The Price of Being Debt Free
This post was written by Associate Wealth Advisor, Arman Hundal.
Usain Bolt winning gold in the 100m at the 2008 Beijing Olympics.
Is paying off your mortgage as fast as possible the best financial decision?
Let's look at an example.
Assume two people each own a $1.5 million home with a $1 million mortgage and 25 years remaining. For simplicity, we'll assume an interest rate of 4% for the entire period.
Both make their regular mortgage payments, and both have an additional $12,000 available per year. The first person wants to be debt free as fast as possible, so every year they put the extra $12,000 against their mortgage. The second person takes that same $12,000 and invests it.
For this example, we'll assume their investments earn an average of 8% per year over the long term. But earning that return means enduring volatility. Equities are volatile, but that's the price you pay for higher expected long-term returns.
Same house, same mortgage, and the same amount of money going out the door every year.
For simplicity, all figures below are rounded.
Five Years Later
After five years, the investor has $70,000 invested. The person paying down their mortgage has $65,000 more equity in their home.
The difference is only $5,000. Not much.
Ten Years Later
After ten years, the investment account has grown to $174,000, while the additional mortgage equity is $144,000.
The difference is now $30,000.
Fifteen Years Later
After fifteen years, the investment account has grown to $326,000, while the person paying down their mortgage has $240,000 in additional home equity.
The difference is now $86,000.
Nineteen Years Later
After nineteen years, the person making additional mortgage payments has almost completely paid off their mortgage, with only $3,500 remaining. The investor still owes $336,000.
At first glance, the person who paid down their mortgage looks much better off. But the investor has something they don't, a $497,000 investment account.
Both people still own the same house. If the house appreciates, they both benefit equally. The value of the home doesn't change the comparison. The difference is what they did with the extra $12,000 each year.
One person has $332,000 more equity in their home. The other has $497,000 invested.
The investor is $165,000 wealthier.
Final Thoughts
According to the numbers and assumptions used in this example, investing the additional money leaves the investor better off financially. But personal finance isn't always just about the numbers.
There is something to be said for being debt free. Some people sleep better knowing their mortgage is paid off. They don't like owing money or seeing a large balance attached to their home. There is value in that.
The peace of mind that comes from being mortgage free may be worth more than the additional $165,000. That's not something a calculator can decide for you.
The important thing is understanding the trade-off. Being debt free feels good, but you should know what you may be giving up to get there.