People can tend to get dogmatic and dismissive of paying down a mortgage early. But I really think this is a function of pure ignorance. Maybe they don’t really understand how to evaluate this option against the conventional wisdom that is dished out on the daily. At first blush, it may appear that I have a bias since the GYFG household chose the path to become mortgage-free (accomplished in just under five years from when we set this goal). But wait – bias appearances can be deceiving!
In theory, I actually agree with those who advocate keeping a mortgage for as long as possible and to invest what it would have taken to pay off the mortgage into the stock market. Over decades, this approach has a very high probability of outperforming the interest you save on paying off your mortgage early. BUT when reality punches theory in the face, there are several flaws in this conventional advice:
(1) The same people telling you to pay the minimum on your mortgage and invest the difference in stocks are also advising you to allocate your funds between stocks and bonds. The rule of thumb is to hold your age in bonds and the rest in stocks. Therefore, if you’re 32 years old, that means you hold 68% of your investments in stocks and 32% in bonds. Hmmm, what do bonds return these days? Isn’t a paid off mortgage synthetically equivalent to a bond? We will come back to these questions a bit later.
(2) An even bigger problem is that most people don’t end up investing the difference. They spend the difference! Based on all the stats, many spend more than the difference and actually dig themselves a big ole debt hole.
So, in one breath the “experts” say “invest the difference in stocks,” and in another breath, they say “allocate between stocks and bonds.” Do they not realize the conflicting advice they are preaching? Can we please pause for a moment and acknowledge the fact that a paid-off mortgage is equivalent to a bond? When you pay extra towards your mortgage, your “coupon rate” is equal to the interest rate on your mortgage. If you have a 30-year mortgage with a 3.5% interest rate, that equates to 3.5% interest on, say, a 30-year treasury.
Remember that the interest you earn from a bond is typically taxed at the federal and state level as ordinary income (unless you’re investing in municipal bonds, which are usually tax-exempt). That being said, the current yield on the 30-year treasury is 3.36% but that is pre-tax. The GYFG household has a very high marginal tax rate of ~45% (federal, state, and FICA). Therefore, if we were to invest in 30-year treasuries today we would expect an after-tax return of ~1.85%.
Compare this to the 2.25% we are saving by paying our mortgage down early. I should state that this is a below market rate since we opted for an adjustable rate mortgage, knowing that we wouldn’t have a mortgage for long. But let’s ignore this fact for a moment. This is the after-tax rate of return and in order to find the gross return that is equivalent to the 3.36% we could earn if we invested in treasuries, it’s going to require a little math to reverse engineer. If we divide the 2.25% by 0.55 (1 less marginal tax rate of 0.45) we find the gross pre-tax equivalent rate is 4.1%.
Of course, you didn’t have to do that math as you could have just as easily concluded that 2.25% is greater than 1.85% (the after-tax treasury return).
Now let’s back up and address the fact that our rate is below market. We bought our house in 2014 and had an initial 30-year rate of 3.75% plus 1.35% for PMI (because we did an FHA loan initially), which put our effective rate at 5.1% (before any tax benefits of course). We began our journey of strategic refinancings in late 2014 which have saved us tens of thousands of dollars in interest. At the time we did our last refinance (June 2016) the 30-year rate was around 4.25% – a full 2% above the 2.25% rate we currently have on our ARM. I say all of this because I actually view our real savings based on the more typical 4.25% we could have locked in if we had opted for a 30-year mortgage at the time of our last refinance.
So, instead of the 4.1% I calculated above, the gross return for us paying our mortgage down early is closer to 7.72%.
What’s my point?
Nice, put the pressure on! I really have four main points I’m trying to get across:
(1) In theory, paying the minimum mortgage payment over a 30-year term and investing the difference is most likely the optimal strategy to maximize returns. However, theory rarely comes to real-world fruition. If you opt to invest the difference and then allocate those funds between stocks and bonds, you’re not really doing what is being recommended, and you may be better off treating your mortgage as your bond allocation for the same or superior results. You just have to do the math.
(2) Expanding further on #1 above, most people rarely invest the difference, and instead spend the difference. “Stupid human trick” of immediate gratification!
(3) Keep in mind where conventional wisdom comes from. Much of this advice originates from financial advisors and you have to look a level deeper into what may be driving their motivations. They can collect a fee for the money they manage in your stock and bond portfolio but collect nothing on the extra money you throw at your mortgage. I’m a big believer in following the money to get to the truth.
(4) Lastly, if your risk profile is such that a split between stocks and bonds makes sense, don’t be so fast to dismiss the synthetic bond position you can build from a paid-off mortgage.
By all means, if you have the risk tolerance to hold the cheap debt, and invest all your additional capital into stocks, don’t let me stop you. All I ask is that you don’t blindly accept advice that may not be 100% accurate. Do the math!
It’s no secret that the GYFG household aggressively paid down our mortgage to be mortgage-free in less than five years. Let me make it very clear that I’m not recommending you do this in place of investing in stocks. We have done this as part of a holistic approach to building a solid financial future, which includes also investing in stocks and other investments. But, we don’t hold a traditional allocation to bonds because we have opted to build a synthetic one by paying off our mortgage.
We even follow the rule of thumb of holding our age in “bonds.” Today the equity in our house makes up about 39% of our total net worth (at 33 we are slightly over-allocated but that will work itself down over the remainder of 2019).
Not every financial decision needs to be optimized for maximum gain. There is a balance of addressing your tolerance for risk and working towards reaching your ultimate financial goals. It’s more important to find a strategy you can stomach for decades rather than one that simply promises the potential for higher returns, which typically comes with a lot more volatility. I can guarantee you that having our house paid off early ensures that we will be sleeping like babies through the next financial crisis. The peace of mind knowing that your house is paid for is priceless, in my opinion. And the math might be better than you think.
– Gen Y Finance Guy
An excellent write up, which serves to concrete my personal thoughts on this matter. Whilst I was quite-to-very sure about the potential benefits of investing in stocks over paying down the mortgage (I am 100% Vanguard FTSE Global All Cap in the UK) I hadn’t made the bridge to it acting as a synthetic bond holding.
At 31, with a realistic minimum 25 year time horizon and a late start, I have chosen to ignore traditional bonds for now, swapped out the over-payment and focus all of my contributions, and the majority of my accumulated pension assets, into globally diversified 100% share holding portfolios out of their relatively safe but dismally performing default profiles. Being relatively early into my journey my net worth is split 40% property equity, 37% stock market and 23% liquid. My liquid holding is relatively high because we are planning on doing house renovations in the near future plus I am the main earner in our household so the responsibility for any “shocks” is mine and as you will find out in the next few years, there’s always something the kids need!
I’m glad I could shed some light on how a paid-off mortgage is synthetically equivalent to a bond allocation. It sounds like you have found the right path for you and your family.
Great write up as usual. While it is certainly hard to dismiss the relief of stress of being mortgage free, I have to say anyone < 40, with an investment horizon of 20+ years… has to forego the old adage of age = bonds. I think one would come out ahead if invested in broad low cost index TSM with a splash of international stocks thrown in, with remainder going to passive real estate 🙂
I can’t say I disagree that it’s highly probable that your suggested path will lead to a larger net worth. For me, the fact that I have completely de-risked my life is worth more than the opportunity cost of not throwing that additional money towards stocks or passive real estate. This is even truer as I transition from full-time employment to full-time entrepreneur.
I’ll make up the difference on the income side of the equation.
Jimmy – I don’t disagree with you if someone is only pursuing the path to maximize returns and nothing else.
For others that are looking to optimize a set of variables, this might be a viable path to pursue. For me, I’m optimizing to have very minimal risk in my life, and maximizing peace of mind. I will take more risk by being aggressive with income generation to make up for the conservative nature of paying off the mortgage early.
Thanks for the comment.
Despite the low interest rates on offer, I’d always suggest paying off the mortgage on the family home first. The security of moving forward without that is worth loads.
KeninNZ – We are now into our second month of being mortgage-free and it is a great feeling knowing that we always have a roof over our head – especially since working towards going full-time entrepreneur. My wife and I joke that if we fail at life we could always work as a barista at Starbucks to pay the annual property taxes of $7,500/year and put food on the table. I don’t think that will happen but if it does…
Dom – you raised a lot of good and valid points in your post.
My own preference is to not pay down my mortgage and have as much liquidity as possible at this point. I am refinancing my mortgage to take advantage of the low interest rate environment and to reduce my monthly mortgage balance. I want liquidity to take advantage of opportunities in the market place if the Wall Street talking heads are right about a recession over the next year or so.
That is just my preference and another perspective on this matter.
Hi Rich – At your $10M+ net worth I don’t think I’m even qualified to comment – LOL! But seriously, I totally understand and appreciate your position on this. I will add that I’m in the process of locking in a $450,000 line of credit just in case…you never know what opportunity may arise…or need that may come up. I know the HELOC could be revoked at any time but that’s a risk I’m willing to take.
“Lack of self control” (not investing the money saved by keeping a low interest mortgage) is a reason that can be applied to any scenario at any point in life. To me, self control (dedication, perseverance, etc.) is critical to the success of any wealth building strategy. If you have it, you can take many paths; if you lack it, no path will work.
Rick – I consider myself to be a pretty disciplined person but I’m not infallible (like most humans). I tend to try and put systems in place to protect me from my moments of weakness. I don’t think that a lack of self-control is the only reason to pay off the mortgage but it is a path to be more disciplined. The reality is that many people may not have the risk tolerance to invest in the stock market and paying down their mortgage is a good choice in that example to build discipline into their lives (without the volatility of the market swings). I also think that peace of mind is another reason that paying down the mortgage is a valid reason, despite the opportunity cost of not investing in the market.
Everyone has to evaluate their own unique circumstances and risk tolerance.
I appreciate your comment.
“Keep your overhead low.” – Mick Foley
Foley is legendary for his thrift, stories abound. One of my favorites is him refusing to pay for a motel but instead buying a newspaper, putting on sunglasses, and pretending to read it for six hours in the sitting position. Another is him being offered a free drink at Applebee’s, and instead negotiating to have his soup taken off the bill. He was FI at 34, and retired five times (so far). He walks it like he talks it.
So, this post is just great, for three reasons that jump out at me. 1) mortgage expense is now removed from cashflow; 2) Property Tax growth limited to 2%/year from purchase price; and 3) Capital Gains will be tax-free up to $500K.
De-risking your life by reducing overhead. Flawless PF technique, GYFG!
JayCeezy – I’m going to start calling you the quote king. Of your 101 comments you have left so far, I’m willing to bet at least 50% start with a quote of some sort. I have to agree with Mick Foley, I’ve always tried to keep our fixed overhead low. I don’t like being obligated to lots of recurring monthly expenses. I don’t mind spending money, but I prefer the majority of our spending be discretionary, leaving a much larger lever to pull on if tightening is required.
As you have observed from following along these past four years, I’m all about de-risking and risk mitigation. I don’t chase returns, I chase income!
To add my perspective on this, in my current situation my investment portfolio is worth about 60% of the value of my mortgage. Since the returns on my portfolio are generally much higher than my mortgage interest (currently just over 1% here in the UK), my mortgage is paid every month from passive income. Ok, some months it doesn’t quite make it and other months it’s paid several times over. I guess that’s the trade off. If I sold my investments and paid down the mortgage, I’d still be left with a smaller mortgage which I’d have to fund from earned income again.
I used to use paying down my mortgage as a bond alternative, but stopped for two reasons:
(1) I went too gung-ho on the mortgage and was overly “investing” in fixed-rate vehicles relative to my preferred asset allocation and
(2) I learned the value of liquidity.
I personally regret the amount I paid down on my mortgage. But that’s because I have a higher risk tolerance and could have better deployed that money in the market. That said, it gives some folks comfort and satisfaction. And that means something.
Just wrote my last check to the mortgage company for my primary residence. A weird feeling…took me 9 years and 9 months, but it’s done. Thanks for the motivation, didn’t take the idea seriously until reading your blog a couple years ago. My plan will be to eventually move to a new place and rent this one out. Until then will just stack the extra cash or pay down my second home. I started just throwing a couple hundred bucks a month at it, then all of a sudden I was throwing a couple thousand extra a month. It snowballs quick!
This is one of the best opportunity-cost writeups of the value of paying off your mortgage that I have read. Nicely explained! I hadn’t thought of the payoff investment being a bond equivalent, but of course it is. I was working on the “peace of mind” angle, along with reducing my family overhead in case sh#t hits the fan.
I also love this quote from Dom in the above comments. “I don’t chase returns, I chase income!” It’s simple, yet profound. Personally, I believe in having a many, many legged retirement stool, and I look at tranches. Social security, pension if you can get it, investment property (may or may not make sense to pay it off/down), Roth and traditional IRAs, taxable portfolio, etc. Once you hit the FI number, then you can decide if you want to RE, as the FIRE folks say. I’m not there yet, but hope to pay the mortgage off by year end, which will really move the needle toward the FI part!
Thanks for a great read!
I totally agree on the multi-legged approach. Good luck on paying your own mortgage off and thanks for the comment.
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