Do you have some extra money, and a mortgage, and you’re wondering whether you should put that extra money towards that mortgage?
Maybe you have some room in every paycheck after doing the “usual” savings. Or maybe you recently had a windfall, like an inheritance or bonus or RSUs that vested.
If you have a mortgage, this is usually when you’d start asking yourself, “I wonder what I should do with this extra money. Should I put it towards my mortgage? But then again, I always hear that you should invest it, because the stock market should return more than my mortgage rate. Oh, I’m so confused!”
And then you close your eyes and make a decision, which may or may not involve actually spending the money or setting it aside in a savings account, earning bupkus, because it’s too damn stressful to figure out what to do with it.
Comparing Your Mortgage Rate to Stock Market Returns Is Apples and Oranges. So Stop It, Already.
Since 1992, the Vanguard Total Stock Market Index Fund has earned an average of 9.67% each year. If your mortgage interest rate is 4%, why would you ever pay down your mortgage, for a 4% return, when you can invest it in the stock market for a 9.67% return?!
Let’s start with this: That isn’t the right or helpful comparison. Why? Because you’re only comparing returns (4% vs. 9.67%), not risk. What do I mean by risk, in this case? The risk of losing your money, basically.
- If you invest $100 in the stock market, yes, you could have $120 at the end of the year (a 20% gain). You could also have $50 (a 50% loss). It’s unknown, and therefore risky.
- If you “invest” $100 by paying down your mortgage, you are guaranteed to save 4%.
The proper and instructive comparison to make is: What return could I get with this $100 if I bought a U.S. government bond with it? A government bond is as close to “guaranteed return” as an investment can get.
Most of us wouldn’t buy individual bonds, so let’s look at Vanguard Long-Term Government Bond Index Fund Admiral Shares (VLGSX) for what such an investment would return. The current yield in this bond fund is 2.73%.
If your mortgage interest rate is 4%, you will get a “return” of 4% by paying down the mortgage, whereas you’d get a return of only 2.73% by investing in something with a similar risk level.
So, if your mortgage is higher than 2.73%, you will be better off paying down your mortgage instead of investing your extra money.
Yes, You Can Adjust for Itemizing/”Writing Off” Mortgage Interest. Oh, I can hear the cries already: “But what about writing off your mortgage interest on your taxes!” And yes, valid point.
If you itemize your taxes, and you include the mortgage interest you paid, your effective interest rate is that 4% reduced by your tax rate. So, if your top tax rate is 25%, then your effective mortgage interest rate is 4% minus (25% of 4% = 1%), which is 3%. (Which, you might notice, is still higher than the long-term government bond fund’s return. But, of course, that isn’t always the case.)
This “writing off” thing, however, isn’t universal. For those of us who live in no-income-tax states like Washington here, this argument is weaker: with no state income tax to itemize, fewer of us end up itemizing at all. For those of you who live in high-income-tax states like California, and therefore are more likely to itemize taxes, this argument is stronger.
But keep in mind that if the Republican tax proposal goes through, everyone is less likely to itemize deductions, and your ability to itemize mortgage interest will be reduced (you will be able to itemize interest only on the first $500k of a mortgage…and I have lots of clients taking out larger mortgages than that, to buy in these expensive markets).
Keep Enough Money for “Oh Sh*t!” Moments and Good Opportunities
My very first boss in this industry taught me a lot. (And I didn’t appreciate it nearly enough. Oh, lord, if your mid-30s isn’t mature enough to appreciate the wisdom of your elders, when is?)
One of the things she harped on with clients is having a good balance of taxable and retirement money. I’ve written about the importance of having both kinds of money before.
- Retirement money is hidden away behind IRS wrappers like IRAs and 401(k)s, where you can’t get it out until you’re a certain age (59 ½), lest you owe a substantial penalty.
- Taxable money—be it cash in the bank or investments in a brokerage account—on the other hand, is yours to use for whatever reason whenever you want. The byword of taxable investments is flexibility.
You know what is the most effective way of having too little taxable money? Using all of it to buy your home. This is often unavoidable: In expensive markets like the Bay Area or Seattle or Washington DC, a downpayment is simply a lot of freaking money, and you wring out your savings and investment accounts to come up with it.
But now your wealth is in two places: Your House and Your Retirement Accounts. This situation is risky. Why? Because sh*t happens. Sometimes it’s even good sh*t! But sh*t usually requires money: medical surprises, an invitation to go around the world with a friend, the opportunity to quit a job and start your own business, oops! Pregnant! And so on.
And where is that money going to come from?
From your retirement accounts? If you take it from your 401(k) or IRA, that’s gonna cost you. In income tax and in penalties. I also believe that there’s an important psychological reason for Never Touching Your Retirement Accounts (even if there are some savvy ways of doing so, which there are). Once that protective wrapping is breached for non-retirement purposes, I think it gets waaaay too easy to breach it again.
From your house? To get the money from your house, you’d have to refinance or take a home-equity loan. I don’t like those ideas, generally, for two reasons:
- Those loans are usually at a higher interest rate than your original mortgage, and
- Again, it starts creating a habit of using your home equity for non-home stuff. And that is a habit, much like the habit of taking money from our 401(k)s, that I desperately don’t want you to start cultivating.
How Much Taxable Money Do You Need?
How much taxable money you need “depends.” It depends on how much cash you need to feel comfortable, how uncertain your life is for the next few years, and what dreams you have for your life in the next few years.
At the very least, you need an emergency fund that can cover 6 months of basic expenses. But that’s just cash in a bank account. That’s not investments that can grow and enable you to take advantage of opportunities that open up, say, 10 years from now.
And you need some of that, too. Alas, unless you’ve got a crystal ball, the exact dollar amount you need is unknown, and unknowable. But “some” is definitely a good start, so don’t let the lack of exact knowledge keep you from building that “Dream Bucket.”
Let me tell you, I am happy that my husband and I didn’t deplete our taxable savings when we bought our house a little over 2 years ago…because it wasn’t long after that we decided that I would launch my own financial planning firm and my husband would quit his job to become the stay-at-home parent.
We stopped having an income and lived off that sweet sweet taxable money for a while. Having taxable savings gave this financially conservative woman the confidence to Try Something Big.
Our Animal Brains and How They Hate Debt
The book Happy Money (highly recommended, fwiw) talks at length about how debt make us unhappy. (Just google “debt makes us unhappy” to find an abundance of other articles on this topic.)
Some of us more so than others, and some kinds of debt more so than others, to be sure. But it is a relationship that has nothing to do with logical comparisons of investment returns and interest rates. Being indebted simply makes us unhappy.
So, if we understand that we should use money to make ourselves happier, which is not the same as richer, that argues for using extra money to pay down our mortgages.
When you think about owning your house outright, do you immediately feel lighter, happier, unconstrained? You proooobably want to think about paying down your debt with extra money, rather than doing anything else.
I have a client couple who credits their explosion in Net Worth to paying down their mortgage. It wasn’t any fancy financial shenanigans…it was simply that once they no longer had a mortgage hanging over them, they felt empowered and motivated to save and invest and <grrr!> own it, baby!
I, for one, am eager to pay off my mortgage ASAP, as I love love love the idea of being debt free. It fills me with a gooey warmth.
What’s Your Answer?
There are a few times when it’s obvious what you should do with that extra money:
- Do you have a big enough emergency fund? I like a fund that can cover 6 months worth of basic expenses. Yes, that’s a lot of money! Deal with it. Life turns to crap sometimes, and you really need that cash to get you through. If you don’t have that much cash, any extra money you have first goes to build an emergency fund.
- Do you have other debt, with higher interest rates? A car loan? Student loans? Credit card debt? Pay those off first.
- Are you saving at least 15% towards retirement? No? Make sure 15% savings is coming automatically out of each paycheck.
But honestly, like many other financial decisions, most times this is not obvious. It has many influences:
- Your attitude towards risk and investing
- Your attitude towards debt
- Your financial goals
- You current balance of taxable money versus retirement money
But let me reassure you: Whether you use your extra money to either save/invest, or pay down your mortgage, you’ll be better off than if you choose to spend the extra money. The “save/invest vs. spend” question dwarfs the “save/invest vs. pay down mortgage” question.
If you’re asking yourself “Should I pay down mortgage or invest this extra money?” you’ve damn near won the game already.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Meg Bartelt, and all rights are reserved. Read the full Disclaimer.