You have money set aside to cover emergencies, and you have money in a savings account as well. Should you use savings 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.