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Ask Jill: Investing vs Mortgage Pay Down

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:

1. 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.
2. Max-out your retirement contributions. Not only will you crank on your long-term savings, but you'll get that sweet tax deduction too.
3. 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.
4. 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.