Longer version. Purchased a home a few months ago, and sold my previous house last week. So I now have several hundred thousand in my checking account but a new mortgage of several hundred thousand dollars. My options are to invest the money, or to pay off the mortgage that I’ve had a few months now.
I paid off the previous house about 10 years ago, through a second job, saving like a banshee and going without. I like the idea of not having a mortgage. I know there is a tax deduction for the interest, but I’ve always believed that that tax advantage is significantly overblown. The standard deduction is $12,700 for married filing jointly anyway, so any deduction for interest is over that amount, and you’re only getting pennies on the dollar on that anyway.
I’m concerned that we are at the end of this bull market not at the beginning of it so I’m not sure that’s a great option.
I have an emergency fund, and I’m able to max my 401(k) and finance my backdoor Roth.
So the question is this: Is there a plausible scenario where I should invest the money, with the understanding that I could overcome the 4% interest payment and tax on the earnings, or am I better of going mortgage free again?
It’s not a crazy strategy, though lots of risk-averse people will probably yell you that. But it is a question of your appetite for risk. Here’s some questions I would ask to figure out whether it makes sense:
[ul]
[li]How long are you prepared to keep the money in investments? Can you wait out a downturn without having to sell at the bottom?[/li]
[li]How secure are your other sources of income? Any chance you might lose your job unexpectedly?[/li]
[li]What is the likelihood that you will incur some major financial liability that would exceed your savings? Do you have older parents who are still alive? Kids?[/li]
[li]Are you psychologically prepared to see your money go up in smoke during a recession without pulling out of the market so you can ride out the downturn?[/li]
[li]Would you be happier having financial stability, or having more wealth that you can spend on things you like?[/li][/ul]
If you feel secure about your income, have an average or fewer number of likely sources of financial catastrophe, are prepared both financially and psychologically to ride out a downturn, and have some reason to think having more wealth will make you happier than having more financial stability, then I’d probably do it.
That said, I wouldn’t consider a max’d 401k and emergency fund sufficient. The big missing piece there is insurance. I wouldn’t place a lot of non-retirement investments before making sure I had appropriate coverage for life insurance, long-term care insurance, liability insurance (depending on your circumstances), etc.
Also: Don’t forget that you can deduct state and local taxes if you itemize, among other very common deductions. You may want to see if the mortgage interest in addition to these other items puts you significantly over the standard deduction, in which case you’ll at least want to discount the 4% slightly to account for that.
You may want to consider another option: partially paying off the mortgage and then refinancing it. You can probably get a much better interest rate if your mortgage is half the size and a shorter term.
If you pay it off, make sure you add it in to your bond allocation. It’s the equivalent of a 4% bond, so depending on how high your bond allocation is you might want to have your other investments 100% in stocks.
There is no right or wrong answer, but the way you frame the situation leads me to believe that you are risk-averse, and would value being mortgage-free more than investment gains that involve risk. The mortgage interest rate is reduced by any tax-savings you are entitled to above the standard deduction. If you have been itemizing, then it makes more sense to keep the mortgage. If you take the standard deduction, then the mortgage interest deduction isn’t worth much to you. It’s very difficult to earn more than 4 percent with a low-risk investment. It’s reasonable to earn more than that with long-term investments that might go down in value. So, yes, it’s plausible - and even likely - to earn more by keeping the mortgage, but not without ups and downs along the way. Keeping it in your checking account, or a savings account, will not earn you more than 4 percent. Buying broad-based mutual funds probably will, but not without risk and not without downturns that may take years to overcome.
If you choose not to pay off the mortgage, can you continue to maintain the emergency fund, max out the 401(k) and finance the Roth IRA while making the mortgage payments? If so, perhaps pay off the mortgage and then invest whatever the mortgage payment would have been.
Sure, there’s a “plausible scenario” where you’d wish you had kept the mortgage. Specifically, inflation might go higher than 4% and you might find investments that pay more than 4%. But the mere fact that the bank has offered to give you a 4% loan shows that they have already done the analysis for you and determined that it’s not likely. Why would they take only 4% profit from you if there was a strong possibility that they could make an 8% profit somewhere else?
Before you bought this new house, did you ever think “I should take out a loan for hundreds of thousands of dollars on my old house and invest in the stock market”?
Probably not.
But, that’s essentially the state you’re in.
You’re falling prey to overweighing the current existence of the mortgage in your calculations. Don’t let your choice of housing nudge you into other financial choices that you wouldn’t have otherwise made.
As Munch points out, this is an easy thing to change if you later feel like you really want a larger stock portfolio backed by a mortgage on your house.
Because mortgage loan to a qualified borrower is less risky than a stock purchase of equivalent value, and it will have lower return. Banks also make much riskier loans, with higher expected return. Indeed, they make riskier home loans.
For the OP, the question returns to appetite for risk. As others have pointed out, it’s not all-or-nothing. You can reduce the total interest you will pay on the home by paying off the mortgage marginally faster than you would have, but less than would eat up all your investment cash, and then put that cash in investments with higher expected returns.
A mortgage (or lack) distorts the investment picture because you are combining a domicile with an investment. In pure terms, assuming steady-state and consistent house value, think of it this way: you are essentially paying a rent on a house (mortgage plus maintenance, utilities) and also buying an investment (equity in house). The risks are of course, that the resulting paid off house is not worth as much as anticipated, and that the market may out-perform the house as an investment. Compounding this is that once paid off, a house is a saleable asset, possibly accrues in value, and is also free rent for as long as you choose not to sell.
So if you value stability and are there for the long term, paying off the house is the optimum strategy. Any other investment has to beat the 4% consistent your house is costing you since you chose not to pay it off.
Since you say you already have an emergency fund, I’ll restate the question this way.
If you have a giant multi-thousand dollar catastrophe (your car gets destroyed and you have to pay it off and get a new one, an earthquake strikes and you don’t have earthquake insurance on your home, etc.) How much will you have to pay to borrow enough money to fix things?
Assuming you can get a home equity loan for four percent, then great. Pay off the mortgage, and should you need a big sum of money quickly, get a home equity loan.
If you find that the cost of borrowing money is substantially higher than your current mortgage, then you may want to keep your cash in something safe but liquid.
Alternately, you might take Pleonast’s suggestion, put some of that money toward paying down your balance and possibly negotiate a lower interest rate.
It’s a mistake to think of yourself as losing the tax advantage of having a mortgage, because whatever you do with the money instead of paying it off is likely to itself be taxable, so you’re paying the same taxes.
Right now, the market is close to an all-time high. Which doesn’t mean that it can’t get even higher, but everything works in cycles and what goes up must come down. Especially since the Fed’s prior actions in goosing up the market means that they will be a substantial brake going forward. If the economy tanks, then the stock market probably will too. If the economy continues to move along as it’s been doing, then the Fed will gradually increase interest rates, which will undercut both the stock and bond markets.
If I were you, I would pay off the mortgage. If you were a veteran investor and/or already owned a portfolio that would be one thing. But if you just happened across a lot of money with both options, then I would think odds are on paying it off. You never know how it will turn out, of course.
This is probably right. But it’s also been probably right for going on 5-6 years now, hasn’t it? Has anything in the 5-6 year period caused you to update or modify your assessment?
One way to frame this would be to ask over how many 15-year periods the after-tax investment return on low-fee index funds has been <4%, and how many >4%. That’s at least a way to reach some kind of prior before factoring in how you think the market might be different this time.
I haven’t done that, and the sample size isn’t that large, but I suspect the answer is that few if any 15-year periods have failed to show a 4% (real) return.
I’ve always held that since I have no privileged (or reliable) view into the future, it would be a foolish risk for me to presume that I will ever again receive so much as one thin dime from any source. This attitude informs my lifelong reluctance (refusal) to subject myself to a mortgage.
It probably also plays a significant role in the fact that I do not expect to be able to retire before the age of 100.
The same could be said in response to anyone warning of any bubble.
There’s an old warning about betting against the market: “the market can remain irrational for longer than you can remain solvent”. The odds have been favoring the downside for a few years now (I don’t know if it’s as long as 5-6). How long the market can continue to rise is anyone’s guess. But it could turn any time, and you don’t want to be heavily leveraged when that happens.
FWIW, the sample size would be pretty big. The 15 year periods would be overlapping, e.g. 1993-2008 would be one period and 1994-2009 would be another, and so on. I suspect there are quite a lot of such periods.
But I don’t think it’s worth much. My point is that at this particular time the odds are tilted to the downside. If you limited your study to 15 year periods which began with the markets close to all-time highs, I suspect you would have a pretty high percentage failing to meet that target. More importantly, if you also limited it to periods where the starting interest rates were close to all-time lows, it would be a lot higher. (I’m not sure if historically these two things every happened at the same time. Generally high stock prices correlate with a strong economy which correlates with high interest rates. At this time the rates are artificially low due to Fed monetary policy, but I believe this combination is highly unusual or perhaps unique.)
Not that I think everyone needs to take all their money out right now (I myself have considerable funds in the market at this time and am taking a very long-term view of this). But I think for someone who doesn’t currently have a portfolio and who is not an experienced investor, this would not be the time to keep a definite debt in exchange for a risky portfolio.
Except in your scenario 2 you might end up with a fully-paid for house but little spare cash and have difficulty securing a mortgage on it (because you’re not employed).