Paying off your mortgage early, especially before retirement, is a worthy financial goal. But doing so in lieu of investing isn’t the best decision for everyone, according to a recent study from Fidelity.
Using a 27-year time horizon, Fidelity pinpointed the thresholds at which paying off your mortgage is wiser than staying invested and vice versa. For example, the firm’s research indicates that the most conservative investors, like retirees and those approaching retirement, should consider paying off their loan early when the interest rate on their mortgage is more than 2.875%. The most aggressive investors, on the other hand, should only consider prepaying their mortgage if their interest rate is well over 5%.
“Prepaying debt sort of functions like buying an annuity: You reduce your risk by creating a guaranteed return equivalent to the interest rate on the mortgage,” said Mike Rusinak, a director of Fidelity’s Financial Solutions group. “For some investors, that certainty might be compelling, but for others it has the potential to actually reduce wealth.”
A financial advisor can help you decide whether prepaying your mortgage is the right move. Find a trusted advisor today.
Consider Your Asset Allocation and Interest Rate
The result of Fidelity’s analysis is a set of guidelines to help homeowners decide whether paying off their mortgage early or staying invested in the stock market is the best long-term option. In mulling the two strategies, Fidelity says to consider your asset allocation – the percentage of your portfolio invested in stocks, bonds and cash – and the interest rate of your mortgage.
Guidelines for Conservative Investors
Retirees and those approaching retirement typically take a more conservative approach to investing. They often limit their exposure to risky equities and have a larger percentage of assets allocated to fixed income investments and cash. As a result, retirees and the risk-averse may benefit more from paying off their mortgage early, Fidelity found. Here are Fidelity’s guidelines for investors with conservative investment portfolios:
Asset allocation: 20% stock / 50% bonds / 30% cash
Pay off your mortgage early if your interest rate exceeds 2.875%
Asset allocation: 30/50/20
Pay off your mortgage early if your interest rate exceeds 3.250%
Asset allocation: 45/40/15
Pay off your mortgage early if your interest rate exceeds 3.625%
Guidelines for Moderate Investors
Investors with slightly longer time horizons or simply more tolerance for risk will likely have a higher percentage of their portfolio allocated to equities. The classic 60/40 portfolio carries some of the upside of the other more aggressive asset allocations, but with less risk. As a result, these investors can afford slightly higher interest rates on their mortgages. Here are Fidelity’s guidelines for investors with moderate risk portfolios:
Asset allocation: 50/40/10
Pay off your mortgage early if your interest rate exceeds 4%
Asset allocation: 60/35/5
Pay off your mortgage early if your interest rate exceeds 4.375%
Guidelines for Aggressive Investors
Investors with longer time horizons and more tolerance for risk typically have more exposure to equities than bonds and cash. As a result, they can capture higher returns over time compared to conservative or moderate portfolios. Some can afford mortgage rates that exceed 5% because the returns their investment portfolio produces will be even higher. Here are Fidelity’s guidelines for investors with aggressive portfolios:
Asset allocation: 70/25/5
Pay off your mortgage early if your interest rate exceeds 4.625%
Asset allocation: 85/15/0
Pay off your mortgage early if your interest rate exceeds 5%
Asset allocation: 100/0/0
Pay off your mortgage early if your interest rate exceeds 5.375%
Don’t Forget Taxes
When deciding whether to remain invested in the stock market or pay off their mortgage early, an investor will compare the interest rate on their mortgage with the expected rate of return of their investment portfolio. Typically, when a portfolio’s rate of return exceeds the interest rate on a mortgage, it makes more sense to stay invested in the market. The analysis specifically examined whether prepaying a loan decreases your risk of running out of money in retirement, whether it lessens the volatility of your portfolio and the impact it can have on your total wealth.
However, the study did not take into account taxes or investment fees. Selling stock or withdrawing money from a retirement account to pay off your mortgage will trigger a tax bill that will increase the cost of paying off the loan. For that reason, borrowers with lower interest rates may benefit from staying invested in the stock market.
Fidelity’s guidelines also may not be appropriate for taxpayers who itemize expenses. For those who itemize and wish to pay off their mortgage early, the interest rate on your mortgage may need to be even higher than the guidelines suggest, according to Fidelity.
“The mortgage interest tax break lowers the cost of a mortgage, so for those who itemize deductions, losing the mortgage interest deduction also reduces the savings if you pay it off,” the firm said in its analysis. “So people who benefit from that deduction might need a higher rate before it makes sense to pay off the loan.”
Prepaying your mortgage can be as big of an emotional lift as a financial one. Not only do you end up paying less in interest, but you also reduce your monthly spending needs and create more flexibility within your budget. However, prepaying your mortgage may not produce as much total wealth compared to investing. Investing may be preferable for people who are more comfortable with risk, are behind on their retirement savings goals or are simply attracted by the prospect of higher returns.
Fidelity’s guidelines can help you determine which strategy is right for you based on mix breakdown of assets and the interest rate on your mortgage.
Tips for Managing Your Mortgage
- A real estate agent isn’t the only person who can help you through the homebuying process. A financial advisor can help you set a budget and integrate your mortgage into a holistic financial plan. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Shopping around for a mortgage lender can help you lock in the best rate and terms for your purchase. Use SmartAsset’s rate comparison tool to track current rates and find the lender best for you.
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