Pay Off Debt or Invest? The Answer, in 2 Charts

Throughout the course of human history, there have been some age-old debates:

Nature vs. Nurture

Free Will vs. Determinism

Ketchup vs. Mustard

Jordan vs. Lebron

Laurel vs. Yanny

Thankfully, all of these debates have already been settled (combination, free will, mustard, Lebron, and Laurel, obviously). Now, on to the debate that continues to plague the personal finance community:

Pay off Debt vs. Invest

This topic has been covered ad nauseam, so I will not rehash the talking points of each side. Rather, I will direct you to some recent posts that summarize the argument quite well. Mind you, all of the following posts were published in the last 8 weeks. This topic is on FIRE! (ha ha ha)

First of all, I must qualify this debate by saying that we are talking about low-to-mid single digits interest rate debt. For most people, this means your mortgage. As I covered in the Brewing FIRE Investing Hierarchy, any debt higher than ~6% should be paid off aggressively before funding most other investment accounts.

The Pros and Cons of Paying Off Debt

The pros and cons of as to whether you should pay off debt can be summed up as follows:

Pros

  • Guaranteed Return: the interest rate of your debt equals the return you will receive as you retire the debt. Guaranteed.
  • Reduced Expenses: once your loan or mortgage is paid off, that is a monthly recurring expense that you no longer have to worry about.
  • Peace of Mind: for many, this is the most important benefit. Knowing you own your residence and no longer have a large debt obligation is freeing and can reduce stress. Also, it makes your financial situation more ‘recession-proof’.

Cons

  • Better Returns if Invested: we all know the long-term stock market return is somewhere in the 8-10% range. On average, the market will earn higher returns than the 3-5% interest rate of your debt.
  • Loss of Liquidity: the money you pay toward your principal is essentially ‘locked up’ and is no longer available to you (unless you draw a home equity loan or line of credit).
  • Tax Benefits (maybe?): mortgage interest is tax deductible on your federal return. Historically, this means a 20-25% discount on the interest payment, depending on your effective marginal tax rate. However, with the new Tax Cuts and Jobs Act, most households will take the standard deduction, which limits the ‘benefit’ of the tax deduction.

I’ve been thinking about this topic a lot lately, and trying to decide how our household should be allocating our extra cash each month. Ultimately, I’ve decided to increase our mortgage principal payments each month with the hopes of paying off our mortgage in the next 5-6 years. 

The following 2 charts had a large bearing on my decision, and maybe they will persuade you to reevaluate your situation as well.

Chart 1: 30 Years of Interest

Recently I saw a quote that said something to this effect:

“When you take out a 30-year mortgage, you are buying a house for yourself and a house for the bank.”

And if you run the numbers, it’s true! Depending on the terms of the loan, you can end up paying most of the loan value in interest, in addition to the principal that you borrowed. It’s pretty scary when you look at it this way.

For illustrative purposes, let’s assume you purchase a $300,000 home and put 20% down (borrow $240k). You get a 30-year, fixed-rate loan with an APR of 4.5%, which is roughly the prime rate these days.

Total Mortgage Cost vs. Extra Monthly Payments ($240,000 30-year loan, 4.5% APR)

If you make no extra principal payments, you will pay almost $200,000 in interest over the course of your loan, which is more than 80% of original loan value. Yikes!

Thankfully, if you make additional monthly payments toward the principal, you’ll make a significant dent in this interest expense. Even $250 monthly extra principal payments ($3000 annually) can reduce your total interest owed by a third. Not to mention, you will pay off your home approximately 9 years earlier.

As shown in my April Net Worth Update, there are diminishing returns to the amount of extra cash you throw at your mortgage each month. However, I think it’s pretty clear that you should at least consider making a small periodic principal payment on your mortgage. 

Another way to reduce the total interest paid is to refinance your mortgage to a lower interest rate (if possible), or to switch to a short loan term. This will cause the monthly payment to be higher, though, and is outside the scope of the “pay off debt vs. invest” debate.

In our case, I would like to own our house outright (or at least have significant equity in it) by the time we starting thinking about FI, which is 5 or 6 years away. This would reduce our monthly expenses and give us more flexibility when it comes to our retirement earning/drawdown strategy.

Chart 2: Time Horizon and Expected Returns

Every one of the articles cited at the beginning of this post mentions the expected return of investing in the market vs. the interest rate of the debt. It is true that, on average, investing in the broad market has returned somewhere in the 8-10% range annually since forever. I think what a lot of bloggers are missing, however, is one key point:

Time Horizon

It’s understandable to expect a long-term return in the 8% range. But in this case, we’re not talking about paying off your mortgage in 20-30 years. Most people are trying to eliminate debt ASAP. This might mean 1-2 years, or 5-10 years, but in any case it’s a shorter-term strategy.

So why does time horizon matter? Because your expected returns are completely different when your investment period changes.

The following charts show the historical average returns for the S&P 500 for 20, 10, and 5-year investment holding periods (including dividends).

S&P 500 Returns vs. Average Holding Period, 1928-Present

What we can deduce from these graphs is this: for longer holding periods, you can reliably expect a positive return with a more narrow distribution of outcomes. For shorter durations, however, there is far greater volatility, with a much higher probability of low (or negative) returns.

In other words, you cannot expect 8-10% returns over a 3, 5, or even 10 year investment period.

To further illustrate this point, I’ve tabulated the results for each of the stated holding periods. I’ve also added a line item that shows the percentage of holding periods that would underperform the guaranteed 4.5% return of paying off your mortgage.

S&P Performance vs. Investment Holding Period, 1928-Present

As you can see, the average return is quite similar for the different holding periods. The big difference is in variability, which is represented by the standard deviation. For a 20 year holding period, your one standard deviation return should be 5.6 – 11.2%. Not bad. For a 5 year hold period, however, the one standard deviation return ranges anywhere from 0.2 – 15.2%. That doesn’t sound as nice to me. And you would underperform the 4.5% guaranteed return of your mortgage in one third of all cases.

To further complicate matters, we are currently nine years into a bull market. Now I’m not advocating trying to time the market, but chances are pretty good that we will be facing a correction/recession within the next few years. This means the return for the next 5 years probably will not be stellar.

Our Plan

So what do these 2 charts really mean, and what decisions am I making for my family based on this data?

First, I’ve decided to crank up our monthly principal payments on our mortgage. We had previously been making $400 contributions, but at this rate we wouldn’t pay off the house until 2036. We will now increase our principal payments to $2000-3000 per month, depending on our free cash flow. Assuming no major changes in our lives and/or the economy, we will continue with this plan at least until our regular payments are going 50-60% to the principal. At this point, the total interest expense will be lower, and I may reevaluate.

read also: House Hacking our Way to FI

If we do in fact enter a recession and markets retreat from all time highs, I will think about reallocating our capital. For instance, if we had a 30% market correction, I would certainly want to divert more funds into equities to take advantage of more reasonable prices.

To be clear, I am not advocating paying off a 4% mortgage instead of maxing out your 401k. The funds we are directing to mortgage principal would otherwise go into taxable brokerage accounts, since we have already maxed out all tax-advantaged investments.

As always, every situation in personal finance is, in fact, personal. You may have reason to take a different approach, and that’s OK. For me, it seems like a good time to funnel additional funds toward our home loan balance, in hopes of becoming debt-free around the time we reach FI.

I hope these charts helped you decide whether you should pay off debt or invest your extra cash. Please let me know what you think in the comments!

10 thoughts on “Pay Off Debt or Invest? The Answer, in 2 Charts

  • “When you take out a 30-year mortgage, you are buying a house for yourself and a house for the bank.” That’s an awesome quote. I might have to whip that out at parties 😉 . Awesome analysis! I especially love the mortgage mortgage paydown chart (I’m a visual person…). I might have to save that for a future discussion with my friends.

    • I read it somewhere, but for the life of me I can’t find the source of that quote. Does that mean I can just take credit for it? 😉 I’m also a visual person, sometimes numbers alone don’t do justice, whereas a nice graph or chart can have such a strong impact. Thanks for reading!

  • Very useful.

    Like you say in your penultimate paragraph, this type of personal finance dilemma is personal.
    Meaning there is not right or wrong answer.

    I hope to pay off my mortgage with extra mortgage payments while contributing a significant % of my income to investing.

    • Thanks for commenting. I guess I am grateful that we are in a financial position to even have this decision (pay off mortgage early or invest). A lot of people can barely meet their basic needs.

  • we paid off our mortgage about 4-5 years ago. i wanted the free cash flow and it allowed me to comfortably replace a car. then we lost one income and that free cash flow was nice and the car was paid off so it wasn’t much of a lifestyle hit. we also got a heloc which we don’t intend to use and costs zero if we don’t touch it. but in case of nuclear emergency break glass. i like that bird in the hand thing with guaranteed 4.5%. i would take that guarantee and you don’t HAVE to stay with the strategy if it’s not working out. nice analysis.

    • I agree re:increasing free cash flow. It’s not so much “peace of mind” as it is “less expenses”, which ultimately gives us more flexibility. I also opened a HELOC last month as our emergency float of cash. We’re not planning to use it, but it’s nice to have (at no additional cost). I’m still debating whether I should use it to accelerate mortgage payoff, but I don’t think it would actually save us that much in interest.

      • well, not that you asked, but i wouldn’t exchange debt for debt i don’t think. ours was opened in case our huge house repairs turned out even huge-er than expected! sounds like you’re on the right track in your house.

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