The common answer to paying off debt or investing is wrong
Whether to pay off your debt before you start investing. It’s one of the most common financial questions, financial arguments really.
Most people say look at the numbers but I’ve got two reasons that make absolutely no mathematical sense but might just save your finances.
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Pay Off the Mortgage First or Invest?
Paying off a mortgage is the ultimate goal of many homeowners and investors. Some find comfort in knowing that they don't owe anyone but themselves; others enjoy the feeling of financial freedom and control.
But what if instead of using your money to pay down a loan, you invested it? How much more could you make by investing rather than paying off your mortgage early?
There can never be one perfect answer to this question because it always depends so as for financial experts, they advise individuals to seek out their personal best option, weighing numerous factors such as interest rates, time horizon for investment, available returns, risk tolerance, income needs in retirement, etc.
If you're thinking about putting all of your investment dollars to work by paying off your mortgage early and don't know whether it's worth it or not, here are some points to consider:
- It's a good idea if you're on the fence about paying off your loan early.
- This option may not make sense for everyone, however it is a great way to supplement investing and diversify your returns considering that mortgage interest rates can range from 3.5% to 6%.
- If money is short, this option will appeal to you because it doesn't require any further borrowing or credit availability like other forms of investment do (like stocks, bonds). Although by doing so you'd be losing out on future returns that could've been made in the stock market, for example.
- Even if you're at a relatively young age and not ready to retire anytime soon, consider looking into the benefits of taking out a reverse mortgage or other forms of equity release to supplement your income during retirement rather than pay off your mortgage early. However, keep in mind that this will decrease the amount you can leave to heirs (without paying estate taxes) because it counts as an asset.
- Owning a home may be considered less risky than investing since there is no chance of default on mortgages like there can be with stocks or bonds; however, should real estate values start falling and you find yourself unable to meet your payment obligations, you can expect other potential consequences such as foreclosure or lawsuits from creditors.
- The number one benefit that comes with paying down a mortgage early is that it increases your net worth by the amount you pay off; however, this will decrease over time due to inflation.
- If homes in your area are appreciating quickly and you want to keep up with real estate growth, investing would be more beneficial since equity gains on non-real estate investments via stocks or bonds won't be taxed like they are when selling property (capital gains tax), which could run up to 20% in some cases.
- Another thing to think about is if you can afford to allocate your funds towards paying off the mortgage early while still meeting all of your other investment requirements; for example, do you have enough equity in your home or other assets to take out a reverse mortgage? Do you have an emergency fund built up consisting of 6 months' worth of expenses?
- If the majority of your net worth is tied up into investments that generate income (example: dividends or interest), then it may be more beneficial to pay down the mortgage early rather than invest since there are tax implications involved with these kinds of returns.
- If you're currently investing in a taxable account and paying a higher rate of tax than the mortgage interest rate, this would make a case for not investing and simply pay down the mortgage early.
However, keep in mind that it's also important to note possible future changes to income tax rates since you may fall into a lower tax bracket after retirement when your income decreases significantly.
As with any major financial decision, there are numerous factors that need to be considered prior to making your final choice. While one option may seem preferable over another from an emotional standpoint, it's always best to look at things from an objective perspective and choose what makes most sense financially rather than what you want to do.
Why the Answer to Investing vs Paying Off Debt is Not a Numbers Game
One of the most common questions I get from the community is whether you should pay off debt or invest. There are a lot of side questions on this like whether to pay off student loans or the mortgage or just paying off those high rate credit cards before you start putting money to stocks and bonds.
Now the answer you usually see is a numbers game. You’re told to compare the interest rates on debt against investment returns and put money to the biggest numbers first. Essentially paying off any debt that costs more than you think you can earn on investments.
But that mathematical reasoning doesn’t account for a lot of the emotion around debt or other factors that are going to surprise you and change how you think about the question.
So what I want to do with this video is first do a quick run-through on the numbers. Show you the average rate on different types of debt and compare it against the average return on different investments. Then I’m going to reveal two surprise reasons that have nothing to do with the numbers but everything to do with the right answer.
I’m doing this video as a collaboration with Sarah, the Budget Girl, and I love the idea. I’ll share my perspective in this video but be sure to click over and watch her video next for the other view-point. We’ve argued back and forth on the question and she makes some great points so look for the link to her video in the description.
The Numbers Behind Pay Off Mortgage or Invest
So here we see average interest rates for three types of debt and different credit scores. This is from a survey by CreditSesame in early 2018 so rates are a little lower right now but we see mortgage rates from 4.5% to just over 6%. Car loan rates range from 3.6% to over 15% and credit card rates are the highest with an average 25% annual interest for bad credit borrowers.
Compare that against the average annual returns on different investments here in this data by JP Morgan for 20 years through 2018. We’ve got real estate stocks topping the list at 10% return, followed by investments in gold and oil producing a 7%+ return and stocks returning an average 5.6% return over the period. But let’s use this 60/40 bar, that’s a pretty common split for stocks and bonds and would have produced a 5.2% annual return over the last two decades.
Now if you were to take a hundred dollars a month and put it to one of these six types of debt or investment, over 10 years, the numbers should speak for themselves right?
Using that money on credit card debt, and I used the middle interest rate for each of these debts, using the $100 a month paying credit card debt would be worth over $27,000 at a 15% rate. Investing the money in REIT stocks would make you twenty grand over the period, paying off a car loan would be worth over $17,000 and investing across the stocks in the S&P 500 would have earned you just over $16,000 over the ten years.
Here at the bottom, so close that you really can’t make the two lines out is that 60/40 split between stock and bond investments and the mortgage debt at 5.16% interest.
Just going off the numbers, it makes sense to pay off just about any type of debt before you start investing and it’s a wash whether you pay off the mortgage or invest.
That’s the easy answer, the one you get from most people. You pay off that high-rate debt on credit cards and personal loans while slow-paying your mortgage and student loans.
That’s where I’m at with my student loans. I still owe over $61,000 on undergrad and graduate programs but at a weighted average rate of 2.9%…I’m paying the minimum and investing the rest.
Reasons to Invest instead of Debt Payoff
But even looking at the numbers, there are two reasons why you should break the rule and start investing even if you have higher-rate debt, let alone low-rate debt like student loans or a mortgage. It seems like a financially-dumb decision, investing for maybe a seven or eight percent return while paying 14% on a credit card balance…but I want you to think about this.
First off, shopping is just too much fun! You may never be completely out of debt or even if you do get to your debt-free scream, it might only be a few months before you find that new car you absolutely must have.
So even if you never get completely debt-free, you will definitely reach a point someday where you need to rely on your investments for retirement…God willing.
Now as a financial person, I know I’m not supposed to say this. I’m supposed to march to the drum of YOU MUST PAY OFF DEBT…but it’s just not realistic for everyone. Waiting to pay off debt before you invest means you may never start investing and you’ll be living off ramen noodles in retirement.
By the way, the average social security benefit is just over $1,400 a month and that’s before taxes…so yeah, ramen noodles and government cheese.
The other reason to start investing even while you pay off higher-rate debt is that it’s going to get you in the habit of saving and motivate you by watching that compound interest grow. Debt payoff is great but even if you manage to reach debt-free by your 40s, what then? You haven’t built that habit of saving and investing.
At this point, you’re looking at starting from zero and that can be a little scary. The result…a lot of people just don’t get started investing even after paying off debt.
Getting started investing early, even if it’s just $50 a month while you pay off debt is going to motivate you to save. That $50 a month started in your 20s grows to almost fifty grand over thirty years and that’s just what you can do on less than a dinner out.
So make the financially-dumb decision to start investing, even if you have debt or a mortgage at a little higher rate. Start that habit of saving and making your money work for you so someday, you’ll be able to stop working for your money.
Read the Entire Mortgage Series
- 4 Best Ways to Repay Your Mortgage Faster
- How SoFi Mortgage Rates are Beating the Competition
- Pay Off My Mortgage Early? Pfft…Not in This Economy!
- How a Portfolio Loan Can Help You Get a Mortgage on Bad Credit
- 5 Reverse Mortgage Alternatives to Get the Money You Need
About the Author
Joseph Hogue is a financial expert and investment analyst. After serving in the Marine Corps, he started his career investing in real estate before becoming an investment analyst for some of the largest private investors. He's appeared on Bloomberg and on CNBC as an investment expert and has published ten books in personal finance. Now he helps investors reach their financial goals and invest in the stock market with some of the same advice he used when working for the rich.