Paying off a mortgage early can free up cash flow and save a lot of money on interest payments. But investors shouldn’t view their mortgage in a vacuum. Putting extra money toward a mortgage can be seen as part of an overall investment plan.
While there are reasons why paying off your mortgage early makes sense in certain cases, many investors are better off paying the minimum every month. Here are three reasons why.
1. Real interest rates are negative right now
Inflation caused prices to climb nearly 7% year over year last month, and it might be some time still before inflation comes back to the Federal Reserve’s target of about 2%. Several economists believe inflation will remain above 3% throughout 2022. Even the Fed policymakers have raised their forecast to 2.6% inflation in 2022.
Meanwhile, average 30-year mortgage rates remain close to 3%. Those with good credit or are willing to buy down the rate can get a loan at less than 3%.
With inflation running high and mortgage interest rates near record lows, the real interest rate for the next few years may very well remain negative. It’s kind of like getting paid to take on debt. Each dollar you borrow against your home can provide an increase in buying power if the inflation rate remains higher than the interest rate on the loan.
When real interest rates are negative, you should be taking on as much low-interest long-term debt as you can (up to your comfort level).
2. You can earn better long-term returns elsewhere
When you pay down your mortgage, you’re effectively locking in a return on your investment roughly equal to the loan’s interest rate. Paying off your mortgage early means you’re effectively using cash you could have invested elsewhere for the remaining life of the mortgage — as much as 30 years. With rates so low, you should be able to find better long-term returns with other investments.
The stock market, for example, ought to produce returns in the 7% to 8% range over the long run. Analysts at Morningstar expect a well-diversified portfolio of stocks to produce an 8% average annual return going forward.
Importantly, though, that return comes with greater volatility. The standard deviation on the Morningstar forecast is 17%, which means annual returns will range anywhere from -9% to 25% about two-thirds of the time. Over the long run, though, investors should expect their investment portfolio to outperform their mortgage rate.
The counterargument here is that most investors wouldn’t borrow against their house in order to raise investment capital. That’s suboptimal from an economist’s point of view, but it may be optimal from an “I like to sleep at night” point of view. In today’s environment of high home values and low mortgage rates, capital is readily accessible for those willing to take on more debt, but it may be outside your personal comfort zone.
3. Paying off early means increased sequence of return risk
Paying off your mortgage early means foregoing adding more to your investment portfolio today. The effect is that most of your investments are compressed into a smaller time frame — post-mortgage payoff — which increases your exposure to sequence of return risk.
Sequence of return risk is the potential for a few years in the stock market to have an outsized impact on your investment portfolio. If the stock market has a few bad years in a row when you have most of your money invested, the impact is significant. Likewise, if the market goes on a tear for a few years and you have practically nothing invested, you’ll have missed out on a significant portion of returns the market provides.
Since stocks are more volatile than other assets, the real benefit of the asset class — greater expected returns — is often seen over long periods of time. But if your investment horizon is shorter, you could face several years of poor returns at the most inopportune time. That risk is mitigated with more time invested in the stock market, which means spreading your investments out over as much time as possible.
Debt can be good
Some people are very debt-averse, but some debt can improve your financial well-being and provide additional flexibility while decreasing the risks posed by inflation and volatile stock market returns. A home mortgage is a prime example of that kind of debt, and the decision to pay it off early should factor in the above three considerations.
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