A common goal for homeowners is to quickly pay off their mortgage. This means paying more each month so the principal is paid down at a faster rate.
Before you start paying extra to your mortgage, make sure you’re investing elsewhere first. Maximizing 401(k)’s and/or Roth IRA’s is a great way to do this. If you still have margin in your cashflow to put extra on your mortgage, it’s important to weigh your options objectively.
Consider this scenario:
30-year, $500,000 mortgage loan, at 4.25% interest rate, with a $2,459.70 monthly payment.
Option 1: Pay down your mortgage, then invest.
People who prefer paying off their mortgage insist they will get to invest larger amounts down the road when they no longer have a monthly payment.
If you start right away by applying an extra $500 each month to your mortgage payment, your mortgage will be paid off in roughly 21 ½ years instead of 30. At that point, you can invest a total of $2,959.70 each month (your regular mortgage payment plus the additional $500). After 30 years (paying the mortgage for 21 ½ years and investing for another 8 ½ years), you will have a paid mortgage plus an additional:
- $391,675 if you get 6% annually on your investments, or
- $446,868 if you get 9% annually on your investments
Option 2: Invest now and pay your regular mortgage payment.
Alternately, you can take that $500 every month and invest it in the stock market. Your mortgage will be paid off in the original 30 years, but you started investing a smaller amount for a much longer period of time than in option one.
After 30 years, you will have a paid mortgage plus an additional:
- $489,628 if you get 6% annually on your investments ($97,953 more than the first option) or,
- $857,190 if you get 9% annually on your investments ($410,322 more than the first option)
Time value of money says to invest earlier.
Many people falsely think that paying off their mortgage quickly and investing a larger monthly amount will mean greater wealth. But they’ve sacrificed years (in this scenario, 21 ½ years) that meant their money wasn’t growing and compounding.
These examples illustrate the power of the time value of money. For building wealth, time is the most important variable. The smaller amount invested over a longer period of time resulted in more wealth.
What do most people do?
In my experience as a financial planner, most people (given these two options) will choose to pay off their mortgage early. If the math supports investing, why would people do the opposite?
There are two powerful emotions at play:
1) Our desire for peace of mind and certainty. Paying down a mortgage means you are buying an asset—your home—where you raise your family, sleep at night, and spend most of your time. For some, having their home paid off brings peace of mind. They also see paying down debt as a certain outcome. There’s no reliance on the performance of the stock market to accomplish their goal.
2) A bias called loss aversion reflects our strong desire to avoid a loss rather than have an equivalent gain. In other words, we view our mortgage payment and the cumulative amount of interest that we will pay as a loss. This “loss” has a stronger grasp on our emotions than the potential to have over $400,000 more by taking the investing route. Even though we can invest and enjoy a sizable gain, the amount of earnings would have to be even larger to convince us to invest.
What role should emotions play in our financial decision making?
It might be impossible to be completely objective when it comes to making decisions with our own money. But it’s important to recognize when our emotions are causing us to make suboptimal choices.
Peace of mind is a great thing! But is it causing you to avoid investing in anything with risk and uncertainty? Not wanting to lose money can help you stay away from speculative investments, but is loss aversion making you invest in a diversified portfolio that’s too conservative?
Loyalty is commendable, but does your loyalty mean you’re attached to an insurance company you’ve had for years? Wanting to protect your assets is smart, but are you buying insurance on your cell phone while ignoring disability insurance?
I’m not saying to ignore emotions. Going back to our original scenario, some would be better off paying down their mortgage. But this decision needs to be made with objective advice.
In what areas of your finances do you need advice? Our team of financial advisors is here to help you make the decisions that are best for your situation.
*Future value calculations made at Dinkytown.net