By Dustin Sobolik, CFP® – Investment Officer
One question I’m often asked by clients is what to do with excess savings. Should they invest it or pay extra on their mortgage? I’m going to frame this article with a simple question and a simple answer, followed by a much more complicated answer. Let’s boil this down to a few core considerations:
- Expected returns
- Risk tolerance and psychology
- Tax considerations
The simple answer:
If the interest rate on your debt exceeds your portfolio’s expected return, assuming an equal value of both the debt and investment portfolio, I would generally gravitate toward paying down your debt first. If your portfolio’s expected return is substantially higher than the interest rate on your debt, I would generally gravitate toward investing. This comes with an important caveat: everyone’s portfolio and personal situation is different.
A well-diversified stock portfolio can generate extraordinary amounts of wealth over the long term despite periodic bouts of volatility. That return may easily outpace the interest on your debt. Erm, oh, what’s that? A whisper off in the distance? Someone is saying, “But Dustin, you said forecasted returns were exceptionally low during your recent engaging and outstandingly informative webinar?!” And you’d be right. However, forecasted stock market returns are still higher than the interest accruing on your sweet 2.85% 30-year mortgage if you took advantage of the recent low refinancing rates.
Risk Tolerance and Psychology
“Dustin, you don’t know what market returns are going to be! And my portfolio is well-diversified to account for market swings!”
These are very fair arguments. It’s great for your portfolio to be diversified and I absolutely cannot predict market returns. But it does bring me to a few points:
- The sequence of returns isn’t always ideal.
- Your risk tolerance may not be what you think it is.
- A mortgage is effectively leverage.
What do I mean when I say the sequence of returns isn’t ideal? A portfolio return over a ten-year period might average 6% annually, but that average may include a 35% gain in one year and a loss of 25% in another year. If you owned a U.S. stock portfolio from 2000 to 2010, there’s a good chance you could have had a lost decade from a return standpoint.
This is where your risk tolerance comes into play. Oftentimes, it’s easy for people to say they’re willing to weather market volatility when markets are sanguine. It’s another thing to actually follow through when markets nosedive like they did during the early days of COVID – or worse yet, when you’re confronted with poor returns several years in a row. If my nearly ten years in investment management has taught me anything, it’s that not everyone can handle volatility like they say they can.
My third point: a mortgage is effectively leverage and therefore increases the risk of your portfolio. Your portfolio does not consist solely of stocks and bonds. It’s a much larger part of your balance sheet, if not the entire balance sheet. The primary difference between a margin account (a loan secured by investments) and a mortgage is just the collateral. So, if my logic follows, a risk averse investor should also be risk averse with the amount of debt they carry.
Acknowledging everything you’ve read up until this point, withdrawing a large sum from your IRA to pay off your mortgage is probably a bad idea. Why? It’ll likely be subject to ordinary income tax, and you could end up vaulting yourself into another bracket. I would echo that point if you’re selling an investment with substantial capital gains in a similar scenario. Simply put, the extra tax may not be worth it. However, I am not an accountant or a tax advisor and everyone’s situation is different. So, visit with your tax professional before you make any final decisions.