Even though I know the math favors putting that money in the market…
My wife and I bought our house in 2019 in the Bay Area. While that immediately signifies a massive purchase price, we secured a home we love for under the median price for the region. As we conducted our home search, we knew we would aim to buy far less house than we could afford, with aspirations of early financial freedom.
We ended up buying our home for only 35% of what we were pre-approved for. While we took out a 30-year mortgage to minimize monthly obligations, we always anticipated aggressively using any surplus cash flow toward extra payments to pay off the home in a small fraction of that time.
There is plenty of financial content out there debating whether to allocate cash flow to extra mortgage payments or into a heavily equity-weighted portfolio, with most of it recommending the latter as long as your mortgage rate is low (under 4% for example). The reason is that the expected return in the market after inflation is commonly modeled in the 7–10% range based on historical averages. Therefore, you should reasonably be able to expect a higher return on your investments than what you are paying in interest on your mortgage.
Additionally, if you have a fixed-rate mortgage, your mortgage payments are insulated from inflation. This means you will effectively be paying far less at the end of your mortgage term than at the beginning: less in interest due to the amortization and less in principle due to inflation protection.
All of this is true and my mortgage rate is right around 4%, yet I’ve still been paying it down aggressively with an expectation of full payoff later this year.
Why would I do that?
My family’s situation is specific to us, but our rationale boils down to 4 key points…
My belief in the market long-term is unwavering, but in the short-term, I’m not so sure.
I’m a firm believer in the long-term reliability of the stock market. I don’t get too concerned about dips here and there as the long-term trend has always gone up. The US economy is more resilient than many people think, having endured two world wars, a dot com bubble burst, 9/11, a massive lending crisis, and so much more.
The market as a whole has an inherent upward bias because the great companies reliably turn profits and the failing companies get replaced by companies that reliably turn profits. This “self-cleansing” element of the stock market protects its short-term volatility from posing long-term risk.
That said, there is still short-term risk. While the market has been on a tear since recovery from the housing crisis, it would be difficult to prolong that performance over the next decade. It’s not impossible, but bull markets typically don’t last for 20+ years.
Additionally, Vanguard’s 2021 Economic and Market Outlook Report forecasts only about 3.5–6% annualized returns over the next decade for US equities. As I plan to reach financial freedom during that decade, I do have some leanings towards minimizing my cash flow risk with a paid-off house. I want to avoid having to sell a substantial portion of my stocks during unfavorable years just to cover my expenses.
The faster you do it the more it makes sense.
If you have a mortgage, have ever had a mortgage, or have ever even thought of having a mortgage, you are probably at least somewhat familiar with amortization schedules. These schedules preclude you from paying much of your principal until the latter years of your mortgage schedule, heavily front-loading the amount of interest you pay in the early years. This is because the lenders want to get back their money quickly in order to lower their risk in the case of default, and also to reinvest that capital at today’s prices.
Because of how front-loaded the interest payments are in a typical mortgage, the total interest paid is substantially less if you pay down your house in year 5 versus year 10, but NOT so significant if you pay down your house in year 25 versus year 30. Here is the math behind that concept:
Scenario 1: On a $1,000,000 fixed loan at 4% over a 30-year term, paying off the outstanding balance in a lump sum in year 5 results in total interest payments of about $194k. Waiting until year 10 results in total interest payments of $363k, a difference of $169k!
Scenario 2: On the same $1,000,000 loan, paying off the outstanding balance in year 25 results in total interest payments of $692k while doing so at full term in year 30 results in $718k. This is a difference of only $26k even though the time difference is the same as in Scenario 1 (5 years).
There are plenty of free mortgage amortization calculators out there for you to plug in your own numbers and understand the tradeoffs for your specific loan, term, and interest rate. For the scenarios above as well as for my own analysis, I have used this one.
This is our forever home.
We plan to live in our current home for the long haul. Maybe a few decades down the line when we are empty nesters we could seek out a change, but for all intents and purposes, this is where we are laying our roots. If we were planning to sell in the short term, we likely would not pay down our home and instead, use the debt leverage to our benefit with disproportionate returns relative to our principal investment. In fact, that’s exactly what we did with our previous home…
We sold our previous property after about 5 years and 20% of the home paid. The home appreciated by 60% during that time. Since we only paid 20% of the purchase price, our effective return was about 300% (60% appreciation divided by 20% equity) excluding agent commissions, interest paid, and other expenses during those 5 years.
We used that profit to put into our forever home and turbocharge our payoff schedule. We could have instead used it to buy a more lavish home, but we were more interested in being wealthy than looking wealthy.
We want the freedom now to design our lives around our children.
Currently, about 50% of our monthly expenses are spent on two things: mortgage and childcare. With my oldest child starting public school this year, we have an opportunity to eliminate both of these expenses around the same time. Wiping out half of our expenses can buy us choices and flexibility during the years when our family needs it most.
If one of us wants to take an extended hiatus from work to be with the kids, or pursue an independent business venture built around our schedule, we can comfortably make that decision without fear or uncertainty when we don’t have a mortgage. We’re happy to forego some of the upsides of investment returns in exchange for that flexibility now because our children are only young once.
Additionally, the other 50% of our expenses are predominantly variable expenses and discretionary spending. This buys us added protection because if money unexpectedly gets tight, we can dial back these expenses as needed (which obviously we couldn’t do with a mortgage). Cash flow flexibility ultimately lets us design our lives around our kids instead of planning our kids’ environment around our jobs.
In summary, choosing between mortgage payoffs and investing is not purely a mathematical equation. If it were, the choice would be pretty simple in favor of investing.
The decision must also take into account your time horizon of when you expect a temporary or permanent decrease in income, how long you plan to stay in your home, and how quickly you could pay down your mortgage (during the early high-interest years or later in your term where the benefit is reduced). For us, the combination of these factors along with an insatiable desire for flexibility with our young children makes a paid-off home the right course of action for us.
This journey has taken a lot of frugality and discipline, but I’ll be happy to splurge on a nice bottle to enjoy in my fully owned backyard when the time comes.
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