It is common advice in financial circles today to keep your mortgage as long as possible. In fact, many even advocate keeping your mortgage throughout your retirement. The basic principle is relatively straightforward: with today’s incredibly low borrowing rates – where a mortgage can cost you less than 5% per year in interest – keeping a mortgage allows you to keep your assets invested where they can earn the higher long-term returns available in stocks.
For example, if you have a $250,000 mortgage, you owe $12,500 per year in mortgage interest costs to the bank. However, if at the same time you have a $250,000 portfolio that is invested in stocks capable of earning of long-term return of 10%, you can average growth of $25,000/year over time. Thus, by paying only 5% per year in interest ($12,500) to earn 10% per year in growth ($25,000), you can increase your wealth and assets available for retirement.
Unfortunately, though, sometimes portfolios don’t generate the returns we expect; the past decade has been a prime example. Investors who kept their mortgage outstanding in 2000 and put their money instead into the S&P 500 hoping to generate growth in excess of their mortgage interest have instead been rewarded with a barely 2% dividend yield and no price appreciation, while their mortgage payments have slowly eroded the portfolio. Ten years later, the investor is far behind where he would have been by simply paying off the mortgage and having less money invested in the first place.
In other words, investing for growth rates in excess of your mortgage interest has risk, and superior returns are not guaranteed. After all, if there was truly a sure thing to earn returns higher than the cost to borrow money, the banks wouldn’t lend you the money – they’d just invest for the higher return themselves.
In the end, we all acknowledge that buying stocks on margin – where you borrow money to invest using the assets already in your portfolio as collateral – entails significant risk. The fact that you happen to borrow the money by taking out a mortgage and pledging your home as collateral, instead of your portfolio, doesn’t take that risk off the table.
So what’s the alternative? The good news is that by paying down your mortgage, you won’t have as many retirement expenses to support in the first place, without that monthly mortgage payment obligation looming! And you don’t face the risk that by earning less than your mortgage interest rate, you might end out with even less money than you had in the first place!
So if you don’t want to bet your home – and your retirement – on the stock market, you might consider just paying down your mortgage by the time you retire and making it work the old-fashioned way: save and invest the assets you have and take the less risky path. It’s really O.K.
Michael Kitces, CFP, is the director of research for Pinnacle Advisory Group, a private wealth management firm located in Columbia, Maryland that oversees approximately $850 million of client assets. He is the publisher of the e-newsletter The Kitces Report and the blog Nerd’s Eye View through his website www.Kitces.com. Kitces is also one of the 2010 recipients of the Financial Planning Association’s “Heart of Financial Planning” awards for his dedication to advancing the financial planning profession. Follow Kitces on Twitter at @MichaelKitces.