Why you should (and shouldn't) pay off your mortgage
The question comes to investment adviser Jim Miller in various guises, but it comes frequently and it boils down to this: Is money better used to pay down debts or to build an investment nest egg?Skip to next paragraph
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Most often the inquiry involves a home mortgage. The other day, Mr. Miller says, it involved a pickup truck.
A client had just bought a vehicle, and wondered if he should pay for it by selling some investments. Miller asked him first to check what rate of return those investments had achieved over the past few years. The exercise prompted the client to change gears: He took out a loan for the truck so that he could keep more money invested.
The equation doesn't always work out that way, Miller says. Sometimes "eliminate debt" wins over "invest."
But the question is central to American family finances today. Household debt has reached a historic high, while personal savings are running low for many.
Interest rates add another wrinkle to the pocketbook puzzle: A recent rise in rates means that investors may be able to earn higher interest on a certificate of deposit than they're paying on their mortgage. In such cases, plowing free cash into investments may be more lucrative than paying down the mortgage.
"My take on it is pure bottom line," says Miller, a registered investment adviser in Columbiana, Ohio. "If in fact the rate that they're paying on a loan ... is substantially less than the rate that they're earning on their investments through real life experience, I encourage them to extend the mortgage as long as they can."
The phrase "real life experience" is key.
Some people invest on their own, others with help from a broker or adviser. But either way, it's important to gauge whether your money has been earning 10 percent or 3 percent annually - after averaging out the good and bad years. The rate of return is crucial, but just one of several factors in deciding whether to invest money rather than use it to pay down a mortgage.
Other factors include your level of financial discipline, your willingness to take on additional risk, your taxes, and your time horizon. Indeed, the choice is probably less about spreadsheet calculations than about temperament. For some people, paying off debt brings great peace of mind, while investing brings worry.
Others advocate keeping the largest mortgage possible - even borrowing home equity to put more money into stocks during market downturns.
"If you're aggressive, I'll tell you to leverage," says Roland Manarin, president of Manarin Investment Counsel Ltd. in Omaha, Neb. "The key to success is discipline."
In essence, this wealth-building strategy applies the principle known as "arbitrage." It's what bankers or bond traders do when they borrow at one interest rate, and lend (invest) at a higher one. This adds risk in the form of investment price swings. But in another way it reduces risk, since less of your net worth is tied to the value of a single asset: your home.