Should I Pay Off My Mortgage or Invest, Using Asset Allocation
Recently, I wrote a post titled Should I Pay Off My Mortgage or Invest?
In the contents of that article, I addressed several factors to consider when evaluating whether or not to pay off your mortgage or invest. Some factors include:
- How much do you hate having debt?
- How far in the future is retirement for you?
- What’s the condition of your emergency fund?
These get a little subjective and I highly suggest you go back and check out the post or video if you haven’t already done so.
I did eventually get around to talking about the math behind the decision as well.
When making this choice from a purely mathematical standpoint, you’ll obviously want to direct your money to whichever option has the higher interest rate.
If the interest rate on your mortgage is higher than what you can earn on the money you invest, then you should pay off the mortgage.
If you can obtain a higher return by investing, then you should do that instead.
The math really is that simple, but forecasting returns on investments presents a significant challenge. After all, who knows how investments will perform from one day, week, month, or year to the next?
In the past, I’ve tried to avoid this lack of predictability by suggesting that one compare the interest rate on their mortgage to the risk-free rate of return which isn’t normally very volatile.
There isn’t really a completely “risk-free” return, but US Treasuries are the closest thing available to most of us, so that’s what I’ve proposed.
Anyhow, the idea is if you can make, say, 5% on a short-term T-bill, but you’ll only save 3.5% on prepaying part of your mortgage, then you’d want to buy some T-bills, right?
Here’s the math on that, assuming you have $1,000 extra you want to invest or put on the mortgage:
- T-bill – $1,000 x 5% = $50
- Mortgage – $1,000 x 3.5% = $35
In this case, you’d come out $15 better for each and every year you can manage to earn 5% from those T-bills.
Yeah, But Treasuries?
Here’s the thing…I don’t normally invest in treasuries.
Sure, I have some short-term notes inside of a money market fund, but that’s for my emergency money, not long-term assets that I’m trying to grow.
Recommending one thing while I’m doing something else seems hypocritical so I thought I should write a post explaining the decision I’ve made and why.
In my case, I have a mortgage with a balance of about $220,000 at 3.5% interest and 22 years left on the term of the loan.
No, 3.5% is not a very high interest rate so you can probably predict where I’m headed with this.
I’m earning over 4% in my money market account right now, so this really is a no brainer for me.
However, like I already said the decision to invest or pay off my mortgage isn’t being made with money that I’m going to put into treasuries. It’s with money I plan to invest for a long time. So, how can I be confident that other investments won’t produce lower returns than 3.5% annually?
I can’t.
But what I can do is evaluate the historical performance of an investment portfolio like mine and compare that to my mortgage.
This is where some super helpful data from Vanguard comes into play.
What you see below is a summary of the performance of a variety of portfolios with various asset allocations going all the way back to 1926.
This graph shows portfolios ranging every 10% from 0% to 100% stocks to bonds.
The red and blue bars recommend the worst and best years, respectively, for each of the asset allocations in the graph.
The white line in the center shows the average rate of return for each asset allocation over the period.
So, a 60/40 portfolio has had an 8.6% average rate of return, a minimum single year return of -26.6% and a maximum single year return of 36.7% since 1926.
For reasons I’m not going to bother explaining now, my asset allocation is 100% in stocks meaning the historical average return is 10.2%.
This far outpaces the 3.5% interest rate on my mortgage, so I see no need to pay off my mortgage early.
Again, historical returns are in no way a guarantee of future performance. The next 100 years could look much better or much worse. There’s no way to know for sure.
This information is designed to stir thought. You’ll ultimately have to decide for yourself which course to take in your own situation.
Comparing Other Rates to The Data
Next, I want to illustrate how the result might change based on higher interest rates.
If you’ve paid even a small amount of attention to interest rates in the last couple of years, then you probably know that they have climbed quite a bit in that span.
As I write this in September of 2024, a 30-year mortgage will come with an interest rate of around 6.25% if you have excellent credit.
It’s a completely different realm than what we were in leading up to 2022 and it makes this decision a bit more difficult, especially if you’re relying on math alone.
Well, to help compare the return data based on asset allocation to the interest rate on your own mortgage, I’ve built a little table that I hope will be helpful.
For the combination of mortgage interest rates and expected returns based on asset allocation where investing is advantageous mathematically, the cells are blue. When paying off the mortgage is more beneficial the cells are red.
As you can see, using this method there will rarely be a scenario where it makes sense to pay off the mortgage early instead of investing the money.
Where there was a tie in the interest rate and rate of return, I awarded the advantage to investing because it preserves liquidity while money directed to a mortgage will be much more difficult to retrieve without selling your home.
The only cases where the advantage shifts toward paying off the mortgage is when you either have a very conservative investing approach or when you have a very high interest rate on your mortgage.
Conclusions
In summary, if your investing strategy is relatively aggressive and you don’t have plans for the money within the next 5 years or so then you’re probably better off investing the money.
Even if the interest rate on your mortgage is high you need to bear in mind that there is value to having liquidity. If you direct cash into paying off your mortgage early you will lose access to that money unless you either sell your house or take out a loan against it.
As a result, if returns are similar to your interest rate I tend to lean toward investing instead of paying off your mortgage early.
Finally, the closer you are to retirement, the less the difference in returns over your interest rate matters because there’s less time for the difference to compound and grow. It’s just not as valuable because there isn’t as much time.
In that case, just having the mortgage gone for good or having a higher degree of control over your income in retirement may be more important to you.
The truth is many people spend far too much mental energy on this decision. Odds are selecting a correct asset allocation for your goals and being careful about how much you spend on a house in the first place are going to have a bigger long-term impact than the decision to invest or pay off the mortgage early.
