Suppose you win the lottery and you win just enough to pay off your mortgage. Should you pay off your mortgage? Or would you be better off investing that money?
In order to answer this question, we must weigh a number of factors. The most important factor deals with your risk profile. You will also want to consider how your current investments are allocated. There are numerous other factors that you must consider. Before we get to all of those factors, let’s make a few assumptions.
Let’s assume the following:
Yeah, I know the saying about people who assume. However, for purposes of answering this question in as full of detail as possible, I need to assume a few things before we dive in and discover my opinion to this question.
The following assumptions are being made:
- You have 25 years left on your mortgage so you have a long timeline left to pay it off.
- You are in the 25% federal tax bracket, and will remain there for the foreseeable future.
- In addition, your state income tax rate is 8%
- You current mortgage rate is on par with national averages at 4.5%
- You have $200,000 left on your mortgage
- You expect the average rate of return of the stock market to be 8% over the next 25 years.
With those assumptions being made, we have the foundation to truly evaluate what you should do with your lottery winnings: invest in the stock market or pay off your mortgage?
Tax deductions make your interest rate lower
The first item that you must consider is that your interest rate is really not the 4.5%. Why is this true? The United States has favorable tax deductions available to homeowners, so your actual interest rate will effectively be lower. What would be the effective interest rate based on our assumptions above?
Your effective interest rate after considering the mortgage tax deduction would actually be 3.105%. How did we arrive at that number? Using this handy calculator at Bankrate, you can easily calculate what your interest rate will be after your mortgage tax deduction.
Go ahead and play with the calculator a bit. It is interesting to see how much the mortgage tax deduction will actually help you. In this example it is almost like cutting 1.4% off your interest rate on your loan!
Paying off your mortgage means no mortgage tax deduction
Why is your interest rate important? This will help us in making our final decision whether to invest our money or pay off the mortgage.
If you choose to pay off your mortgage, you will no longer be eligible for the mortgage tax deduction. You will have to pay more in taxes as a result. But, you won’t be making mortgage payments anymore!
So it looks like a win for paying off you mortgage, doesn’t it? But wait, it can’t be that simple. Well…I guess we have to consider a few other factors before making our big decision.
The opportunity cost of paying off your mortgage
Paying off your mortgage would be a great relief. However, there is an opportunity cost to paying off your mortgage. Ah, opportunity cost, that word you used in economics and never thought you would see again.
By paying off your mortgage, you are foregoing other options with your lottery winnings. What specific opportunity costs can you think of by paying off your mortgage?
The biggest opportunity cost to me is that you will not have that money to invest. This is the biggest opportunity cost in my opinion, so hear me out.
By paying off your mortgage you are taking all of your money off the table to get rid of a huge debt, which can be a relief. However, you will not be able to do anything with that money once to pay off your mortgage.
This brings up an age old question: Should you invest or pay off your debt?
Generally, you would rather invest any extra money when you can achieve returns which are higher than the interest rate on your debts. For example, let’s say you have a loan with 2% interest. Let’s also say that you can make an investment which will return 5% in the next year.
If you choose to pay off your loan, the money will be gone for good. However, if you choose to go with the investment, your money will appreciate by 5%. Now you will have to pay 2% on your loan. As a result, you end up with a net positive return of 3%. Simple enough, right?
The answer is staring you right in the face
Let’s go back to our original example and decide whether you should pay off your mortgage or invest in the stock market.
Based on the assumptions being made, you will be able to achieve an average annual return of 8% in the stock market in the next 25 years. During that same time period, you will be paying an effective interest rate on your loan of 3.105%. You do the math. What will be your total net return of this decision?
Got your answer? Okay good.
I’m sure you answered 4.895% you smart cookie. For simplicity sake, let’s just say you will get an average net return of 4.9% if you decide to invest in the stock market and keep your mortgage as is.
This is precisely where I would stop and not even consider paying off the mortgage. I’m a numbers guy, and the numbers are telling me one thing: INVEST! However, I know that many people aren’t as into the numbers as I am, so I will lay out a few other factors that will help you make your decision.
Factor one: Your risk profile
Your decision will depend heavily on your risk profile. If you like to take on risks and live life on the edge, you would want to invest in the stock market regardless. You don’t care about the fluctuations of the markets, you live for this sort of thing!
Even if you have a moderate risk profile, you would likely opt to invest in the stock market as opposed to paying off your mortgage. Sure, paying off your mortgage would feel good, but you know there is a very good probability the market will return around 8% in 25 years’ time.
If you are extremely risk averse, you will take the sure thing and pay off your mortgage. What if the stock market crashes tomorrow and you lose all your money? You don’t want to take that risk no matter how unlikely it is. You want a sure thing, and the only sure thing is today. You would get rid of that mortgage.
Based on your risk portfolio, what would you do in this situation? Would having a shorter time horizon make you more likely to pay off your mortgage?
Factor two: Asset allocation
Another factor you have to consider is your asset allocation. This will depend on how many assets your had just before winning the lottery.
If you have very few investments, and you choose to pay off your mortgage, you are essentially putting all of your eggs in one back: real estate. This will throw your asset allocation all out of whack, and you will have a high risk exposure to the real estate market. This risk is even higher when you consider you are putting all of your money into one single asset: your home.
If you have few investments and choose to invest in the stock market, you are better able to spread your risk out among number companies, funds, and indexes.
However, if you already have many investments you would not be as impacted by choosing either option. We would assume that you already have a well-balanced profile. Paying off your mortgage wouldn’t expose you to asset allocation risk.
Factor three: Interest rates
In the example above, I illustrated that if you had a low interest rate you would be better off investing in the stock market. I did not consider the factor of higher interest rates.
The interest rate on your mortgage will affect whether or not you choose to invest your money or pay off your mortgage. Logic says the higher the interest rate on your mortgage, the better off you are to pay off the mortgage.
Other factors to consider
Psychological effect of paying off your mortgage early
Paying off your mortgage is a huge accomplishment. For many people, paying off debt is a rewarding experience. You will sleep better at night knowing that your will not have to make to monthly payments every month.
You will no longer have to worry about whether you will have enough money to make mortgage payments. The only payments you will have to make will be for insurance, property taxes, and any miscellaneous repairs and other expenses.
You will have excess cash to invest
While you won’t have the initial $200,000 to invest when you first pay off your mortgage, you will have an extra $1,000 to invest.
While you are deferring compounding interest on your investments, you will also be reducing your risk over time. Having this extra money each month will give you some flexibility for investing and give you extra cash flow every month.
Question to consider:
Would you borrow 3.1% to invest in the stock market?
Answer: for me the answer is a definitive yes. That is basically the decision you are making if you do decide to take your lottery winnings and invest them in the market (again, using our assumptions about market return made above).
What do you think you would do in this situation? Do you think you would pay off the mortgage or invest your money? What other things must you consider before making this decision?