Should I Pay Off My Mortgage Early?

Is proper to pay off debt early? The good news is there are ways to determine if you should pay down debt, including your home mortgage, or invest funds to accelerate net worth building. Low interest credit card teaser rates and equity lines of credit add another dimension to the ever evolving world of personal finance.

There are two factors to consider when balancing reducing debt versus increasing investments; the return on the investments over the cost of capital and the risk factor.

Personal finance can learn a thing or two from corporate finance when it comes to debt and investment. Just like a business, when a household decides to pay down debt there is a tradeoff. Accelerating debt reduction takes money from other areas, spending or investing, but also reduces risks associated with debt servicing.

In this post I will assume you have reduced your spending to a reasonable level and the trade-offs are between debt retirement and investment only. This allows us to ask the age-old question: Should I pay off my mortgage early or invest the extra payments in an investment.

Think like a Wealthy Accountant

Business owners understand investing capital. To survive, businesses must invest capital to grow revenues and profits. Without investment it is only a matter of time before the business stalls, followed by decline. At the same time a business invests in its future it also has to keep an eye on debt levels. Many small businesses choose to operate with no debt, funding investment internally. Many households do the same.

However, a home purchase usually means a mortgage. The question now revolves around paying the mortgage off faster or investing the extra funds into investments generating a better return than the mortgage interest rate.

Business schools teach that value is created when companies invest capital with a greater return than the cost of capital.

Return on Investment – Cost of Capital=Value
(ROI-COC=V)

This is the right place to start when reviewing personal finances. Low interest rates make it easier to find investments throwing off returns greater than the mortgage interest rate. Currently the S&P 500 yields 1.32% as of June 2024. Treasury bills currently pay around 5% (August 2024). Corporate bonds have a higher interest rate than the lowest rate mortgages as long as you are willing to assume risk.

Retirement accounts have significant tax benefits, shifting decisions toward investing over debt reduction. For example, if you are in the 25% tax bracket and contribute to a traditional (deductible) retirement account you are guaranteed an upfront 25% advantage from tax savings alone. Any employer matching increases the advantage of investing over addition debt reduction. Plus, traditional retirement accounts grow tax deferred while Roth plans get no initial tax deduction, but grow tax-free.

Risks

It all looks good on paper. Since many investments have a higher return than mortgage debt, it makes sense to be mortgaged to the hilt (leveraged) to maximize wealth building. But that assumes your investments are 100% risk free. Your mortgage is guaranteed to come due or you lose your home and any accumulated equity. Investments do not afford such guarantees. Government bonds and certain bank deposits are guaranteed, but often at rates below the interest rate of many mortgages. Investment returns have no guarantee.

Credit cards have teaser rates. Clients sometimes want my blessing to borrow from their credit card interest free for a year with only a small fee, in effect a low annual interest rate. The idea has merit because, once again, it looks good on paper. Unfortunately, the loan comes due in a year regardless and if you don’t pay in full the interest rate goes through the roof. Therefore I never encourage this hyper-risky activity.

Back to the mortgage. People with a great credit score can borrow against their home at a low rate compared to other loans. The broad stock market averages around 10% per year over long periods of time. The 1.32% dividend yield is the only real cash flow.

The only way to service debt with money invested in an index fund is from another source. If the other source dries up and your index fund is also down your budget faces stress. The dividend yield is not guaranteed—though it is reasonably stable with an upward bias—is not enough to make full debt service payments. It is safer not to borrow, instead taking the debt service payments you would have made from the other source of income and dollar cost averaging into the index fund over time.

Alternative investments may have significantly higher rates of return. The goal isn’t the highest return, which likely brings increased risk, but a return that is higher than the rate of interest on the mortgage.

Logic would dictate you should max out every lending facility you have and drop it into investments with greater returns than the loan interest rate. Except that is insanity! Borrowing money to invest is very high risk. On paper it looks great. However, even a small hiccup could destroy a massive portion of your wealth, even wipe you out. No accountant worth their salt would ever encourage such reckless behavior.

The formula (ROI-COC=V) has a hidden problem. When the ROI is less than the COC, value is destroyed. Warren Buffett’s Rule #1 is: Never lose money. You can’t make up lost ground from a loss without increasing your risk. The loan never dies until paid; your capital allocation may not fare as well. That is why paying off debt is more valuable than maximizing your potential return. Additional payment to reduce debt has a rate of return in the form of interest not paid.

Balancing Act and the Sleep at Night Factor

I use credit cards in my business and for personal spending, paying them in full each month. I pay no interest. Have no real debt. I have normal bills (utilities, food, transportation, property taxes…). Credit cards are convenient in many cases and offer cash back. Every card is automatically paid in full on the due date.

In years past I did have a mortgage. I retired the debt early and used the mortgage more along the lines of a cash management tool. Today I have a line of credit for emergencies. I have not pulled money from the line in years, but it is there should the need arise.

There is a “sleep at night” factor involved. Attempting to maximize your return with debt almost always ends bad. Leverage, borrowed money, demands time and attention in good times and bad. You can cut many costs in life, but debt has no mercy. Life is to precious and short to waste playing money games.

Eliminating all debt except the mortgage should be a top priority for everyone. If you can’t afford an auto without a loan, you can’t afford the auto. Credit card debt is never acceptable! Credit cards are a convenient tool for managing finances, not for lending. Every credit card I have is set to auto-pay the entire balance on the due date. Anything else is unacceptable. Credit cards with rewards programs benefit users as long as you never carry a balance.

Student loans scare me. I never had a student loan in my life and refused to sign one for my daughter when she went to college. First off, they are hard to discharge in bankruptcy. Student loans follow you around like the plague. My opinion is student loans are a priority to eliminate. Self-fund your education instead. The first test of college is getting there. If you don’t have the money, get a scholarship. If you can’t get a scholarship you are not ready for college. In my humble opinion.

I am more lenient when it comes to mortgages. I understand owning a home without a mortgage is difficult in the beginning. However, your loan to value should be reduced to under 50% as soon as possible. That means if you have a $500,000 home, the mortgage should be less than $250,000. At some point you want a plan to retire even this debt.

A Good Plan

Here is what I consider a good plan balancing debt reduction and investment.

• High interest debt goes first before funding anything else. Credit cards and payday loans fall into this group; student loans and mortgages generally do not.
• If you have bad credit and have a high interest auto loan, sell the auto and find alternative transportation or a vehicle you can afford with cash.
• Now you can fund your retirement accounts. The minimum is the level your employer matches. Once you reach that level it is time to bifurcate your excess funds between investments and mortgage debt reduction. If you only have a mortgage or maybe a student loan you can now ramp up investments into your retirement plan. A good goal might include maxing your retirement plans before increasing payments toward debt reduction due to the tax benefits retirement plans offer.
• Once the retirement plan is filled each year it is time to set aside money in non-qualified investments (non-retirement accounts) and accelerate mortgage reduction until the mortgage is retired.

The final goal is to be debt-free most of the time. A short-term mortgage to move to a new home might be wiser than selling an investment. Maximizing wealth using leverage risks ending in tears. It looks good on paper and some accountants even promote the idea of leverage to spur wealth building. The Wealthy Accountant is not one of them. Debt is a useful tool when used sparingly. Most people who are rich have either no debt or modest levels of debt.

One final tax strategy involving debt. Clients sometimes ask about a large expense when they retire. Rather than take a large sum, causing higher tax brackets to kick in, I suggest using short-term debt to spread the expense over a few years, pushing more of the taxable distributions into lower tax brackets. The tax savings in certain instances are greater than the interest paid. Spreading out traditional retirement plan distributions can be a sound financial strategy where debt is actually the right choice.

In all cases a good night of sleep is your guide. If a financial matter causes you to lose sleep it isn’t worth it. The simplest answer often is the right one.