Most mornings when I first sit down in my office, I like to take a minute or two to look over a few news sites while sipping my coffee. When I run through this ritual these days, I see a growing number of articles with titles such as, “The Secret Way to Pay Down Your Mortgage at a Rapid Rate,” or “Use This Simple Trick to Pay Down Debt.” Each time I see one of these articles I can’t help but think, “who says I want to pay off my mortgage?”
Post-2008 financial crisis, I’ve noticed that debt has almost become a dirty word, and the emphasis has become ever more centered on ridding the American family of its burden. The question is, is this always the best approach? To answer this question, I use the two words that most frustrate anyone asking a question: it depends.
What's Your Return?
The first major question to look at when deciding whether to increase the amount you’re putting towards debt payments is, what is the current interest rate of the debt? At the time I’m writing this, the average mortgage rate for a 30-year mortgage is hovering around 4.625%, the average student loan is around 4.45% for undergraduate and 6% for graduate, and credit card interest is about 17.43%. Given these numbers, we can now start taking a look at when it is and isn’t worth it to accelerate debt payments. To make this decision, look at the opportunity costs, which those who sat through their Econ 101 class will remember is the loss of potential gain from other alternatives when another alternative is chosen.
Let’s say I have an $1,000 and I’m trying to choose whether to pay down my mortgage or do something else with the money. First, I have to take a look at my alternatives for that money, for example investing that $1,000 in the market. Historical records for the S&P 500 average its annual return from 1928-2014 to be roughly 10%.* So if I put that money in an index 500 fund, I would essentially be earning 10% but would be missing out on saving myself the 4.625% of interest, which would still net me a positive 5.375%. In this instance, it’s a better call to take my $1,000 and invest it rather than to pay down my mortgage. However, if my option is paying down $1,000 worth of credit card debt at 17.43%, I would be looking at a loss of 7.43% if I invested my excess cash rather than making that extra credit card payment. The choice then seems fairly straightforward.
The Case for the Worst Case
The second big question to look at when analyzing accelerating debt payments vs building up investment savings is what your options are should the worst case scenario come to pass. I hear a lot of people tell me that they want to pay off their mortgage because, should they lose their job, they won’t lose their house. While this is worth considering, it isn’t always the case. First whether or not a person has their mortgage paid off, they still have to meet their property tax and insurance obligations in order to keep their house. Second, simply put, you can’t eat a house. Should you lose your job and your income disappears, you would then have a place to live (until your local government came to call about those taxes), but you would still have no means to buy groceries, pay for gas, or keep your utilities going. Sure, at this point you would have your house value, but selling your house could take months, and any decent mortgage broker won’t extend a homeowner a line of credit or second mortgage without proof of some income.
If, however, you had systematically invested those excess payments into savings, you would likely now have a pool of money from which to pull your monthly mortgage payment, and pay for other necessities. The same logic holds true for student loans as well. If you paid off your student loans rather than putting aside that money in an investment account, you would no longer have your student loan payment, but the question of how to pay for food would still be on the table, and the U.S. Government would be less likely to lend you that money than your mortgage broker. Beyond that, many borrowers still have the ability to reduce or defer student loan payments in the event that they lose their income, making paying them down even less attractive in this scenario. However, this scenario changes a bit when viewing credit card payments. If you were to pay down credit card debt, and you lost your job, you would still be able to pay expenses for a period of time using that same credit card, and would now have more room between you and the credit card limit.
The Final Answer
Whether or not to pay down debt beyond the minimum payments comes down to your interest rate. Is the interest rate of the debt itself less than the expected return you would make on your investment portfolio? If yes, it may be a good idea to just continue with that minimum payment for now, and put that money in an index or mutual fund to earn more for you. The second big question to ask yourself, is do you, in fact, have enough money to accelerate debt payments? If you focus so completely on paying down your student loans that at the end of the month you’ve run out of money for food, you’ll have to pay those expenses from another source, likely a credit card. If that’s the case, you just essentially refinanced your mortgage of 4.625% into a loan at 17.43%, which is a deal no one would openly take. With all of this said, these rules do vary from situation to situation, and analyzing your individual scenario or talking to your financial advisor can help you make the best call.
* Past performance is not indicative of future performance.