A surprising number of people over at Quora often ask the question “Should I pay off my mortgage early?” and they go on to say that they’ve come into some money and aren’t sure whether they should invest it or use it to pay off their home mortgage.
I’m only one of the thousands of people who help answer questions over there and the other people who answer most commonly give an answer such as this: “If you can earn a return in the stock market that is better than the interest rate on your home mortgage, then you should invest the money and use the proceeds to pay the monthly house payment.” And they leave it at that as if this is nothing more than a math question. But that really isn’t the case, so I also provide an answer whenever I see these questions, and that answer goes along these lines…
Should I pay off my mortgage or invest my windfall?
This is more than just a math question. A bigger part of the discussion is a consideration of risk.
While debt might sometimes be necessary, especially in the case of purchasing a home, it creates a level of risk.
If something happens to you or your household income, and you are carrying debt that requires monthly payments, there is a chance you could wind up in a situation that you cannot reasonably cover those payments. And we’ve all either experienced or heard of the major problems that can happen once you get behind on debt payments. Besides the credit score damage, you also have to deal with the hassle of debt collectors and possibly even facing repossession or foreclosure. This also creates a tremendous amount of emotional and relational strain that just can’t be quantified.
But you have a steady job and think the risk of losing that income is small, so does that change the situation any? Well, no, not really – not in my opinion.
Do you like to gamble?
Some people are very risk-tolerant – they like to gamble and the idea of big potential rewards on the other side of those big risks actually excites them. Most people though, if they are honest with themselves, are much less willing to accept high levels of risk and would prefer to minimize risk when reasonable. For some of us, it just helps us sleep better at night.
One way to consider this situation for you personally is to ask yourself this question:
If your house was 100% paid-off, would you go to the bank and take out a loan against the house so you could put the loan proceeds into the stock market?
I’ve actually heard a couple of people say yes, they would do this, and that’s fine for them because it lines up with their risk tolerance level. The vast majority of people though would say no, I would not create a situation of risk for my personal residence just in hopes of earning a bit higher of a return.
Here’s how my friend Tim, a CFP, addresses the question:
Either way, consider these things first
Regardless of what the person chooses – pay off the house or keep paying the mortgage and invest the money instead – there are a couple of things that should be taken care of. I mentioned these things, and more, in my post 6 Things to Take Care of Before You Start Investing, but I’ll quickly summarize a few key points again here.
If you come into a cash windfall, before either investing OR paying off a mortgage, be sure to address these items:
- Have a fully-funded emergency fund
- Eliminate all consumer debt (especially credit cards)
- Understand your cash flow (budget)
- Clarify your goals and priorities
- Make sure you understand investing basics
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Speaking of investing…
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Wrapping it up
We’re huge fans of eliminating all debt – in fact, our family is 100% debt-free mortgage and all (and no, we would not borrow against the house to invest more!). If interested, here is a post with a couple of tips on how to pay off your mortgage faster, even without a big cash windfall.
I’m curious, how would you answer that risk tolerance question? There isn’t a wrong answer so don’t worry if you have a high risk tolerance – we don’t judge!
Interesting post! I’ve never been a “pay off all debt fast” kinda guy. Over the long run I think this hurts your net worth. That being said, some people swear by it so I think it’s a personal thing as much as it’s a money thing.
Thanks for sharing!
From a pure math perspective it doesn’t make sense. Good financial habits aren’t a math issue though. If it was just math we could all take out huge loans and invest it as long as we made at least enough to cover the interest. That’s a tremendous risk though and most people would crumble at some point under that burden. I’d say for most people it makes sense, but there are some – like yourself – with a higher risk tolerance who can ride things without freaking out and make the best of the “math” situation. Thanks for sharing Lance!