Ask Jill: Investing vs. Mortgage Pay Down

By: Jill Schlesinger
Topics: Financial Decoder

This post by Jill Schlesinger originally appeared on CBS' MoneyWatch.com.

Years ago, I got into a heated argument with another financial advisor about mortgage pay-downs. He was absolutely certain that with rates at all-time lows (at the time, 6% or so), there was NO reason to pay down the outstanding loan because "over the long-term, a diversified portfolio would be after-tax cost of carrying the mortgage." I countered that sometimes a good night's sleep is preferable to the anxiety of being an investor.

This brings me to the age-old question: what's preferable: paying down mortgage debt or investing in a diversified portfolio?

The answer is a little more challenging, now that we know that sometimes investors can go an entire decade when returns aren't exactly "normal". So here's a question from Steve that frames the issue:

I'm 47 years old, and have lived in my current house for 13 years. Six years into the original mortgage, I refinanced from a 30-year 7% APR mortgage to a 15-year 5.5% mortgage. I've just refinanced again to take advantage of a 15-year, 5% mortgage with no closing costs. In addition, I'm continuing to accelerate the mortgage so that it will be fully paid off in 6 years, when I'm 53. Many people tell me I'm crazy for accelerating a 5% APR mortgage, and that I should invest that money elsewhere so that I can get a better return. My 401k is aggressively invested, so I consider the 5% I'm getting on my mortgage acceleration money to be my conservative investment. My parents, in their early 80s, only recently paid off their mortgage. I swore along time ago that I didn't want to carry a mortgage into my retirement. Do you think my strategy is flawed?

First of all, let's have a round of applause for Steve, who has given the issue more thought than the customary "my mortgage company said it was better if I made an extra payment every year." Steve is treating the pay down of his mortgage like a fixed investment, which is fine. Not knowing his tax bracket, let's assume that the net cost of carrying the loan is 3.75%-4%. Essentially, Steve is earning an after-tax return of that amount, which is certainly higher than he could earn from a government or municipal bond of similar duration, that is, 6 years.

That said, there are a couple of things to remember about accelerating mortgage payments. First, by paying down the note, you lose liquidity. If Steve has a bunch of non-retirement assets floating around, it may not be an issue. But I like to remind people who are nearing retirement that one of their goals should be to accumulate 1-2 years of living expenses in liquid, non-retirement assets.

There's also an action point for Steve: as he pays down his mortgage, he will need to shift his 401 (k) allocation to reduce risk. This may include moving a portion of the account into fixed investments.

Here's another question about debt pay-down vs. investing from Will:

"Aunt" Jill - just caught you for the first time on The 404 and thought it was a great episode showing that "Hi-Tech's" can be interested in finance, and a Financial Advisor can hang with the "Low-Brow". Here's my situation. After 15 years of employment, I was recently laid-off in a downsizing and was given a lump sum severance. Fortunately, my wife is employed and I found another job before we had to touch the severance $'s. In a strange twist of fate, my wife was recently left a small inheritance (about equal to my severance). My new job is a contract position in which I'm making 20% less than my previous salary. We have no credit card debit however we do have a young family, a mortgage at 5.75% and a car payment at 4%. I've heard you give advice to have 6-12 months worth of cash on hand. If we have more than that from these two pools of cash, and/or, we're fortunate not to have to touch the "savings", what would you recommend we invest the "extra" cash in and when, if ever, should we consider investing ANY of 6-12 month savings? Or simply, "what should we do with the $'s"?

In Will's situation, I wouldn't suggest paying down his mortgage, because in a young family, my guess is that he and his wife need their cash flow to fund other obligations. I'm psyched that Will and his wife have an adequate emergency reserve fund. Here's what they should do with their extra moolah:

Pay off the car loan: sure, 4% is cheap, but with a car loan, you're paying money for an asset that's depreciating-sort of the opposite of what folks do with a mortgage-pay interest for an asset they hope will appreciate.
Max-out your retirement contributions. Not only will you crank on your long-term savings, but you'll get that sweet tax deduction too.
If you have kids, consider funding a 529 plan. Not sure where these folks live, but most states offer a direct plan-please don't buy this through a broker or an advisor! Some states also offer state tax credits for using state-sponsored 529 plans.
If you don't have kids, and have covered your other bases, you may want to fund either a brokerage account or a Roth IRA, if you qualify. In this case, stick to no-load funds through a discount broker.

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Jill Schlesinger is the Editor-at-Large for CBS MoneyWatch.com. Prior to the launch of MoneyWatch, she was the Chief Investment Officer for an independent investment advisory firm. In her infancy, she was an options trader on the Commodities Exchange of New York.

Jill Schlesinger
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Jill Schlesinger, CFP®, is the Editor-at-Large for CBS MoneyWatch. She covers the economy, markets, investing or anything else with a dollar sign. Prior to the launch of MoneyWatch in 2009, Jill was the chief investment officer for an independent investment advisory firm. In her infancy, she was an options trader on the Commodities Exchange of New York.
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by tmittelstaed March 11, 2010 2:33 AM EST: The simple answer is that if you can get a better rate of return from an investment, you put your money into that, instead of in to your mortgage. But, the actual fact is that quite a lot of people do not get a better rate of return on their investments than their mortgage.

Analysts like Jill are used to telling people to invest their money. Of course, since she cut her teeth making her salary off commissions she has been taught the "invest invest invest" mantra. However, the fact is that an ignored investment is definitely not going to give a very good rate of return. Funds within a 401K that are considered "speculative" and producing a higher rate of return can often over time turn out to not be so, and funds that are considered "safe" can turn out to be speculative. People who read the prospectuses and reports every month or login to their 401K to check them out can rebalance investments, and people who buy and sell stocks can move investments around, all these things result in a decent return on a portfolio. But, not everyone is willing to put the time into doing this.

If someone is more interested in living life than in following their investments, then paying down their mortgage is probably a much smarter thing to do than investing in some fund that supposedly will return better than their home interest rate. Jill loves people who pay attention to their investments - those people do what she does on a smaller scale and so are easy to understand. But, she does seem to have a blind spot when it comes to people who aren't interested in finances very much.

One last comment I will make on this that the Analysts like Jill seem to miss all of the time, and that is the income tax deduction for mortgage interest. Jill and her ilk seem to have this idea that this deduction is going to exist forever. Yet the government is running multi-billion dollar deficits, to say nothing of the debt, and it's not out of the realm of possibility that this deduction will disappear in the future. If it does, then it would have sure been a pi sser if you could have paid down your mortgage earlier, while the interest deduction still existed, and thus reduced the amount of interest that you have to pay with after-tax-dollars after the deduction was removed.; Reply to this comment