Over the last two weeks I discussed four reasons why it’s usually bad advice to pay off your mortgage early. In Part I of the series, I went over Opportunity Cost and how this alone could cost you thousands, if not hundreds of thousands of dollars. And in Part II, I wrapped up the series by discussing Loss of Control, Lack of Diversification, and Shortfalls in Other Goals. However, in this week’s blog post, I will spend some time reviewing three situations when it just might make sense to pay off your mortgage early.
It’s likely you’ve never heard of sequence risk before, so let me explain. Sequence Risk basically boils down to the order in which you receive your investment returns while withdrawing from your investment portfolio. The risk is that you will increase your chances of running out of money if you have negative (or poor) returns when you first start withdrawing from your investment portfolio. The important thing to know is that Sequence Risk only matters when withdrawing from a portfolio. Let’s look at two examples.
Example 1: No Withdrawals From Portfolio
Let’s first start with an example in which you are not withdrawing from your investments. Assume that you have $100,000 that earns 10% in the first year, 5% in the second year, and -9% the third year. Your ending value after three years will be $105,105. Interestingly, if you completely reverse the returns to where you receive -9% in first year, 5% in second, and 10% in third, your ending value will be exactly the same ($105,105).
Example 2: Withdrawals From Portfolio
Now let’s assume that you will be withdrawing $5,000 per year from your $100,000 investment. With the first order of returns (10%, 5%, -9%) your ending value is $90,778. However, with the second order of returns (-9%, 5%, 10%) your ending value is lower at $88,830. Notice that the average of both sequences of returns is 2% per year; however, the portfolio that started out with a negative return ended up with a lower balance. This is what happens with sequence risk and could cause you to run out of money early.
So, how does this tie in to paying off your mortgage early?
If you are saving for retirement then you may also decide to pay off your mortgage early so that you don’t have to deal with sequence risk. Doing so will reduce your retirement expenses which will result in having to withdraw less from your investments and therefore will minimize the effects of sequence risk.
With all that said, there are many factors that go into calculating your probability of running out of money – age, investment time horizon, rate of return expectation, type of investment portfolio, mortgage interest rate, etc… And as a result, there is no substitute for looking at your individual circumstances and modeling both scenarios to determine which option you’re most comfortable with and which option mathematically appears to be the best.
As I mentioned in Part I of Should You Pay Off Your Mortgage Early, if your investment rate of return exceeds the interest rate on your mortgage, then it is financially more beneficial to invest excess cash flow rather than pay extra toward your mortgage. However, if you are a conservative investor then there is a chance that your expected investment return will not exceed your mortgage interest rate.
A good example of this is a person who has accumulated a large enough investment portfolio to sufficiently meet their income needs without having to take on much risk. In this situation, a person could invest the money in a very conservative manner (for example a high quality, short-term bond portfolio) and would possibly not need a large investment return to meet their needs.
In this case, the investment rate of return may not exceed the mortgage interest rate and therefore, it would likely make more sense to pay off the mortgage early. In fact, it would be financially more beneficial to do so.
Let’s go through an example. If you have a $250,000 mortgage with a 30 year note and a 4.00% interest rate, you could pay an extra $650 per month to pay off the mortgage in 15 years. If your investment rate of return was only 3.00%, then you would be financially better off paying extra toward your mortgage. In fact, your net worth would be $38,000 larger by doing so.
So, the important takeaway is that if your investment rate of return is less than your mortgage interest rate, then give some consideration to paying extra toward your mortgage.
TIME IN HOUSE
If you aren’t going to be in your house for “very long” then it could make sense to pay extra to your mortgage as opposed to investing your money. This makes sense as you need time to allow your investments to grow and stock markets are more volatile in the short term.
But, what is defined as “very long”? Is it 1 year in your home, 5 years, 10 years, or more…. I’ll attempt to answer this question in a round-a-bout way.
When you pay down your loan early and ultimately sell the home you will have “guaranteed” equity at your disposal. In other words, you are guaranteed to save interest; it is a sure thing. When you do the alternative and invest your money, there is no guarantee as the stock market (or any investment) could shift downward causing you to lose money. This is especially true in the short term.
Over short periods of time, the stock market can fluctuate wildly. However, the stock market historically has more certainty the longer your investment time horizon. Did you know that from 1926 to 2016, there has never been a 15 year, calendar-year period when the U.S. Stock Market (as measured by the S&P 500) lost money? And when measured monthly, 15-year time periods had a positive return 99.78% of the time. Only 2 out of 919 15-year periods had negative returns.
So, does this mean that if you plan to be in your home for less than 15 years then you should pay extra toward your mortgage?
Not necessarily because even at a 7-year time horizon, the stock market was positive 95% of the time. While not 99.78% like the 15-year time horizon, 95% is still significant odds in your favor. Based on this evidence you should give some consideration to paying extra toward your mortgage if you will be in your house for 7 years or less. Any longer than that, you may want to lean toward investing the money instead.
In summary, you can see how these three particular situations could result in you paying extra toward your mortgage. However, I believe the reasons listed in Part I and Part II of Should You Pay Off Your Mortgage Early provide more compelling evidence for why you should NOT pay off your mortgage early.
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