Hello everyone! Hope all is well. Here I am on a Sunday typing up some thoughts that have been running in my head lately on paying off my mortgage or investing in the stock market. In the backdrop of these thoughts is my recent “liquidity situation” now that I’ve invested most of what was in my taxable brokerage account into my small business.
First, let’s start with a little background. Just a few months ago the US Government gave us a holiday present with their tax reform act. Most everyone will now be paying less in taxes. But how the reform affects me the most right now is the increased standard deduction. I will no longer be itemizing and if I do, there will be marginal benefit over the standard deduction.
So now, having a mortgage on my house doesn’t really have any tax benefit for me. I’ve talked before about how buying a home has been a positive for my net worth, and the tax savings from mortgage interest deductions has been a primary reason.
Now that it makes no difference on my taxes if I pay down my mortgage or not, perhaps I start paying it down faster?
Granted, my mortgage interest rate is close to historic lows. We bought our home in mid 2012 and secured a 30-year rate below 4%. As I pay down the mortgage, there will be no getting back a super low rate like that.
The mortgage tax effective rate is no longer sub-3% since I can’t deduct the interest. What I mean here is that if the mortgage interest expense is tax deductible and for simplicity sake say my normal rate is 4% and my tax rate is 30%, then the tax effective rate is 2.8% (1-.3 X 4% = 2.8%).
The benefit of paying off the mortgage faster now is saving the full ~4% interest expense rather than the tax effective rate of 2.8% before the tax reform. Effectively, putting more money toward my mortgage is locking in a 4% return (interest savings) and my net worth will go up because of the money put toward my mortgage will pay down the loan balance.
The other value driver is paying it off entirely. If I were to divert all the money we make (after continuing to max our 401K and IRAs), it would take me about three years to pay off the mortgage entirely. At that point, our annual expense / cost of living would drop $15K or so as we would no longer have a monthly mortgage payment.
At that point going forward, we’ll have more and more cash flow available to invest in the stock market. That timeframe would also coincide with when both our boys will be out of daycare. That would be another ~$20K of less expense each year to invest.
By paying off the mortgage in the next three years we’ll be investing a lot less in the market now, but still have plenty of opportunity to invest heavily once it’s gone for good.
The Opportunity Cost
While paying off my mortgage is locking in a 4% return on that money, I’d be missing out on investing more into the stock market which I’ve always been a huge proponent of. Right now, I’m 100% in the stock market via various index funds. No doubt the market has been pretty hot in the last 18 months or so, and even if tax reform puts a little more wind in the economic sails, I have a feeling that we’re closer to the peak of the market than the trough.
8% returns has always been my long term expectation for the stock market, so paying a ~4% mortgage may not be a keen decision…
The thought in the back of my mind goes back to the current stock market likely be closer to the next peak than the prior trough. Who knows for sure, but that would be my inclination. I can divert cash flow from the stock market toward my mortgage in the near term, then as soon as the stock market has a ~20% correction, I could do a cash out refinance on my home and throw the money in the market at that point and try to ride it back up. Of course, who knows what kind of market gains I would potentially miss out in the near term.
I know trying to time the market is a tough conquest, but the only sacrifice I’d be making is a the potential upside in the market while paying off my 4% mortgage early. That may not be a huge loss. Meanwhile the rest of my funds and investments will continue to be 100% in the stock market. It isn’t like I will be pulling all my investments to the sidelines.
I’d be trying to time the market and risking it continuing to drop for a while, but those funds would have otherwise already been in the market in the first place had I not chosen to pay off the mortgage early.
Ultimately, it would be a winning proposition if the market gains less than 4% per year between the time I decide to put all my extra cash flow toward the mortgage to the point when I decide to do a cash out refinance to put that money back into the market. If the market simply stagnates for a while (not even a full 20%+ correction), it could be a win because in the meantime I’d be saving that 4% interest. In essence, the decision would be a 4% win if the market is flat.
Something to ponder as we move into 2018 and the new tax environment. The proposition for saving 4% is surely greater than 2.8% when the tax environment allowed me to deduct the interest expense. What do you think? Have you considered a similar plan? Is it silly to change my investment philosophy that has worked for me so well? Let me know in the comments below.
Thanks for taking a look!
The Green Swan
Disclaimer: Refer to my disclosure page. This post is simply for discussion purposes and something I’m currently contemplating. Do not construe this as investment advice. Talk to a professional if you need help with investment considerations.