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Should I pay off my mortgage early?

When thinking about where to put your "investable dollars", paying off your mortgage early is probably one of the first things that come to mind. Now, a lot of you are thinking, "of course! Man, I can't wait until I don't have to make a house payment!" And a lot of you are thinking, "why on earth would I do that? The interest rate on my mortgage is low -- that makes no sense at all!"

And neither is wrong! On one hand, house payments are certainly a hefty chunk of change going out every month. On the other, assuming you refinanced shortly after the housing bubble burst, your mortgage interest rate is probably 3-4%. This is hysterically low for those of us who remember online savings accounts yielding 5%!

However, given that your mortgage is almost certainly the single largest loan you have ever or will ever take on, you should proceed with caution. Here are some things to keep in mind when doing your own analysis.

What's the return on investment?

Paying off a debt is simply a flipped version of investing. By putting money towards your loan, instead of gaining 5% in returns, you're not losing 5% in interest on your principal. The analysis mostly works the same: if your return on an investment is 5%, you will end up with more wealth if you put your money there than if you use it to pay off a 4% loan. Similarly, if the loan's interest rate is 6%, you'll end up with more wealth if you put your money there first, rather than the 5% investment.

I say "mostly" because there are a couple of wrinkles in the calculation. One of them is taxes: investments in a brokerage account are taxed as they grow, which effectively reduces the ROI of making an investment. Debt has no such problem. So when comparing the returns between the two, make sure you reduce the returns on your brokerage account by the effective tax rate, depending on how much of the estimated future returns are from capital gains, dividends, and interest.

Now, if your choice is between paying off your debt or making an investment in a tax-advantaged account such as an IRA or 401(k), this isn't an issue. Growth on tax-advantaged accounts is untaxed, so a 5% return is still 5% net of taxes.*

Barring that, there's another tax issue: the mortgage interest tax deduction. Theoretically, the interest rate of a mortgage is slightly reduced by the fact that every dollar you pay in interest is tax-deductible. I say "theoretically" because this only happens at the federal level if you itemize your deductions, and as of 2018 the standard deduction was raised to the point where most of you Texans won't be doing that anymore. If you're a Californian or otherwise get to deduct mortgage interest at the state level, it might be worth doing the math. The same goes if you have a whole lot of itemized deductions. (If you want to run the numbers, I recommend a spreadsheet and/or amortization table, since the amount of interest you pay annually will decrease over the years!)

Once you've figured out the expected rate of return, though, you're not done. There's also the statistical side to consider.

Monte Carlo simulations

Remember how I said a 5% investment and a 5% debt are exactly the same, save for a couple wrinkles? Another one is volatility: the ROI of your debt is exactly the same every year, but the return on stocks and bonds will vary (greatly) from year to year! This is where Monte Carlo simulations come into play. By looking at the potential outcomes, you can make a better comparison between investing in securities and paying down your debt.

What might that look like? If the expected return on your portfolio is 8% but your mortgage interest rate is 3%, then it might look unliterally better to invest in the portfolio. If the returns are closer, however, you may find that the success rate is higher when you pay down your mortgage, due to lack of volatility. Or the success rate may be the same, but the upside (lucky sequence of returns) results lower while the downside (unlucky) and median results are higher.

It's not all about long-term analysis

Of course, this is all purely looking at long-term analysis in some form or fashion. What about the advantage of not having a mortgage payment? Part of that is covered by a good Monte Carlo analysis: a paid-off mortgage = lower withdrawals in retirement = a higher success rate.

However, let's not forget the importance of short-term flexibility. There are too many stories of individuals/companies/hedge funds that have leveraged themselves into the ground! The 50/20/10 rule is a good place to start when thinking about this aspect of the analysis.

Now, don't make the mistake of assuming that your housing costs will go to zero when your mortgage is paid off, especially if you bundle your property tax into your mortgage payment. Texans may not have to pay state income tax, but our property taxes are the third highest in the nation, next to New Jersey and New Hampshire! (Speaking personally, property taxes are over a third of my total housing payment.)

Flexibility cuts two ways, though! Yes, it's true that when your mortgage is finally paid off, your expenses go down. However, it's also true that it's a lot harder to get money out of a house than it is to invest in it! If you put your money in a brokerage account, then a year later decide you need it, you can sell your securities and get your money back. If you use your money to pay down your debt, it's gone; the only way you're getting it "back" is through a home equity loan!

My take

"So, Mr. Hotshot Financial Advisor: what do you do?" Honestly, my situation is very different from a lot of my clients. As a business owner, I place a high premium on flexibility, so I'm not putting my money where I can't get it back out if I need it (see above)!

Many of my clients, however, have the flexibility they need, in which case we focus on the long-term analysis. Because my planning software takes taxes, withdrawals, expected returns, and volatility into account, the long-term analysis all neatly folds into the Monte Carlo simulations. The outcomes vary as I mentioned earlier, and the ultimate decision is up to the client and their preferences. Sometimes the analysis shows not much difference either way, in which case it's up to the client's emotional preference!

How about you -- what's your strategy? Do you consider mortgage good or bad debt on the financial ladder? Have you already paid it down, or will that be the very last thing you put your money toward?

* "But what about the taxes on withdrawal from a Traditional IRA or 401(k)?" Good point. They're balanced out by the tax deduction you get when you invest...but this assumes your tax rate is the same when you invest as it is when you retire. Feel free to run the numbers, but know that your guess on the tax rate in retirement is just that: a guess! (This is one of the reasons I love financial planning software.)

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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