Paying off a mortgage early has always been an enticing idea: It frees up monthly cash flow, slashes the amount of interest you’d pay over the lifetime of the loan and clears away what is likely your biggest debt. But the fact is that it’s usually better to invest extra cash in the markets rather than to use it to kill off a mortgage. Let’s look at why that remains true even at a time when interest rates are spiking, and the markets are struggling.
Rising Loan Rates
The rise in loan costs has been dramatic. Thanks to the Federal Reserve’s aggressive anti-inflation policies, rates on fixed 30-year loans have more than doubled since the start of the year, to an average of 6.7%. Home loans are now at their most expensive level since July of 2007.1 Homeowners with fixed-rate mortgages at 4% or less are likely feeling good about their rates and are less inclined to pay them off ahead of schedule. But what to do with extra cash? The current investment markets seem perilous to many: A diversified basket of bonds fell to 14.61%,2 while the S&P 500 lost 23.87% as of September 2022.3
Investing in Stocks
Not long ago, the answer to whether to put extra cash to work in the markets or pay off a mortgage was obvious. In 10 of the past 13 years, investing extra cash in the S&P 500 would have resulted in a lopsided advantage. Instead of “earning” a hypothetical 4% or so in 2021 by eliminating mortgage interest, you could have gained 27% by investing in the S&P 500,4 for example. This year’s ugly market might tempt some to avoid direct extra cash toward paying off their mortgage instead of investing it.
How Stocks Have Bounced Back
In the past 48 years, the S&P 500 has gained, on average, more than 8% in the month following market correction bottoms. After a year, the average gain has been more than 24%.5 While no one can accurately predict what the markets will do in the next few years, history is clear, as is the fact that stocks are considerably cheaper than they were just a few months ago. And keep in mind that paying off your mortgage eliminates a tax benefit. In the 2022 tax year, single filers and married couples filing jointly can deduct mortgage interest on the first $750,000 if they qualify.6
Downsizing Your Mortgage
While there are usually better uses for extra cash than paying off a mortgage, there are exceptions. If you have an adjustable-rate mortgage that’s about to reset at a much higher rate, it may make sense to recast the loan. Recasting a loan is an inexpensive process whereby your lender recalculates your monthly payments based on the outstanding balance and remaining term. By using your extra cash to eliminate a big chunk of the loan’s principal, you can lower your monthly payment even as your interest rate rises.
To Buy or Not to Buy
Fast-rising mortgage rates are affecting many decisions aside from how to allocate extra cash. One of them is whether to buy a home or wait. The answer depends on your personal situation and goals, of course. But it’s worth noting that mortgage rates are still reasonable by historical standards. From April of 1971 to the present, 30-year fixed-rate mortgages have averaged 7.76%, a full percentage point higher than where they are now.7
A Home or an Investment?
After sharp, pandemic-era increases, home prices have begun to decelerate: Median prices fell about 1% in July and again in August.8 If you’re hoping to buy real estate as an investment, as so many wealthy families have, that might not be great news. But when you are buying a house to make a home for your family, it’s not just about price appreciation. And keep in mind that interest rates historically alternate between rising and falling. As they eventually trend down, you may choose to refinance at a lower rate.
Decisions about how to use extra cash can be complex. But they’re ultimately best understood through a long-term lens and with an eye toward balancing your most important goals. Your wealth advisor is always available to help you understand your options and how your decision could affect your wealth plan and long-term goals.
Footnotes
1 “Mortgage rates surge, closing in on 7%”
2 “Bloomberg U.S. Aggregate Bond Index as of 9/30/22
3 “S&P 500 Index” as of 9/30/2022
4 “S&P 500 ends 2021 with a nearly 27% gain, but dips in final trading day” as of 12/24/21
5 “Market Corrections are More Common Than You Might Think”
6 “Publication 936 (2021), Home Mortgage Interest Deduction”
7 “Mortgage rates chart: Historical and current rate trends”
8 “US Home Prices Now Posting Biggest Monthly Drops Since 2009”
The S&P 500 Index is a market-value weighted index provided by Standard & Poor’s and is comprised of 500 companies chosen for market size and industry group representation. The Bloomberg U.S. Aggregate Bond Index is designed to measure the performance of the U.S. dollar denominated investment grade bond market. The indexes are unmanaged and are not available for direct investment, and performance does not include any taxes or investment fees which will lower performance. Past performance does not guarantee future results. Investing involves risk and the potential to lose principal.
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