With uncertainty surrounding our investment markets, homeowners with cash are questioning whether to pay off their mortgage or invest the extra dollars. The answer depends on your mortgage rate and your inclination to hold debt.

Because no one can predict the returns that investors will receive over the next ten years, it is impossible to say with great certainty which strategy is better for a homeowner with extra cash.  However, there are two ways to consider this question.  One is purely financial and the other is based on your personal feelings regarding debt. 

Financial Analysis:  Mortgage Rate versus Potential Investment Return

If your mortgage interest rate is greater than the investment return that you can reasonable expect to earn, then apply the extra cash to your mortgage.  But, if this is not the case, then over the long-term you will be money ahead to invest and continue to make the monthly payments on your mortgage.

Long-term Growth-Oriented Investor :  Let’s assume that your mortgage interest rate is 6%.  If your investment portfolio is allocated half to fixed income and half to the stock market, historical returns indicate that you should reasonably expect to achieve an 8% return over the long term.  In this case, it would make sense for you to maintain your 6% mortgage and invest your cash with the expectation of an 8% return.  If your mortgage rate is 8% or above, the smarter option is to use the extra cash to pay down or pay off your mortgage.

The more stock exposure that you have in your portfolio, the higher the long-term expected investment return.  For a portfolio that is invested 100% in the stock market, the expected rate of return based on historical results is 10%.  Adjust your expected investment return for this analysis based on your portfolio’s ideal allocation.

Preservation-Oriented Investor:  If you are intentionally investing on a conservative basis and your expected investment return is 5% to 6%, then paying off a 6% mortgage is appropriate.  As homeowners approach retirement, their investment portfolio should become more oriented to less-risky fixed income investments versus the potentially higher return, but more risky, stock market investments. 

Current Stock Market Environment

When evaluating your options, do not let the current activities of the stock market keep you from making the appropriate decision. When the stock market is sluggish, many people choose not to invest for fear of losing money if the market declines. However, a longer-term perspective is necessary.  If the stock market is the appropriate option for your extra cash, investing when the market is in a down cycle can potentially result in significant future growth for your portfolio.  

Personal Comfort:  Desire to be Mortgage-Free

Your personal comfort with being in debt is as important as the financial analysis described above. If you are by nature risk-adverse, then paying down your mortgage may be the best option regardless of the mortgage rate.  For some homeowners, there is a feeling of security and comfort in being mortgage free, especially at the time of retirement.  If you can sleep better at night, then pay off the mortgage.

Summary

If you have extra cash and a mortgage, it is appropriate to do the financial analysis described above and to consider whether your bigger desire is to be debt free.  However, there may also be other factors that should be involved in your decision making, such as cash flow issues, income tax benefits, other saving goals, and other debt besides your mortgage.  Review your personal financial plan to be sure your decision supports your overall goals.