Paying Off Mortgages vs. Investing

The investment industry is, of course, concerned with getting you to invest more, and therefore can be pretty biased toward that. While there are some good financial advisors out there who will take a more balanced and practical approach to managing your personal finances, which won’t involve an excessive focus and bias on investing, for the most part the industry does tend to seek to drive more business for themselves, which is actually pretty understandable.

Those who have at least some idea of how investments work will be familiar with the dynamic between risk and return, and investments are often compared to what we consider a risk free rate, where we use U.S. treasuries as the benchmark.

The risk of the U.S. government defaulting on treasury notes is about as low as you can get, as these are short term notes and the government will simply do whatever it takes to pay them out. In the very long term, these securities may eventually end up being more risky than they are, when for instance debt becomes unmanageable, but that’s many decades away at a minimum.

What’s even more risk free is paying off debt, because there’s absolutely no risk involved. If you make extra payments on your mortgage for instance, you know what your return will be and that return will never be subject to risk, you owe the money and you are guaranteed the return of the interest savings by paying less.

This is what we need to keep in mind when we compare the strategies of paying down our mortgage versus investing this extra money we may have, and while this does not always mean that we’re better off paying down the mortgage, it often does, given the types of investments that people usually make, long term stock market plays.

People selling investments will of course want you to invest more with them and will cite things like the average return of their investments versus the significantly lower interest savings involved, and when positioned that way, may even seem like a no brainer to the investor. We need to always use our brains when deciding what to do with our money though, and this is not quite as simple of a matter as it may appear.

We Can’t Ignore The Outlook and Time Frames Involved

The first thing we need to realize when we’re considering using our extra money to invest when carrying debt is that the benefits will accrue over the life of the mortgage, how much time we have left. If we owe $50,000 and we are considering paying down $5000 of that, our return on investment will be over the time that is left, let’s say 10 years, this is the time frame we need to be looking at, as far as looking to project what interest we’ll be paying on this extra money if we allocate it elsewhere.

These extra payments will reduce our amortization somewhat, the length of time it will take us to pay it off, but the entire amount will be subject to the rate the ensues during the entire time left. If we reduce the amortization to 9 years with our extra payments, then we’re talking 9 years of what rate we may expect.

Depending on the type of mortgage we have, this can affect our projections. If we know what the rate may be due to locking in a certain rate over the time left, this will be very easy, but less so if it’s an adjustable rate mortgage or if our current rate will expire during its lifetime.

All of this is just designed to give us a general idea of what the return may be expected to be on our extra payments, what we’re going to be using to compare with what we may get if we invest the money instead.

The most important element in this calculation is to take the time frame that our mortgage is offering and apply that to what may be expected with our investments. If we have 5 years left, it doesn’t make sense to look at very long term investment results or even long term.

Even if we expect to invest in the long term, for 30 more years for instance, and the time frame of the mortgage is much shorter, it does not make sense to use this longer time frame to evaluate this investment. At the end of the day, we’re going to have this extra money on one side or other of the ledger, and we are free to invest it after we’ve paid off the mortgage, so what happens in the years after that just isn’t relevant to the calculation.

In our example, on the one hand, we’ve used this $5000 to pay down the mortgage, and once it is paid, we have the $5000 plus the interest we saved in our hands. If we invest it, we have the $5000 plus the gains or losses of the investment in our portfolio. What this money may do many years later just isn’t something that matters.

It Comes Down To Assessing Risks Properly

The reason why this is an important distinction is that the time frame of the mortgage may be less suited or not suited at all to the investment strategy. If there is only 5 years left on the mortgage for instance, just investing the money for 5 years in the stock market, especially during a bear market, may simply not be suitable at all, because of the risk involved.

Investment advisors are not going to have you looking at the decision this way, because it’s their job to sell investments, and in any case it is unlikely that their training or knowledge is going to even put them in a position to think about managing risk very much. This is a lot like going to a car dealership and expecting a fair evaluation on whether you should buy a new car or keep the one you have, and expect that you will get an unbiased opinion.

To further illustrate this, let’s compare two scenarios, where one person used this $5000 to pay down their mortgage, and the other invested it. The 10 years are up, and the person who paid on their mortgage has achieved a 4% per year interest savings, and now has $7000 in their pocket.

The other person, who has invested the money, will have an amount that is entirely dependent upon how his or her investments have done, perhaps they have $10,000 now, or perhaps only $3000, or pretty much anything in between.

This is the point in time where the measurement will be made, and what we do know here is that the investment is going to have a fair bit of risk involved with it, quite a bit actually, and using the money to pay off debt will at least produce a very good return every time with no real risk involved.

We are therefore going to need to expect a considerably higher return with the investment on average to compensate us for taking on this risk. If we do not achieve as good of a return with the investment, or lose money on it, this is going to matter in real terms regardless of whether we’re looking to use or need the money at this point, or at some point many years later.

If we get knocked down to $3000 for instance, it doesn’t matter if in time we will recoup these losses and then some, because the other person can achieve the same thing with their investment. So if the market quadruples from there after this loss, the investor will quadruple their $3000 while the other person will quadruple their $7000.

What Really Matters Here

There are some cases where the expectations with our investments may well exceed that of what we may expect from paying down debt, and if we’re considering which strategy to use, these expectations will matter, and also differ.

The closer we are to needing the money, the more risk averse we need to be, and in our case if we need the money in the 10 years, this should influence our decision a lot. If we don’t need the money for 20 more years, this will matter as well, as we will then be more prepared to take on the risk involved.

Perhaps even more importantly is getting the idea out of our heads that these decisions need to be made once and for all right now. There is no idea that is more harmful to investors than this one, and this situation is a good example of this, where we’re expected to decide and decide now and not subject the decision to any further examination, since we’re supposed to just buy and hold with our investments.

A third person may view the market as bullish and decide, for now, to invest their $5000. At the present time, it has been decided that this money is better situated in the investments. Market conditions do change though, and perhaps when the bull market slows down or starts turning a little bearish, our friend may decide at this point that the money is now better suited to use to pay down their mortgage.

No one knows what will happen with markets and investments and the best we can do is assess the probability of things over a certain time frame. The longer the time frame used, the more uncertainty there is and the more difficult this is to predict.

The worst thing we can do is just subject our investments to however the wind may blow and take a completely passive approach to managing them, which equates to not managing them at all. The idea with investments is to make decisions that will make money, and those who make better decisions will simply make more money over time while at the same time seeking to expose themselves to less risk.

Seeking returns and managing risk are the cornerstones of good investing, we don’t want to use random approaches with either our entries or our exits, and simply ignoring them is most certainly a random approach and one that is executed with no skill or no attempt to be skillful.

By actually looking to assess the desirability of investing versus paying down debt, we can actually do what we’re supposed to be doing when we invest, which is deciding on what the best course of action may be at any given time.

It’s hard to go wrong with paying off your mortgage and saving interest as you can, although there may be instances where it can make more sense and be more profitable overall to invest the money instead. We just need to carefully consider the relative desirability and expectations here, and not just jump in because we’ve been sold.