My 1st Million At 33 – yes, you can do it too

Let’s assume that you have built a sufficient buffer of emergency cash fund (see Cash Management: How Much For Your Emergency Cash Fund). When you have extra monthly cash, should you pay down the balance of your mortgage or invest them into other things?

There are very opinionated people on both sides of this issue. People who are investment gurus in either real estate or stock markets, or unflinching bulls will always advise not to pay down any of your mortgage balance. The more conservative people will always advise to pay down your mortgage and become debt-free if you can. I’m in the more conservative camp, but in general, I will also advise you NOT to pay down your mortgage.

A mortgage is essentially a SHORT position in bond market. Instead of buying a bond and receiving interests on it, you are paying interests on a bond. In respect to Modern Portfolio Theory, your amount of mortgage should count directly against any of your bond allocation. Let’s say if you have $100K in bond, and you have $100K in mortgage, it’s roughly the same as if you don’t have any position in bonds. What’s different in this scenario from having no mortgage and bond at all is that having a mortgage is a leverage action. It is a leverage using your real estate holding. A leverage expands your total size of portfolio using borrowed money.

Given my economic outlook on a heightened inflation going forward, bonds would not be a very good investment (you could read my bond investing series, and my Reasons for Not Investing in Bonds). Certainly, if I don’t like bonds, then SHORTing bonds should be good by default. Therefore, I would advise you NOT to pay down extra for your mortgage in general. Besides, because of inflation, your home is usually your best investment (mainly due to having a mortgage).

However, one thing is obvious. If you have a lot of cash (or bond) that are earning less than your mortgage interest rate, it is obviously a losing deal not to pay down your mortgage. Supposed that you have a mortgage balance that is at 6.25%, and have side cash or bonds lying around earning 5.00%, you are essentially paying an interest expense of 1.25% for having your money in a much more liquid and accessible form. I do believe in the value of having sufficient cash for your emergency needs. But you definitely don’t want to over do it.

I see many financial sites or articles suggesting that one should pay down their debt so that when the economy goes into recession, or deflationary forces are upon us, the house will not go into foreclosure due to miss of the payments. That seemingly makes sense. Except that why would you want to make payments on something that may have a value less than your loan size if housing value also goes down (let’s forget about money ethics for a moment). In a recession, if you could walk away from your loan without triggering deficiency judgment (especially in the event of a job loss), it is probably better for you not to pay down your mortgage so that you could potentially walk away with less loss (and make sure that your money deposits are not at the same bank/institution who owns your mortgage). NOTE: this is just by number-crunching, without any consideration to your long term credit and your own ethics.

Therefore, in both inflation and deflation scenarios, it is very likely that it is better for you NOT to pay down your mortgage. Of course, there are other reasons not related to economy, such as legal reasons and insurance. I will not discuss them here, since they are more obvious than the debate on inflation/deflation.

Does that mean that there is no value of paying down your mortgage? If you can invest in something that has higher return than your mortgage, certainly you should invest. The tough part is to get such return with less risk & volatility. After all, you could have paid something off your mortgage debt. But when your investments don’t work out, your debt obligation still remains as onerous. What one should do is carefully look at the entire picture of one’s net worth and portfolio composition. I will answer the decision between investing and paying down mortgage in a more quantitative way in my future post on Cash Management: Refinance or Accumulate Home Equity?