Should You Pay Down Your Mortgage or Invest?

Mark Meredith, CFP®

With interest rates hovering around all-time lows, borrowers may not be in a hurry to pay down their mortgage. The common perception is that rates are very low, so now we can borrow at 2.5% – 3.5% to buy a home, and invest extra money into a portfolio that can earn more. Effectively you are leveraging your investment returns with a low fixed interest rate loan.

This century (through July of 2021), global stocks have earned 6.04% annually (as measured by the MSCI All Country World Index Gross Dividends), before taxes. Conventional wisdom would say that’s easy math, borrow at 2% or 3% and earn 6%+. End of blog post, right?

What’s Often Overlooked

Stocks do not maintain a constant expected rate of return. The expected rate of return moves regularly, and one of the components of that is interest rates!

Interest rates can affect valuations, and valuations can impact expected returns. Therefore you can’t (or shouldn’t) use past returns to extrapolate future returns.  Let’s view a quick framework of this general idea:

High interest rates = lower equity valuations = higher future expected returns

Low interest rates = higher equity valuations = lower future expected returns

Like everything else in finance, this is not a science. There are many other factors besides interest rates that impact valuations and expected returns. At the start of this century, stocks were at extremely high valuations despite interest rates being far higher than they are today.

People are most familiar with how changes in interest rates affect bond prices. If you bought a bond yesterday at a 5% interest rate, and someone could buy a very similar bond today at a 6% interest rate, it is obvious your bond is now worth less than it was yesterday. Who would want your 5% bond when 6% bonds are now available?

To unload the bond you’d have to discount the price down a bit, to the point where it would yield 6% to maturity for the buyer. Imagine you bought a 10 year bond for $1,000 at 5% interest, and the next day those identical bonds are being offered for 6% interest. Your bond would now have to be sold for about $926 to yield 6% to maturity for the buyer, meaning the paper value of your bond just loss 7%+.

This works in the reverse manner as well. Your 5% bond would be worth a bit more than what you paid if the next day we can only buy 4% interest bearing bonds. Sure, you could sell your bond for a profit but now you must reinvest the proceeds into a lower interest rate. This is market pricing efficiency at work.

The Risk Premium

Should we suspect that interest rate changes only impacts the value of bonds and not other assets? Of course not. Interest rates affect nearly all asset values. If you’re trying to determine what to pay for an investment in a business or a stock, you will model the estimated present value using a discount rate. The higher the discount rate used, the lower your present value is today. The reverse is true as well.

One way to look at this is through the lens that stocks offer investors a “risk premium” for the uncertainty involved. Over the 30 year period from 1988-2017, the global stock market earned 8.0% annualized while US 1 Month Treasury Bills earned 3.1%. Therefore the risk premium on stocks was approximately 4.9% annualized.

Today a 1 Month Treasury Bill pays 0.04% annually. If investors demand the same risk premium going forward from global stocks as was earned the last few decades, you’d only expect a return of about 4.94% annualized going forward (before inflation and taxes!). This is over 3 full percentage points below recent history.

There is good reason to believe the expected returns have dropped, if you look at the expansion of valuation multiples in recent history. NYU valuation professor, Aswath Damodaran, updated his implied expected return for US stocks on August 1st:

As you can see, Professor Damodaran is only expecting a total return of 5.61% annually going forward. But of course, it is an estimate. You can see in 2016 he estimated a 7.51% return, and since then US stocks earned 17%+ annually. The truth is, no one really knows what stocks will return in the future (sorry!).

When it comes to estimating future returns for your planning purposes, it’s good to lean on the conservative side. If you tilt towards areas that have higher expected returns at the moment, such as small cap value or non-US stocks, then you might be able to squeeze out some extra return.

It’s All Relative

It’s time to stir the pot! You should NOT find it any more preferable to pay off a 16% mortgage rate than you would a 3% mortgage rate, as everything should be relative. Why?

As stated in paragraph one, the conventional wisdom is to borrow at a low interest rate and invest into a portfolio earning a higher interest rate. As I’ve shown, stocks reward investors with a risk premium. When you have a higher interest rate mortgage, T-Bill rates are probably higher, meaning valuations are probably lower, meaning expected returns on equities are probably higher. Imagine what T-Bill rates would be if mortgage rates were 16%. Don’t worry I have the data…..

In 1981 we saw 30 year fixed mortgage rates peak at 16.64%. T-Bills were issued that year at a 14.54% annual rate. What do you think people were paying for stocks when T-Bills were paying 14.54% annually? Chances are that equity valuations were severely suppressed, when you can get a risk-free rate of 14.54%. If I’m right, then we should expect high returns after 1981.

Annualized Returns 1981 – 1989 (Source: DFA Returns Program):

MSCI World Index Gross Dividends = 19.09%
One Month US Treasury Bills = 8.60%

We see a risk premium from equities here of approximately 10.49% annually. The nominal returns for stocks in this period are quite high at 19.09% per year, but starting valuations were quite low.

What’s interesting is by the end of this 1981 – 1989 period, T-Bill rates had dropped considerably. You would suspect that with that, one could have refinanced their mortgage to a lower rate along the way.

Stocks should be priced to provide a risk premium over riskless assets like T-Bills. This of course does not always mean stocks will provide you the return you want, as risks can show up. No pain, no risk premium.

As we saw above, even with T-Bill rates paying over 14.5% in 1981 there was still a nice risk premium for equity investing in the subsequent period.

A Misleading Example

When I worked at a bank, we once had a “finance expert” from one of the largest independent firms in the country come present to the employees about personal finance issues. This was one of the very topics he discussed.

The way he framed the comparison on paying down a mortgage versus investing your money still irks me. Here is an example quite similar to what he used:

“Imagine you had $300,000 in a bank account as well as a 30 year mortgage with a $300,000 balance at 3% interest. If you pay the mortgage payments over 30 years, you will pay a total of $455,332. Meanwhile, you take your $300,000 and invest it into an account earning 3%, you’ll have $728,178 after 30 years. This is why you should NEVER pay off a mortgage early. Even if you only had a 2% annual return, you’d have $543,408 after 30 years.”

Seems compelling, no? The math is right, so what are we missing here? One thing not accounted for is taxes, but we’ll continue to ignore that for now.

What the presenter did not mention is the cash flow you’d free up by paying down the mortgage. If you paid off the mortgage immediately with the $300,000 bank account balance, you’d now have an extra $1,265 a month (the amount of the mortgage payment) to invest. If you invest the $1,265 each month and earn 3% annual interest, you’ll have $737,162 after 30 years. Paying off debt frees up cash flow to put towards other uses.

Do You Own Bonds?

A good case can be made that if you own bonds today, you should consider putting the money towards your mortgage (assuming the bonds are not tied up in a retirement account). The expected return on bonds going forward is very low, probably less than the current fixed mortgage rates.

As a bondholder you are a lender, and if you have a mortgage you are a borrower as well. Philosophically, why would you borrow money and turn around and lend it to someone else at the same time. You could be paying a higher interest rate than the one you are receiving. It could be worth considering to use your bond allocation to reduce your personal debt.

What’s The Answer?

The answer is that this can largely be a matter of personal preference. Paying down your mortgage is essentially a guaranteed rate of return, as you are eliminating the interest expense associated with it. If you are one without a strong faith in equity investments, it’s a valid approach.

I would expect a well diversified equity portfolio would outperform the current 30 year mortgage rate over the next few decades, even after taxes. If your goal is to maximize wealth, that would also be a reasonable approach to take.

While some may view money being put towards a mortgage as dead weight and illiquid, you can always have a standing home equity line of credit against the home if you ever wanted to utilize the funds. These credit lines are usually quite inexpensive to set up and you’ll only pay interest as you draw against it. The interest rate floats with market rates. Opening up a home equity line after you obtain a chunk of home equity can be a good way to access credit quickly at rates much lower than a credit card.

What would you regret more, paying off your low interest rate mortgage then watching stocks earn 7% annually the next 30 years? Or keeping the mortgage while investing extra cash, and watching yourself earn an incredibly low return over that time frame?

If you don’t think that is possible, be aware that Japanese stocks earned 0.78% annually over the 30 year period from 1990 – 2019. It’s unlikely that would happen in a globally diversified portfolio, but it could. One must be aware of the potential outcomes before making a decision.

Disclosure: Past performance does not predict future results. This article is for informational purposes only and should not be considered a recommendation. Information contained in this article is obtained from third party resources that Meredith Wealth Planning deems to be reliable. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.

Don't go through retirement alone.

Step 1) 30 Minute Consultation

A quick chat to get to know each other and learn more about what you're looking for in an advisor

Step 2) Think About It

We know that working with an advisor is a big decision, take some time & sleep on it

Step 3) Recommendations, Strategy, & Implementation

When you're ready, we get started with our planning process

Talk with a retirement partner today
A no-pressure, 30-minute conversation to see if we're the right fit for you
Schedule Your Free Consultation