There’s a perennial debate in the financial blogosphere about whether it’s worth paying down a mortgage early or using the funds elsewhere. Often times, financial calculations are trumped by “emotion” whereby people justify paying down a mortgage early for “peace of mind” or because it feels better not having any debt. I suppose if you make decisions primarily on an emotional basis, then objective analysis is of no value regardless of the alternatives. However, if looking to compare apples to apples options financially to see where your excess funds are best spent, here are some different considerations.
- 30 Year Mortgage Term
- 3.75% Rate
- 2.x% Effective Rate given mortgage interest deduction offset by standard deduction
- Ability to put more funds toward paying down mortgage or other options
Now, I used the 30 year term to contrast with other options available (since using a 15 year term or lower is in effect paying down the mortgage early). I used a sub-4% rate with the assumption that you are either a recent homebuyer or have recently refinanced at today’s low rates. Finally, since mortgage interest is deductible, when you consider that into your actual annual payments, chances are your “true” interest rate is something south of 3%, but this depends of course on the size of your mortgage and tax bracket, so to keep it simple, let’s just call it 2.x or something less than 3%, meaning that any guaranteed return of 3% or greater would yield a better return. With these assumptions in mind, here are some alternatives that may or may not make more sense than paying down your mortgage earlier than necessary:
- Stocks – The stock versus mortgage argument is always a tricky one. History has shown that over very long periods of time, in this case, decades, stocks always outperform all other conventional asset classes and notably, don’t end up in the red. So, over a 30 year period, regardless of how scary the Euro situation, Healthcare reform and the impending election may be, chances are that stocks will return greater than 3% (probably double that or more), especially given dividend distributions in the 2-3% range depending on the index you use. The argument against is that in the near-term, there is a very high chance of loss of capital, so you have to be sure that this is a 30 year gambit. Then again, when you’re pre-paying a mortgage, you don’t see that ‘return’ immediately either, only when your mortgage is finally paid off.
- 529 Plan – Here’s a special situation I’d like to draw your attention to. Depending on the state you live in and plans you have access to, you can well exceed the returns on paying down a mortgage if you planned on funding your kids’ college expenses anyway. See, in my state, 529 contributions are state tax deductible, so it’s an automatic +3% return on any funds I invested regardless of underlying assets. Next, with college tuition rising at 5-6% a year, if you put it into the tuition plans (as opposed to stock/bond mix), you’re basically getting an 8-9% return annually without the risk and volatility of stocks and bonds. Of course, if you don’t plan on funding college for the kids then you’ll say it’s not an appropriate comparison, but if you are, it’s money you have to spend one way or the other, so why not let it grow tax free at an effective 8-9% over paying down a mortgage at an effective rate of less than half that?
- Bonds – Most corporate bonds can be had for a yield in excess of 3% for long maturities but you’re taking on the solvency risk of the corporation. Needless to say, a bond ETF is probably the best bet. US Treasury bonds have very low yields (which are driving down mortgage rates), so aside from the potential for loss in bond price when the bond bubble eventually bursts, yields are 3% or less for even longer dated maturities.
- CDs – Most CDs, even the longest durations available will not make sense. You’re tying up money with withdrawal penalties for sub-3% returns for the most part anyway. And they’re taxable. So, CDs probably aren’t a great bet.
What Are Your Thoughts on Mortgage Pre-Payment?