"I want to pay off my house so I'm paying extra on my mortgage" the client beamingly states with confidence.
Financial advisors get this a lot from folks. I know I do.
It's easy to understand why folks want to be debt-free. It makes us feel good, duh. Specifically though, paying off a car loan, mortgage, credit card, or student loan represents a sense of accomplishment. We save interest. And, best of all, we get to brag to our friends.
All of these are benefits that give us that shot of financial dopamine that's hard to come by.
However, before we celebrate our supposed financial savvy too much, we need to examine the opportunity cost of using our cash to pay off debts compared to what else you could have used that cash for.
MY PERSONAL SCREW UP
I'm a nerdy CFP Practitioner that's been working in the financial industry since 2003. One would think I'm smart enough to follow my own debt versus investing advice. Unfortunately, I'm human, and this is my story about my decision to buy a car for cash last year.
Melissa and I needed a new vehicle. We spent $36,000 on a used car with 30K miles last summer.
I have an 800+ credit score, but the 5-year loan rates we were quoted for 2016-model year cars were in the 3.8% to 4.3% range. Without even running the numbers on what the interest would've tallied, I decided that we needed to do something with the extra cash we'd accumulated at the bank.
Eureka! Let's just write a check a be done with it.
So we did.
In my mind, this was justified because I was already on track to max out my 401(k) at $19,500 as well as my HSA at $7,100. Our financial plan was solid. Reducing interest would clearly represent a proven method of increasing my net worth.
I drove off the lot with a massive sense of pride and accomplishment. It was the first time I've ever been financially able to buy something outright at that kind of price. I felt like a big deal.
The reality is that I messed up, and it only took me a month of riding my high horse until the feeling of regret set in.
Ignoring sales tax to keep the math simple, a $36,000 vehicle at 4% interest for 5 years = a $663/mo payment.
That adds up to $3,780 in interest for a total cost of $39,780.
But what if I would've invested that same $36,000 and elected 4% financing? If I was smarter than I was, which I wasn't, I could've taken that $36,000 and invested it in my 401(k) as a company match.
Technical details aside, this is what I'm doing with my spare cash in 2021.
From July 1st, 2020 through yesterday, I've earned a 40.01% rate of return on my 401(k).
Had I invested that $36,000 in my 401(k), it would've grown to $53,249.
I could've seen $17,249 worth of growth on my $36,000 investment, and that is my missed opportunity cost.
Another way to think about this is that I would've made 4.5x the interest cost by investing over the last 9 months.
$17,249 in missed growth - $3,780 in interest saved = a $13,469 mistake.
BUT, BUT, BUT???
I know what you're all thinking.
"But you never would've earned a 40.01% rate of return over the full life of the 5-year car loan"
You would be correct. No one earns 40% consistently.
Let's redo the numbers at a more reasonable rate of return for my 100% stock portfolio model in my 401(k).
A globally diversified stock portfolio that's 60% US stocks & 40% International stocks and annually rebalanced has earned a 9.68% rate of return since December 31st, 1985.
Let's say I earned an expected return of 9.68% over the life of my 5-year loan. My $36,000 investment would grow to $58,298. That's $22,298 in growth.
$22,298 in growth is still a massive difference over the $3,780 in interest I saved because I paid cash.
When we expand our time frame from the last 9 months to 5 years, my $13,469 mistake becomes an $18,518 mistake.
To put that into perspective, that's almost 1 year of college for one of my kids because I was so fixated on not having debt and not paying interest.
Hopefully, my wife Melissa and our kids never read this blog post.
OTHER WHAT IFs AND BUTs
Emotions- there will always be that intangible feeling of pride and accomplishment by paying off debt early. Although difficult to quantify, it's real and has value. We can't ignore this fact. However, this intangible value is likely very different for different people.
Taxes- yes, you have to pay taxes on your investments. This reduces the "after-tax" values I summarized above. However, the tax drag is never so much that it makes paying cash or accelerating your debt payoff better.
What if I don't get the long-term expected return on my investments if I invest spare cash versus accelerating debt payoffs? That is a risk, but on average, is the rate of return you earn in the market more than the cost of borrowed money? 9 out of 10 times, yes, so go with the averages.
OK GREAT, NOW DO MORTGAGES
Paying off your mortgage sooner is likely to leave you in an even worse predicament than I am paying cash for my car.
Refis are all the rage right now. This can either work for us or against us.
According to Bankrate.com, you can qualify for a 30-year mortgage for ~ 2.75%, depending on credit score, lender, down payment, etc.
The current cost of borrowed money is ridiculously low. It's so low you might be tempted to go with a 15-year mortgage for an even lower rate of ~ 2%.
Wouldn't it feel so good to tell your friends at your next social function that you're only paying 2% on your mortgage? Makes us feel smart, right?
Not so fast.
In almost all cases, it doesn't make sense to pay off a debt with a low-interest rate when, on average, you'll be more efficient using your cash to invest instead.
Here is the math.
A 30-year mortgage @ 2.75% = $2,449.45/mo principal & interest and costs $281,800.95 in total interest over the life of the loan.
A 15-year mortgage @ 2.00% = $3,861.05/mo principal & interest and costs $94,989.40 in total interest over the life of the loan.
It's the following scenario that folks assume is better: what if I went with the 15-year loan, then invested that $3,861.05/mo over a 15-year period once the loan was paid off?
Assuming you have the financial discipline to do this, it allows for a valid comparison between a 15-year mortgage + investing versus a 30-year mortgage and investing your extra cash flow over a 30 year period.
Investing $3,861.05/mo over 15 years, earning an average 7% return = $1,207,967. Subtract the interest cost of the 15-year loan and our net value over a 30 year period is $1,112,978.
Now let's see what investing the monthly payment difference ($1,411.60) between the 30-year mortgage and the 15-year mortgage gets us.
$1,411.60, invested monthly over a 30-year time frame, earning the same 7% rate of return = $1,661,780. Following the same apples-to-apples logic as we did for the 15-year mortgage, when we subtract the $281.800.95 interest cost on the 30-year loan, our net value is $1,379,979.
What does all this prove? It shows that on average, paying off your mortgage early will cost you a lot more money than you might think compared to investing your cash instead.
In my example above, someone buying or refinancing a $600,000 property is making a $267,001 mistake compared to accepting a slightly higher interest rate over a longer time period of being in debt.
How many years worth of retirement income does an extra $267,001 sitting in your investment account represent when added to your Social Security and/or pension payments? 5 years? 7 years? 10 years?
This makes a massive difference in a financial plan's probability of success.
THIS CAN'T BE TRUE, YOU'VE DESTROYED MY WORLD
That's the beauty of math. Numbers don't lie.
We're taught by our parents, society, the Suzy Orman/Dave Ramsey's of the world, and our mortgage bankers who want to sell us loan products, that getting out of debt as soon as possible is in our best interest.
We are conditioned to believe that debt is bad.
Retiring with a mortgage is still relatively taboo.
None of this is true.
My advice is to ask yourself if getting out of debt sooner or paying a lower interest rate worth the opportunity cost of extra money you could've earned by investing instead?
If you sleep better knowing that you're paying off debt sooner even when it's costing you tens of thousands, if not hundreds of thousands of dollars, then that's potentially valid (at least for you).
Just know that you could be growing your net worth more efficiently as well as increasing the success of your financial plan if you modified your behavior.
Personally, I can't justify these types of missed opportunities and will not be paying cash for my next vehicle nor will I be refinancing to a 15-year mortgage anytime soon.
You might be wondering what you should do. Usually, seeing two different scenarios laid out before you helps. It's way more accurate than going with our gut or guessing.
If you'd like us to run your numbers, just reach out. There's a "Contact" button in the upper right corner of your screen. Just shoot us a message so we can get in touch about your decision-making process.