On this blog and elsewhere, I’ve been an advocate for shedding debt. Including paying down your mortgage early.
Investments are a gamble. If the percentage gains in my 401(k) were turned into a roller coaster design, I’d probably make more money off the design than my 401(k) would over the long term. I said this commenting on an article on ABC News called “Making extra mortgage payments can pay off, but should you?”
I’ve seen my 401(k) go up or down in any given week by more than I take home in a paycheck. I’ve seen that happen in a single day. The “rate of return” on my 401(k) for calendar year 2015 was -3.7% according to the brokerage. Let me emphasize that:-3.7%. Minus 3.7%. Sometimes it’s lost more than that in a month. If I go for June 1, 2015, to June 1, 2016, the rate becomes -11%. Minus 11%.
Investment accounts can be a roller coaster with no guarantee on gains. Putting that money against your mortgage is a guaranteed gain in your wealth since you are paying down a liability.
And now, Business Insider published an article called “I’m worth $1.5 million, and I’d never recommend paying off your mortgage early“. And why is it that this person would never make that recommendation? You guessed it: invest it instead. Seriously these kind of articles piss me off. They operate on the presumption that investments will only go up. And this article that BI published pisses me off even more than any other article I’ve read on the topic.
My current home set me back $176,000 and I had the money to pay cash. I briefly considered it, but instead took out a mortgage. I kept the money invested, mostly in an S&P 500 index fund. Let’s take a look at how the experiment is coming along.
And that is why.
The author had enough money to be able to put down $180,000 without borrowing. But instead he put down only $40,000 and kept the rest invested. Hands up if you can do the same.
So nothing about the author’s situation makes anything he has to say realistic. His article is nothing but speculation and hypothetical. “See how great your wealth could be if you invest.” Come down to the rest of us in the real world, with needs and tighter budgets that need to be balanced against the potential of financial disaster. In general you need money to be able to invest, and not many actually have a chunk of change they’re just willing to hand over to someone on the possibility they’ll get more back over time.
Most don’t even have a positive net wealth, meaning they owe more than they actually have. I’m fortunate to say that isn’t the case for me, but I know I’m in a minority on that.
And if I had the ability to buy a home for cash, I too would still take out a mortgage courtesy of the accounting concept called “leveraging“. It’s why businesses borrow money all the time even if they have cash in the bank.
In business-to-business and wholesale transactions, many vendors offer their customers a discount if an invoice is paid in a shorter period of time. An example is “2% 10 Net 30”, meaning 2% discount if the invoice is paid in 10 days, otherwise the full balance is due in 30 days.
Let’s you have a $2,400 invoice on 2% 10 Net 30 terms. If you can pay the invoice within the 10-days, you’ll receive a discount of $48 and pay $2,352.
Now let’s do a little math. If you borrow the $2,352 at 10% interest and pay that off in a month, you’ll pay $19.60 in interest on the loan. Even if you take two months to pay off the loan, you’re still coming out ahead, albeit not nearly as much. In raw numbers, that is. Depending on what the invoice represents, that leveraging may have put you further ahead than paying the invoice out of pocket, either with or without the discount, simply because of the utility you’d have gained with the item(s) or service(s) in question.
That is why leveraging is a very important concept in business and personal finance.
But two points are overlooked in the common “invest the money instead of paying down debt” advice: 1. paying down debt is a guaranteed way to increase your net wealth and 2. investments aren’t. You are trading money for an asset of fluctuating value. If you’ve handed your money over to an investment firm to put into an index fund, you’re trading money for a wish.
You can throw all the hypothetical numbers you want at people to try to convince them to hand their money over to the stock market. I’ve gone after the idea numerous times over, and, again, it’s about trading what would be a real, guaranteed gain in net wealth for what might be a gain in net wealth over time.
There’s also a third point: paying down your mortgage early doesn’t require putting out much. Again, in a comment on the ABC article:
Putting extra cash toward the mortgage is a guaranteed, real gain in wealth as well, unlike the gamble investments can be, as you are helping to shed a liability faster. An extra payment here and there, if you can afford it, is going to help in the long run. And that’s the same with any loan: mortgage, student loans, personal loans, car loans, what have you. Even inflating your payment a little — an extra $20 or $50 or even $100 for example — will help in the long run. Depending on your loan payment, this could be a spread-out substitute of making an extra payment per year. With my car payment, I put an extra $50/mo on top of what the loan agreement called for, about the same as an extra payment for a calendar year. This put me far enough ahead that I was able to skip a payment entirely and still stay ahead on the loan.
Much of the backlash against those of us who recommend paying down your mortgage seems to come from a fallacious foundation, and by extension fallacious reasoning. If you put a few hundred dollars into a stock market index fund, it’s likely not going to gain much, especially if there are fees involved — how exactly do you think investment brokers make money? You have to keep adding to it. And there’s always the risk your investments will go down in value.
But if you take a couple hundred dollars and use that to make a higher payment toward a loan, that’s several hundred dollars in principal that you no longer owe. And that pays off in the long run through less interest. If you keep doing that, you’ll pay still less interest over time. And you might even be able to open your loan up enough to be able to skip a payment and still be ahead on the loan, as I was able to do with my vehicle loan.
Those of us who make that recommendation don’t say to put all your spare cash at your debts. That would be beyond stupid, financially speaking, as you’d be taking an even greater risk. Instead, put extra money against your debts only if you can afford to do so. Invest only if you can afford it.
The problem is that most likely can’t do so. Most don’t have a 6-figures in an investment account that will earn more in raw dollars in a year than will be paid against a mortgage in 10 years. Most can’t readily put 20% down on a home. Hell, most can’t afford to readily pay out several hundred dollars.
So in short, the Business Insider article wasn’t even realistic, let alone persuasive.