Mortgage Pay-off the Wrong Way

July 6, 2010

With the recent market volatility and low interest rate environment, paying off the mortgage seems like a prudent investment choice to many. The rate on the mortgage is likely more than you recall earning on your stock portfolio, as well as what you are currently earning at the bank.

 

But the timing of this decision could make it the worst financial choice you could ever make.

 

Like many timing decisions, those paying off the mortgage today are failing at doing it correctly. They project the current environment too far into the future and cannot imagine an economy different than what we have today.

 

When we consider the opportunity cost of placing a significant amount of our household wealth into a home -- an asset that will appreciate or depreciate no matter if we pay-off the loan -- we can see the true risk that many are taking.

 

Stocks are one of the few assets that outpace inflation over time, but this is true only if invested during the periods of growth -- which frequently come after crashes. If missed, the ability to outpace inflation is diminished. Real estate, on average, we hope will keep up with inflation over time (5-6% by most estimates before considering costs).

 

By placing funds in the home at the end of 2008, one would have missed out on a 23.1% S&P 500 return. Some went further than simply not investing new dollars in the market and sold their stocks. These investors locked in a historic loss. Only time will tell, but it is possible these individuals repeated this ‘buy high, sell low’ mistake by placing those funds in a housing market that could go lower yet. When rates do eventually rise, the value of homes may stay depressed as buyers can afford to purchase less. Today is not the best time by any measurement to sell financial assets to pay-off the mortgage.

 

If you are convinced of the need to pay-off the mortgage, a more prudent move would be to do it over time by making an additional payment each year. Place the remaining amount into your portfolio and allow it to increase in value, and provide safety though diversification.

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