Paying Off Your Mortgage? Think Again!

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Includes: IWM, SPY
by: Manoj Madhavan
Summary

Paying off your mortgage may be done for emotional reasons. But it rarely makes financial sense.

This is especially so when you have a 20-year or 30-year fixed rate mortgage at a low rate.

Over any twenty-year period, the US stock market has never lost money.

Even a small increase in the average rate of return translates into a big dollar number over the long term.

The US Stock Market Has Never Lost Money Over A Twenty-year Period

If you look at the US stock market between 1825 and 2018, there have been many up years and many down years. However, the market has had many more up years than down years - 71% up years as opposed to 29% down years! In the last 194 years, there have been 138 positive years and 56 negative years.

You can read more about this here

The Stock Market: A Look at the Last 200 Years

and here

CAGR of the Stock Market: Annualized Returns of the S&P 500

and here

Long Term Total Returns

The fact is, the US stock market has never lost money over a 20-year period!! What is more, stocks have handily beaten bonds, gold, and real estate over the long run. If you reinvest dividends and are willing to stay invested for a 20-year period or longer, you can expect to get a return of 6% to 9% over time in the US stock market. Please note - I am not talking about investing all your money in Enron and losing it all or investing all your money just as Amazon (NASDAQ:AMZN) became a public company and making a gazillion dollars. I am talking about investing in a broad-based market ETF such as the S&P 500 Index fund (SPY) or the Russell 2000 Index fund (IWM).

Paying A 30-year 4% Mortgage Versus A 30-year Monthly Investment

Have you wondered what your savings would be if you paid the equivalent of a 30-year mortgage payment, every month, into an investment yielding a higher return? Wonder no more. I have calculated the final value of a 30-year monthly investment in the table below.

Mortgage rates fluctuate up and down, on a daily basis. Current 15-year, 20-year, and 30-year mortgage rates vary from 3.5% to 5% depending on your credit score, geographic location, and other factors. Let us assume a rate of 4%. We will also use a median mortgage balance of $225,000. Using these values, your monthly mortgage payment, excluding property taxes and insurance, would be $1,074.

Instead of making that mortgage payment if you could invest $1,074 in an index fund such as the S&P 500 Exchange-Traded Fund (SPY), what would the future value of those 360 payments (30 years of monthly payments) of $1,074 be?

Future Value of 360 monthly payments of $1074 with an average return of 6% per year

Future Value of 360 monthly payments of $1074 with an average return of 6.5% per year

Future Value of 360 monthly payments of $1074 with an average return of 7% per year

$1,078,849

$1,188,035

$1,310,249

As you can see from the above table, even a 0.5% increase in your investment return from 6% to 6.5% increased the final value by (1,188,035 - 1,078,849) or $109,186!

A 1% increase in your investment return from 6% to 7% increased the final value by (1,310,249 - 1,078,849) or $231,400!!

The point of this exercise is to show you that, even modest increases in your investment returns can translate to significant increases in final value, due to the magic of compounding.

Another point to be noted here - 30 years of mortgage payments of $1,074 every month for a 4% mortgage pays off a $225,000 mortgage balance. In those same 30 years, an investment with a 6% return gives you $1,078,849! Much higher amounts at 6.5% and 7%!!

As we saw in the section above, the US stock market has never lost money in any 20-year period. In fact, the long-term average return of the US stock market is between 6% and 9%, which is way above prevailing mortgage rates. So, from a financial standpoint, this is a no-brainer. If you have some extra money, put it to work in the stock market instead of making extra principal payments. We will go through similar exercises in the next couple of sections to drive home this point.

Paying Off A 20-year Fixed Rate Mortgage Today Versus Other Investment Options

As of Feb. 2019, the average 20-year mortgage was around 4.1%. Depending on your credit score and other factors, your rate may be higher or lower. Let us assume a rate of 4%.

The median home price around this time was about $225,000. Depending on the location of the home, size of the home, and many other factors, this number could be much higher or much lower than your specific case. I am going to assume $225,000 for my calculations.

Using an online mortgage calculator, I came up with a monthly payment of $1,363. I assumed $0 for property taxes and $0 for insurance because you have to pay those if you own a home (in most states). When it comes to property taxes and insurance, it does not matter whether you are making monthly mortgage payments or have no mortgage balance.

Let's say your rich aunt died and left you $225,000. You have two choices now. Invest the $225,000 in the stock market and continue making monthly mortgage payments for 20 years or pay off the mortgage and free up $1,363 each month to be invested in the stock market for 20 years. You could, of course, spend the $1,363 that you have now freed up, on vacations and other things, but we are trying to compare the two options strictly from a financial perspective. I know, I know - you could also, pay off part of the mortgage and invest the rest. In fact, there are a number of permutations and combinations between investing it all and investing none of it. But the two ends of the spectrum will give you a good idea of the magic of compounding.

Invest $225,000 in the stock market @6% annual return

Invest $1,363 every month in the stock market for 20 years @6% annual return

Invest $225,000 in the stock market @7% annual return

Invest $1,363 every month in the stock market for 20 years @7% annual return

Final value at the end of Year 20

$721,605

$629,762

$870,679

$710,023

As you can see from the above table, paying off the mortgage and investing all future would-be mortgage payments in the stock market is an inferior choice to keeping the mortgage and investing the inheritance.

If you had invested the inheritance and continued to pay the mortgage, assuming a 6% average annual return, you would have been better off by $721,605 - $629,762 or $91,843.

If you had invested the inheritance and continued to pay the mortgage, assuming a 7% average annual return, you would have been better off by $870,679 - $710,023 or $160,656.

Whichever option you choose, at the end of twenty years, you will own the house free and clear, and be left with a pile of money. How big the pile is, depends on, whether or not, you pay off the mortgage right away.

Of course, if you were confident of future income or cash flows at the end of the 20 years, you could always refinance the mortgage for another twenty years if the mortgage rates were low then. However, that would depend on your age, your health, and a host of other factors.

Paying Off A 30-year Fixed Rate Mortgage Today Versus Other Investment Options

As of Feb. 2019, the average 30-year mortgage was around 4.3%. Depending on your credit score and other factors, your rate may be higher or lower. Let us assume a rate of 4.5%.

As in the 20-year mortgage above, I am going to assume $225,000 as the mortgage balance for my calculations.

Using an online mortgage calculator, I came up with a monthly payment of $1,140. I assumed $0 for property taxes and $0 for insurance as in the 20-year scenarios.

Remember the rich aunt from the example above. Yes - you are not dreaming. You did inherit $225,000. However, you happen to have a 30-year mortgage and not a 20-year one. You have the same two choices. Invest the $225,000 in the stock market and continue making monthly mortgage payments for 30 years or pay off the mortgage and free up $1,140 each month to be invested in the stock market for 30 years. You could, of course, spend the $1,140 that you have now freed up, on vacations and other things, but, once again, we are trying to compare the two options strictly from a financial perspective.

Invest $225,000 in the stock market @6% annual return

Invest $1,140 every month in the stock market for 30 years @6% annual return

Invest $225,000 in the stock market @7% annual return

Invest $1,140 every month in the stock market for 30 years @7% annual return

Final value at the end of Year 30

$1,292,286

$1,145,147

$1,712,757

$1,390,767

As you can see from the above table, paying off the mortgage and investing all future would-be mortgage payments in the stock market is an inferior choice compared to investing your windfall in the stock market and continuing to make the monthly mortgage payments.

If you had invested the inheritance and continued to pay the mortgage, assuming a 6% average annual return, you would have been better off by $1,292,286 - $1,145,147 or $147,139.

If you had invested the inheritance and continued to pay the mortgage, assuming a 7% average annual return, you would have been better off by $1,712,757 - $1,390,767 or $321,990.

Whichever option you choose, at the end of thirty years, you will own the house free and clear, and be left with a pile of money. How big the pile is, depends on, whether or not, you pay off the mortgage right away.

Of course, if you were confident of future income or cash flows at the end of the 30 years, you could always refinance the mortgage for another twenty years. However, that would depend on your age, your health, and a host of other factors.

Reasons To Pay Off Your Mortgage

Of course, as with everything in life, there are trade-offs. And non-financial drivers for financial decisions.

There are a number of situations where paying off your mortgage, or making extra principal payments towards your mortgage, makes sense. The primary one is peace of mind. You (or your spouse) hate debt and you would rather pay off the mortgage and sleep well at night rather than earn a higher return on your money.

Another reason is that you expect to move in a few years and expect the house to hold up better in value over this time period as compared to the stock market. Remember, the stock market returns are higher only over the long term. In the short term, say 3-10 years, all bets are off. You could be in the market for a new home just as the stock market is going through a correction.

A third reason could be that you have trouble making the monthly mortgage payments and would like to build up some equity in the house in order to refinance to a more manageable mortgage payment.

A fourth reason is that you do not have the discipline to stay invested in the stock market through good times and bad times and would rather put the money towards the house where you will not touch it.

I am sure there are many other perfectly valid reasons to pay off your mortgage or to make extra principal payments towards your mortgage. However, if you compare the prevailing mortgage rates to the long-term historic returns from the US market, the smart thing to do would be to invest any extra money in a broad-based index fund such as the S&P 500 Index fund.

Conclusion

Due to the magic of compounding, even small differences in investment return percentages result in large dollar differences in final value over the long term. Current mortgage rates for 15-year, 20-year, and 30-year mortgages range from 3.5% to 5%. These rates are far below the historic long-run returns of the US stock market which has averaged 6% to 9% over any 20-year period going back almost 200 years. Many homeowners would be financially better off investing their savings in the US stock market as opposed to paying off (or making extra principal payments on) their fixed-rate mortgages.

Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.