One of the great debates among personal finance enthusiasts is “invest or pay off the mortgage early?” There are a number of arguments on both sides, but it essentially comes down to the return optimization of investing vs. the psychological benefit of having a paid off home.
We recently faced this exact choice with a sizable amount of money. Despite my optimization twitch, it wasn’t a particularly difficult choice for us. We chose mortgage freedom over optimization. Here’s why.
Table of contents
The Choice
We’ve been on a crazy housing journey over the past two years. By the end of it we’ll have reduced our monthly housing expenses by 80%.
Recently, several factors converged leaving us directly facing the very real question “do we pay off the mortgage or put this lump of cash in the market?”
Holding Cash
First, I want to make it clear we weren’t holding cash in order to time the market. Last year, we ran the pros and cons of downsizing our home and chose to move from our lifestyle inflation palace.
At the time, we’d planned to buy another more reasonably priced home. In our search for the right smaller home, we decided to rent for a year to test out smaller living and a new location.
Knowing that we’d possibly be buying a place within the next year, we kept some of the equity we cashed out of our home sale in cash equivalents. (You shouldn’t put money in the market you expect to use in the short term.)
We invested the rest, but had about $100,000 we were keeping liquid but moving through various savings vehicles. Using high interest savings accounts and bonuses, it’s earned about 3%. At the end of January, we cleared our final bonus and were looking at new options returning at or below 2%.
Our Rental
About the same time, we made the decision to stop renting and move back into our rental property for the next few years.
I won’t rehash it all here, but essentially by moving back we would reduce our monthly expenses, recapture a potential tax deduction, and rehab the property over time at reduced cost. This would give us the option to stay, sell later, or put it back on the rental market.
We still had a mortgage on the rental property. It was cash flowing, but we were using the excess to pay down the mortgage more quickly. It was timed to pay off about when we expect to fully retire. We had about $80,000 and 8 years remaining.
So, we were looking at moving back into our rental and had about $100,000 earning 2% at most.
Should we continue to carry the mortgage and invest the money *or* pay off the mortgage and live mortgage free?
Why We Choose to Pay Off the Mortgage
As I said in the opening, it wasn’t a particularly hard choice for us. A number of factors made mortgage freedom the clear winner.
Beliefs About the Future
The math side of the equation depends entirely on what you believe about future market returns. Our mortgage was at 4.25%. If I believe the market will earn more than that in the future, then investing makes sense as our money will grow over time.
I base all of my financial scenarios on a 7% expected return. I believe the market will go up in the future, and that over time it will meet this expectation. I don’t pretend to know enough about the immediate future to vary this expectation.
Yes, 7% is greater than 4.25%. So, the math and my beliefs about future returns support investing over paying off the mortgage.
I don’t deny the optimal financial path is to invest the money. I felt it important to acknowledge this right off. This single factor supported the opposite decision of the one we made. Yet, the others didn’t.
Risk
There is greater risk in earning that 7% than there is in the 4.25% from paying off the mortgage. One is certain, the other is a strongly held belief that the market goes up over time.
The certainty of paying off housing over potentially earning more in the market over the long term was a factor.
Risk related to my housing is important because…
Impact of Financial Insecurity
I’ve written before about the mindset impacts of financial insecurity. I grew up moving frequently, cycling through rentals and never living in a single place for more than a few years. Several of those moves were landlord related, or because we could simply no longer afford the house. That leaves a mark.
There is a huge psychological benefit for me in owning my home outright. While I recognize there are ongoing costs (including the opportunity cost of money locked into the house) those costs are worth the sense of control owning a house gives.
Owning outright also means there are very few scenarios where you are suddenly forced to move. That matters to me. A lot.
Phase In Life
If we were facing this decision earlier in life, we may have decided differently. Time is always a factor, especially when comparing two close choices.
Related Post: Capturing Our Financial Phases in Money Maps
The truth is we are less than five years from financial independence. We have a relatively large amount invested and earning market returns already. Our plan is on track without squeezing out a little extra return.
Lowering costs approaching potential retirement has benefits that it wouldn’t if we were still early in the accumulation phase. In fact, I can make an argument that it is more beneficial to eliminate our housing costs within a few years of retirement.
The Math When Nearing Retirement
Let’s say we invested that $80,000 now. In the next five years. It earns 7% annually:
| Year 1 | $85,600 |
| Year 2 | $91,592 |
| Year 3 | $98,003 |
| Year 4 | $104,863 |
| Year 5 | $112,204 |
At the end of 5 years, we have $112,204. Not bad at all!
If we decided to stop working at the end of 5 years, we’d go into drawdown mode. Given the 4% rule that will generate $4488 per year.
However, we’d still have a ~$1200/month mortgage payment for about 3 years into that retirement. That’s $14400 annually. For those 3 years, we’d be down about $10,000/year based on the choice.
Sure – that would end after three years. Eventually, the math works out again. Unless we face a bad sequence of returns. That compounds the risk.
Also, this assumes that for the next five, mortgage free, years we don’t use the freed up monthly cash flow to invest. We intend to do that, putting $1200 a month ($14400/year) into the market.
That looks like this:
| Starting Amount | Invested During the Year | Total | |
| Year 1 | $0 | $7200 (1/2 year) | $7704 |
| Year 2 | $7704 | $14,400 | $23651 |
| Year 3 | $23651 | $14,400 | $40,715 |
| Year 4 | $40,715 | $14,400 | $58,973 |
| Year 5 | $58,973 | $14,400 | $78,509 |
Now the difference between the two options is less than $34,000. With the 4% rule, that’s only $1435 a year. We’d still have $1200/month payments for three more years – meaning a 4% SWR (safe withdrawal rate) would cover just over a month of the ongoing payments.
This is why the phase you are in matters. Mortgage freedom becomes more attractive as you near retirement.
Increased Flexibility
Essentially, paying off the mortgage gives us a sense of freedom and increased flexibility.
We could choose to stop working immediately (or be forced to – never forget this possibility!) and have a place to live. Mortgage freedom instantly makes us lean FI. We could never earn another cent and still live comfortably – just not optimally.
If we work until retirement, we could keep the house as a home base and travel. Or, we could rent it out again and use the cash flow to cover a new housing choice. We could also sell it and cash out the full equity to cover whatever future housing choice we want.
Financial independence is about flexibility. Mortgage freedom isn’t optimal by the numbers, but it optimizes our flexibility.
Mortgage Freedom Was an Easy Choice
We sat down to talk about it, and knew immediately both of us were leaning heavily toward paying off the remaining mortgage. We still tested the concept in a number of ways, but everytime landed back on the freedom of living with a very small housing cost.
The extra savings won’t kick in for three more months, since we are finishing our rental agreements with our tenant and where we live. (Don’t worry – we have enough tax credit stored up so we don’t need the mortgage interest.) Yet, we already feel incredible about it.
It also helps that the week after we made the choice the market took a quick 12.5% drop. That sure 4.25% return looks pretty good compared to the immediate market result. Of course, I avoid resulting (check out Thinking in Bets for more context) and don’t use this as reason to justify the decision. I am comfortable with the base decision-making and the short-term result was positive.
The sense of security and future flexibility is unlike anything I’ve ever felt. For the first time in my entire life, I am in full control of my housing situation.
Mortgage freedom was an easy choice for us. Increased freedom, flexibility, and sense of security? Yes, please.
Should You Pay Off Your Mortgage or Invest?
This question is tied with the “rent vs. buy” debate for most frequent, and ultimately unwinnable, personal finance debate. Both debates perfectly highlight why personal finance is, and should be, personal.
Depending on what parameters you use, what beliefs you hold about the future, your own risk tolerance, and your personal need for security, you can land on either side of these debates. It’s why I believe in the importance of so many voices in personal finance sharing their real experiences.
This is ours. We chose mortgage freedom over optimization. I don’t regret it a bit.
We chose buying over renting and paying off over investing. You may do something different.
For other perspectives:
- 5 Reasons to Pay Off Your Mortgage – Financial Pilgrimage
- How Not Paying Off Your Mortgage Can Lead to More Financial Flexibility and a Larger Investment Portfolio – Military Guide
What do you think?
Very interesting and at 4.5% that certainly makes a lot of sense. I wonder how you abou tyour thoughts on if you had the same situtaiton but with rates around 1%?
Yeah, the decision certainly gets harder as rates go lower. I prioritize the debt freedom highly, but at the extreme of 0% would I still pay it off just to own it outright? Probably not.
When we learned about the FIRE movement in 2017, one of the first things we did was pay off our mortgage. Over the years we had been investing and building up a sizable cash cushion. Once we understood the math of what was enough, we realized we didn’t need nearly as much cash as we had so we used a bunch of the excess cash to pay off the house.
We were at a 4.25% interest rate and definitely could have gotten a greater return in the market. But we had won the game of financial independence so I was happy to take a 4.25% guaranteed return. Now that we are early retired, it is nice not having that additional monthly payment weighing down our budget. Our savings rate increased dramatically in 2018 and 2019 without the mortgage payment, which really helped our investment balance grow.
I definitely want to enter retirement (early or otherwise) without a mortgage payment. Our plan is to make 2020 and 2021 similar to your 18/19 and potentially push our savings rate up over 75%. You two have done it right!
I, like you, chose to pay off the house rather than put it all in the market.
Security is a huge comfort and I like the fact that if TSHTF, which it seems like it’s doing right now, I can trim my outgoing and live very cheaply without worrying about having to pay a mortgage.
I want to keep my outgoings as low as possible.
Yes! That’s the biggest benefit – I know we can dial spending back quite a bit, have a place to live, and still be just fine.
Congratulations! Paying off the mortgage is great. Investing is great too. They’re both good moves. Most people would spend that extra cash and take a step back financially.
We still have a mortgage, but it’s not a huge portion of our net worth. It can wait. I’m not in a big hurry to pay it off. Our housing expense is already pretty low because we rent out one unit in our duplex.
Thanks, Joe! Yeah, the behavioral aspect is a big one. Fortunately, we are pretty good about putting extra towards investments. You’ve got a nice house hack going.