Most people assume that the sooner they pay off their mortgage, the better they will be financially. They point to the thousands of dollars of interest expense that they would avoid each year that the mortgage is paid off early. While the cost of keeping a mortgage is easily understood...most people don't consider the opportunity cost of paying off their mortgage early. This opportunity cost is the amount of money that could have been earned above the cost of the mortgage if the extra payments were invested for long term growth instead of used to pay off the mortgage early. Andrew Mohrmann, a financial advisor, illustrates this opportunity cost well in his article entitled "Why You Shouldn't Pay Off Your Mortgage Early".
In his article, Mohrmann shows how, by investing the money that would have otherwise been used to make extra mortgage payments, you could increase your net worth by tens of thousands of dollars over the life of a 30-year mortgage – even assuming conservative rates on your investments. Given current 30-year fixed mortgage rates (especially their after-tax cost, assuming you itemize deductions) and the tax-advantaged investment vehicles that most people have access to (Roth IRA, 401K, 403B, etc), investing instead of pre-paying a mortgage is a strategy worth considering.
Whether or not this is a smart financial strategy, depends on your individual circumstances, goals, time horizon, and whether you have sufficient safety nets (emergency funds, disability insurance, life insurance, etc) to afford the additional risks. Obviously, for individuals approaching or in retirement, the considerations are different. While not pre-paying your mortgage is likely the most optimal financial path for younger individuals, it comes with some trade-offs:
- There is no guarantee that investments will outperform the cost of the ~4% fixed 30-year mortgage (although that would be unprecedented in the history of the markets over a 30 year time horizon).
- It may prolong the importance of life and disability insurance coverage.
- It only works if you actually invest the money for long term, diversified growth. Without follow-through, you’d be better off making extra payments on the mortgage. It’s also important to keep the underlying investment/fund expenses to minimum.
If you're interested in knowing which strategy makes the most sense in your situation or how to implement your investment strategy, we'd love to help you. You can reach us by phone at 620.931.5285 or email John@LongviewAdvice.com.