Should you prepay your mortgage?
When should you begin collecting social security?
How should you distribute your assets to your children or others?
How would you make these decisions? These are issues that we advise and discuss with our clients.
For decades, the conventional recommendation would be to prepay your mortgage, particularly if you are retired or nearing retirement. For many people, it is emotionally important that they reduce or eliminate their mortgage prior to retirement. But is this the best thing to do today?
With interest rates so low, consider a new perspective. If you have a mortgage with an interest rate of 3-4%, the after tax cost of the mortgage is 2-3%. When interest rates eventually rise, your current mortgage interest rate will seem cheap. The longer your mortgage maturity, the greater this benefit may be. These facts should cause you to re-evaluate your thinking.
Let’s assume that you have a diversified portfolio which is balanced between stocks and bonds and you get an average annual return of 8-10% on the stock half of the portfolio. Over the long term, the investment return of the stocks and bonds should exceed the after-tax cost of the mortgage expense. And when interest rates rise, the fixed income return will increase. But your mortgage cost will not. Thus, in today’s economic environment, it does not make economic sense to prepay or accelerate your mortgage payments.
What will actually happen to the investment portfolio? There is risk involved, as no one can predict the exact return that will be earned each year. Over the long term, historical data tells us that 8-10% is the average return of the S&P 500 (made up of large US companies). Structuring a globally diversified stock portfolio, the expected return should be even greater than the expected return of the S&P 500. Adding components such as value stocks, small stocks, international and emerging markets stocks causes the expected return of this diversified portfolio to increase.
If your mortgage is 10-20 years, then your investment timeframe for this analysis should be 10-20 years. You should not focus on what the stock market will do in the next 3 months or 3 years. This decision requires that you change your perspective from an emotional decision (“I want to pay off my mortgage before I retire”) to a rational decision (“what is in my long-term best financial interest?”). This is the benefit of an advisor’s perspective.
Your financial flexibility should also be considered. If most of your money is in retirement accounts, you should not pay down your mortgage faster. If you start to get new money, such as collecting social security or increases in your earnings, using the money to build an investment portfolio actually gives you more financial freedom and security. If you pre-pay the mortgage, that money is “gone” or harder to get access to. If you really need the additional money, you would need to refinance or apply for a home equity loan.
This decision should be reviewed on an individual basis, but the general concepts apply to most people. When facts and times change, advice can change. Just because your parents or friends may have wanted to pre-pay or reduce their mortgage as fast as possible does not mean that strategy is in your financial best interest today.