The average mortgage debt is just over $200,000, which is up nearly 10% since the housing crash. As an investor, you might face a conundrum: Is it a smarter move to pay off your mortgage or to invest in general, and how does the math work?
When you buy a house (after October 2015), somewhere in the pile of papers you sign at closing, there’s a total interest percentage (TIP) and it spells out how much you pay in interest relative to the loan amount. (Earlier mortgages had a “finance charge” in loan documents.)
At 5% APR, the TIP for a $200,000 loan is over 90%, meaning an extra $180,000 will be paid in loan costs over the 30-year term of the loan.
Assuming you don’t have $200,000 in cash to pay off the mortgage, you might be considering extra payments. We can work with a conservative $100 per month as an extra payment, about $3 per day. Over a 30-year loan the extra $100 per month will trim 5 years off the loan and save $37,000 in interest.
Here’s the real question: Can you make more than $37,000 in 30 years by investing $100 per month?
Historically speaking, yes.
Know someone who bought Google, Microsoft, or Apple in the early days? Or someone who saw his retirement savings cut dramatically in 2009? Investing can be equally as risky as it is rewarding.
One of the safest routes is to follow a diversified index. Index investing isn’t exactly new. The concept (and the first index mutual fund) dates back to the early 1970s, when Vanguard introduced a fund that closely tracked the S&P 500. Today, there are many alternatives that can also track the S&P 500, a wide cross section of the larger companies in the stock market; one of the most popular investment options is SPY, a low-expense exchange traded fund.
What’s interesting about index investing is not just that it’s easy; it often outperforms actively managed mutual funds.
You can easily track historical S&P performance to better understand what’s likely to happen in the long term. Individual stocks or more focused indexes may not have as much history or provide as much diversification in a single ETF or mutual fund.
Historically, the S&P has delivered about a 10% return, including 7% real return and 3% from inflation.
The rate of return depends on the time frame. For example, the S&P dipped in 1928, 1930, 1954, and once again in 1982, 54 years after first visiting that level. Later years show the S&P’s dramatic rise, with several dips or crashes along the way. Even in the decades where the S&P was essentially flat, reinvested dividends from the index made the investment worthwhile, helping to multiply the growth when the market began to grow rapidly.
It’s impossible to know what will happen with the S&P index or any other investment over a 30 year time frame, but history tells us we can probably earn a 10% average annual return if we hold the investment and don’t sell at the first sign of trouble.
Using history as a guide, investing $100 per month in the S&P would net a nest egg of nearly $165,000 if you had started investing in May of 1988 and continued through May of 2018, the length of a 30-year mortgage. According to census data, the average home price in May of 1988 was $133,500. To be fair, interest rates were higher 30 years ago as well, topping 10% as an average for a 30-year fixed rate mortgage.
90-year historical S&P chart
Advantages of paying off your mortgage
If you’re nearing retirement age or if you expect a change in your household income, it can make sense to pay off the mortgage to free up more cash each month. It’s also one less thing to worry about. Retirees in particular are likely to enjoy the freedom of not having a monthly mortgage payment and not needing to work part-time to make mortgage payments.
The money saved by not paying mortgage interest diminishes later in the loan, however, with the payment toward interest in the last 10 years of the loan becoming just over half what it was at the start of the loan. In the last few years of a mortgage, nearly all of your mortgage payment goes towards principal. Paying off a mortgage late in the term does more for peace of mind than it does for financial gain through not paying interest.
Advantages of investing
The primary advantage of investing instead of paying off your mortgage is that you’re building a liquid asset that has the potential to put you in a better financial position than if you simply eliminated your mortgage interest expense. There aren’t any guarantees that your money will grow, but there is historical data that suggests your chances of earning more through index investing are very good, assuming an extended time frame. Short-term investments often do not allow enough time for the market to recover from dips or downturns.
Using data from a 30-year history of the S&P 500, investing $100 per month can create an investment portfolio worth over $160,000 over 30 years.
Disadvantages of paying off your mortgage
One of the only guaranteed returns we ever have in life is when we pay down debt. The gains are particularly strong when the debt is high interest debt that isn’t tax advantaged. If you have credit card debt at 15% interest, it’s unlikely that you can expect that kind of return from investments. Paying off the debt is the best move — and it’s paid with after-tax money, which makes it equivalent to a taxable investment that returns well above 15%.
The return on investment from paying down mortgage debt becomes less evident. Mortgage interest rates haven’t been at 15% for a long time. Rates hover at about 5%, so it’s difficult to imagine that you can’t earn a higher return by investing instead. Additionally, by paying off your mortgage early, you lose the mortgage interest tax deduction, which for most households serves to effectively lower the cost of mortgage interest. Depending on your tax bracket, the mortgage interest deduction might lower a 5% mortgage rate to about 3.5%.
Paying off your mortgage can also reduce your liquidity by putting more of your money into an illiquid asset. It’s not 2005 anymore and selling a home can take months, possibly requiring that you make price concessions or upgrades that cut into the cash you recover from the sale.
Disadvantages of investing
An honest look at the performance charts for the S&P 500 show spans, sometimes decades-long, where little or no return was realized by investors. In some cases, investments are still upside down after 10 years or more. There aren’t any guarantees of a return on investment — with the exception of paying down debt, which always creates a return on investment. Whether that return on investment from paying down debt is small or large depends on the interest rate and whether the interest is tax deductible, like in the case of mortgage interest.
If historical averages are any indication of what investors can expect going forward, investing in an index, like the S&P 500, provides a significant financial advantage over paying down low-interest tax advantaged-debt, like a mortgage. There aren’t any guarantees, however, and some people may value security over a higher chance of return. Paying off the mortgage accomplishes this.
If you have enough spare money each month, you also have the option of doing both. In a best-case scenario based on historical averages, committing $100 per month to an S&P index fund can build a portfolio worth six figures over the next 30 years. Committing another $100 per month to your 5% mortgage will reduce your mortgage length by over 5 years and save you about $37,000 in mortgage interest.