invest it?

The simple answer

If, in the past, you have had trouble managing your finances, particularly managing debt, then you are probably better off continuing to make mortgage payments. You can see the progress you’re making with these payments by simply looking at your bank statements.

On the other hand, if you have demonstrated in the past that you can successfully manage your finances and you are willing to spend time in the future managing them, then you should consider using the money for investing. While investing can do a better job of building wealth than paying off debt, this is by no means a certainty.

Relevant factors in your decision

General factors to consider are your age, your home’s current market value and anticipated future appreciation, your marginal income tax rate now and your estimated marginal tax rate in retirement, your current mortgage interest rate and terms, and your estimate and confidence of future returns in alternative investments such as stocks and bonds.

Paying down, or paying off, a mortgage, pros and cons

If your mortgage rate of interest is 4%, then your mortgage is costing you 4%  in interest payments providing you do not itemize your deductions for federal tax purposes. If you itemize, your cost is less than 4%; the actual cost will depend on your marginal tax bracket. Note that as a mortgage balance declines or is eliminated, any tax benefits you get with itemizing deductions also decline and are eventually eliminated.

In your retirement years having lower monthly expenses is always good; having a small or zero mortgage payment could be a valuable benefit especially for people who rely heavily on social security payments or who have minimal or no pensions.

Sinking all your money into an illiquid asset – a house – is a big drawback. You probably never thought of your “free and clear” home as having an associated cost, but that’s exactly what it is – the opportunity cost of the money tied up in it. Home equity lines of credit and reverse mortgages can be used to offset this drawback, but they have their own downsides.

A house does not care whether it has a mortgage or not. It exists for people to live in and enjoy. Mentally coupling money tightly with housing can restrict your overall financial options when thinking about strategies appropriate for your total financial circumstances.

Going with investing, pros and cons

Assuming you can capture only half the return of stocks in the last 80 years, that’s half of 10% or 5%; you are still getting a better return on these investments than the 4% you’re getting paying down or paying off the mortgage (ignoring taxes). But that return may fluctuate considerably over time. A more conservative and predictable approach would be to compare the percentage return from a very low risk investment such as a Treasury note or bond with your mortgage rate. When comparing returns always consider the tax effects – taxes potentially reduced from the mortagage interest deduction and taxes potentially owed from investment returns.

Investments such as stocks and bonds are far more liquid than real estate. Asset diversification is improved as you now have investments, real estate, and investments that can be turned easily and quickly into cash when needed.

Unlike your monthly mortgage payment, you will have to monitor the performance of your investments either by yourself or through turning them over to a broker or financial adviser. And these values will fluctuate. You should ask yourself how comfortable you are with that –  How to Gauge Your Tolerance for Investment Risk.

Two different simple but meaningful perspectives for deciding

From an emotional perspective, consider what is most appealing to you, and what you can live with. Decisions based on emotion are not necessarily bad; they merely need to be acknowledged for what they are.

From a practical perspective, consider how easy it is to undo whichever choice you make, as there may come a time when you need to do exactly that. Having options is always good given the difficulty of predicting the future.

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Advantages of owning a home

Purely emotional reasons. This should not be discounted as a factor.

Possible deductions for mortgage interest and property taxes depending on income and your overall tax situation, and also dependent on the state in which you live or are thinking of moving to.

Fixed cost in recurring mortgage payments provided you get a 15 or 30-year fixed mortgage.

Possibility of building equity. Contrary to popular opinion, this is not guaranteed, and depends greatly on where the property is located.

Stability. Assuming you pay your mortgage on time you can’t be forced to move except under unusual circumstances.

Option of getting a reverse mortgage when you’re much older and have built up substantial equity.

Disadvantages of owning 

Requirement of a down payment that could strain or exhaust your financial resources.

Upfront purchase costs including realtor’s commissions. That money is gone forever.

Ongoing costs of maintenance and repair, typically 1% – 4% annually of the value of the home depending on its age. And frequently not considered by new buyers.

Ongoing time required for maintenance and repair. Don’t underestimate this.

High probability of future rising property taxes.

High probability of future rising homeowner’s insurance premiums.

Lack of liquidity. You cannot easily and quickly convert your house to cash.

Advantages of renting 

Flexibility. It’s much easier to move to a different rental than selling a house and moving elsewhere. You might surprised at how many times people on average move to other residences.

Liquidity. Since you do not have money tied up in a down payment for a house or tied up in the equity of a house, you have greater control and more options of what to do with that money. Don’t underestimate the importance of this.

Possible lower monthly cost. See the financial analysis below.

No hassle maintenance. If something breaks, it’s someone else’s problem to fix it.

Upscale amenities usually not found in homes: gyms, swimming pools, movie theaters, basketball courts, and wine cellars.

Disadvantages of renting 

Emotional – “I’m throwing money away”. Not really valid: you’re spending money on a place to live as contrasted with spending that same money on something else.

Potential loss of control. Possibility of eviction through changes in ownership of the rental.

Exposure to rising rents over which you and other tenants have little if any control.

Less flexibility in choosing neighbors. Another one not to underestimate.

Financial analysis – the Price to Rent ratio

Here’s a way to look at this more objectively. Go to Zillow and find the median home price and median monthly rent for the area you’re interested in. Divide the median home price by the median annual rent to give you a price/rental number. The number could be anywhere from 12 to 25.

Now take the sale price of a specific house you’re interested in, find a rental in the same area that’s roughly equivalent to the house, and then compute the price/rental number.

The higher the number compared to the median P/R number the more you should consider renting. You can compare the two numbers – the median P/R number and the house-specific P/R number to get an idea as to whether the house is reasonably priced for that particular area.

Possible outcomes of your financial analysis

1) The costs of renting and owning are comparable. With no clear financial advantage with either choice, I would spend some time defining where you expect to be and what you expect to be doing in 3-5 years. The more uncertain your future, the better renting looks as it avoids all the sunk costs that come with purchasing.

And it doesn’t tie up money in a house in the event of an unanticipated downturn in housing prices like the US experienced in 2008/2009. This could happen again and could be initiated by a nationwide credit crisis.

2) The cost of renting is higher than the cost of owning on a monthly basis. First thing I would do is ask “Why?”; what is it about the local market that is causing this? If the answer is acceptable, then I would consider buying, but only after I had done the 3-5 year exercise mentioned in the previous paragraph.

3) The cost of owning is higher than the cost of renting on a monthly basis. I’d choose renting to give you the maximum flexibility and options. It gives you the opportunity to familiarize yourself with the entire area relative to costs, traffic, and school systems, while monitoring price changes in neighborhoods of interest.

And you can save or invest the difference in the cost between owning and renting in the meantime.

Recommendations for deciding 

Consider both the emotional aspects and financial implications.

Be clear on your assumptions, including how long you expect to live there.

Do the price/rental analysis.

If buying, buy the least expensive home that meets your needs in an area that has the greatest potential for appreciation. Do not be swayed by realtors who try to get you focused on the most expensive house you can “afford”.  Never buy into the sales pitch “you’ll grow into it”.

If renting, try hard to save the money you expect to save having made the decision to rent rather than buy.

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