Jason and Joy are homeowners in their mid-40s. They purchased their home in Scituate as first time homebuyers when they were 25. For the last 21 years, they have been scrupulous savers - moving every dime they could into paying off their mortgage and putting their two kids through college.
At long last, the day has come. They are ready to submit their very last mortgage payment and pay off their home. No more principal and interest. All of that cheddar now flows straight into their pockets. Sure, they still have to pay taxes and insurance, but they are immensely relieved and feel they can retire sooner given they have 100% equity in their home.
Sounds nice, doesn’t it?
Well, there’s more to the story here.
Because Jason and Joy put all of their discretionary income towards their home and college savings, they are going to rely 100% on their 401(k)s and social security for their retirements. For some, that may not be an issue.
The bigger issue here is one that you cannot even see at all, though it is very much real, and that issue is opportunity cost.
Opportunity Cost
The question here is the following: What else could they have done with that money? Answering this question helps us answer a few more critical downstream questions:
Did they make the right decision?
What does this mean for me?
In this article, we’ll look at one possible alternative - taking that extra discretionary income and putting it into the stock market instead of putting it towards your mortgage to pay it down early.
While I am a very financially-minded real estate agent who has researched and thought about these things for over a decade, I am not a licensed financial advisor. This is not financial nor investment advice, and I encourage you to chat with a licensed financial advisor before making any major financial life decisions.
Alternative Outcome
When Jason and Joy purchased their home 21 years ago, the purchase price was $715,625. They put down $143,125 and borrowed the difference ($572,500) at a 5.75% interest rate. It was a 30-year conventional mortgage. For simplicity, we are not including taxes/insurance, and we are assuming they have not refinanced at all during this period. Rest assured that if we did consider these factors that the math would tell the same story.
Purchase Price | $715,625 |
Down Payment | $143,125 |
Loan Amount | $572,500 |
Interest Rate | 5.75% |
Monthly Payment (principal + interest) | $3,373.75 |
Mortgage Type | Conventional 30-yr fixed |
After their monthly payment of $3,373.75 and their college savings payments, they have an extra $1,000 to put towards anything they’d like. Let’s assume their options are:
Put $1,000/mo into stock market index funds historically averaging 8% appreciation per year
Put $1,000/mo towards their mortgage, so they can pay it off earlier.
The Results
I ran the numbers in this spreadsheet, which you can make a copy of to check my math and run your own scenarios. You’ll find that the math is always going to tell the same story - putting money into an investment vehicle historically averaging returns greater than the interest rate results in a higher net worth figure.
With option 2, Jason and Joy paid off their home during year 21. At that point, they began investing the mortgage payment amount of $3,73.75 + $1,000 each month into the stock market index funds.
By the end of year 30, option 1 resulted in a net worth of $2,314,187.45 while option 2 resulted in a net worth of $1,445,250.85. The difference is a staggering $869,000.
$869,000 is a lot, especially when you consider the fact that the average American net worth in 2022 was estimated at $1.1 million.
How is this possible? What are the mechanisms, nuances, and caveats?
The math works this way mainly because of compound interest but also because there is a spread on the interest rates - the interest rate you are charged for borrowing on your home is 5.75%, whereas the average historical return on the index funds is 8%. If you borrow at 5.75% and earn at 8%, there is a spread of 2.25% that gets compounded over a very long period of time.
Most importantly, option 1 assumes that the investor puts $1,000 in each month regardless of financial situation and how the market is doing. Most people will not have the discipline to stick with this strategy. We all know the adage of buy low and sell high, but in reality no one has the fortitude nor the acumen to do this. This is why the index fund strategy works so well on paper and in reality. As an example, right now the stock market is getting crushed. Would you have the fortitude to invest $1,000 each and every month while the market is correcting? If the answer to that is no, then you may be better off with option 2.
Conclusion
Paying down your mortgage early when your interest rate is less than the long-term historical rate of return on a readily accessible vehicle like stock market index funds means there could be a lot of meat left on the bone.
That said, financial upside must be balanced with your real and perceived sense of financial security. Everyone has a different situation, different starting point, different level of financial education, and different comfort levels when it comes to employing what may seem like non-traditional strategies.
I strongly encourage you to engage a professional, licensed financial advisor to help you define your long term wealth building strategy and hold you accountable in sticking to it.
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