In boom times, it can make sense to mortgage your home, which typically appreciates in the single-digit range, and use your excess cash to invest in stocks, which had been soaring until early 2020.
And in tough times, the conventional wisdom advises paying down the mortgage while eschewing investment risk.
During the economic slowdown caused by the coronavirus pandemic, which approach is the correct one? Advocates for both strategies make compelling cases, and the reality is that the right answer for you probably depends on your tolerance for financial risk.
Thomas Anderson, the author of “The Value of Debt in Building Wealth,” says the instinct to pay down the mortgage in tough times is a natural one — but you should ignore that urge.
“When times are bad, the gut reaction is, ‘I should be paying down debt,’” says Anderson, who runs Anasova, a personal finance marketplace headquartered in Chicago. “People should actually be doing the opposite.”
Chris Hogan, the author of “Everyday Millionaires,” disagrees. He advises clients and audiences to pay down their mortgages as quickly as possible, and especially when the economy hits a rocky patch.
“I’m allergic to debt,” says Hogan, a Nashville-based financial coach and a protege of Dave Ramsey, the prominent financial guru. “I see debt as a threat.”
Which approach you take depends on your appetite for risk
Both strategies are correct in theory, says Ken H. Johnson, a housing economist at Florida Atlantic University. Using debt as leverage to boost returns is a common practice in the financial world. On the other hand, there’s much to be said for the cozy feeling created by an utter lack of creditors seeking monthly payments.
“You can’t go broke if you don’t have any debt,” Johnson says.
Which approach is right for you really depends on how you feel about debt and how comfortable you are with the market’s inevitable swings.
“The average person has to fall back to, ‘What is my tolerance for risk?’” Johnson says. “It’s well established in academic research that different people have different tolerances for risk.”
Personal preference isn’t the only variable. Risk tolerance can shift with economic cycles, too. In an episode of the classic TV series “All in the Family,” Archie Bunker burned his mortgage after he paid it off. Archie was old enough to remember the Great Depression, and he adjusted his risk tolerance accordingly. Today’s generations are accustomed to low mortgage rates, and they’re more comfortable owing money on an asset that usually appreciates.
While the pro-debt Anderson and the anti-debt Hogan have divergent views on home equity, they agree on the basics of building wealth. Both hate credit card debt, both suggest building emergency savings accounts with six months of living expenses, and both urge investing for retirement.
But for those who already have achieved homeownership and financial stability, the two experts espouse very different approaches to using the value of your residence.
The traditional view: Pay down your mortgage
Hogan advises putting 15 percent of your income toward retirement savings and using excess cash to trim mortgage debt. He sees debt not as a tool but as an insidious enemy that must be attacked.
“I know this about debt: It brings risk,” Hogan says. “Debt doesn’t care if your kid is sick or if you’re sick or if you lost your job. It just takes.”
Hogan interviewed millionaires for his most recent book, and he discovered a common theme: Many paid down their home loans as quickly as they could.
If you must have a mortgage, Hogan advises, take a 15-year loan, because you’ll retire the debt more quickly and pay much less interest than with a 30-year mortgage.
About 37 percent of owner-occupied homes in the United States were owned without a mortgage as of 2018, according to the U.S. Census Bureau. The other 63 percent of homeowners should accelerate the day they make the final payment, Hogan argues.
“When you get that deed to your house and you realize you own it now, it’s a game-changer,” Hogan says. “You get the gift of options.”
Instead of diverting money to a monthly mortgage payment, you can route that money to saving and investing.
The opposing view: Use your home equity as an investment tool
Anderson, on the other hand, takes a contrarian view. While he says Americans are right to avoid credit card debt and to quickly retire student loan debt, Anderson argues that too many consumers have learned the lesson that all debt is bad.
“Yes, there’s value to owning your house outright,” Anderson says. “Of course there is. But there’s also a value to having $100,000 in the bank.”
He cites $100,000 as a hypothetical number. It might be more or less depending on your situation. But say that instead of paying off the $100,000 you owe on your mortgage, you hang onto the $100,000 and continue paying the loan.
You can use the $100,000 to make an investment if you see an opportunity, or to provide a cash cushion should you lose your job. Anderson notes that it’s almost impossible to tap into your home equity if you apply for a loan without a steady income.
“If you don’t have a job, what you need is money,” Anderson says.
Assuming that the rest of your financial situation is stable, making monthly payments on a home loan shouldn’t create undue stress.
“People are so quick to want to own their house but not have cash,” Anderson says. “I sleep well at night if I have $100,000 in cash. Cash is king.”
Running the numbers
With mortgage rates near record lows, using your home equity as a tool is a wise move, says Anderson. He calls it “strategic debt,” and he says that if you redirect your home equity to tax-advantaged retirement savings, you’ll reach retirement with far more in your portfolio than if you had focused on paying down your mortgage.
In “The Value of Debt in Building Wealth,” Anderson lays out three scenarios that illustrate how leverage can affect your retirement savings. He starts with a 35-year-old homeowner, household income of $120,000 a year and a $300,000 interest-only mortgage. The homeowner has $30,000 annually to devote to mortgage payments and retirement savings, and earns a 6 percent annual return on retirement savings. Here’s how the results would stack up:
The no-debt approach gets you to retirement with $1 million: Say you despise debt and spend extra income not on retirement savings but on retiring the mortgage. After 12 years of mortgage payments of $2,500 a month, you’re debt-free. At age 47, you redirect the $2,500 that had gone to the mortgage into retirement savings. You’ll reach retirement age with $1 million, Anderson says.
The medium-risk approach gives you a nest egg of $1.25 million: With this strategy, you opt to pay just $1,250 per month toward your mortgage and devote the other $1,250 to retirement savings. You’ll hit age 65 with $1.25 million in the retirement account and pay off the mortgage at age 65.
The high-leverage strategy creates a retirement account of $1.45 million: Instead of aggressively paying down the mortgage, you pay only the interest on your mortgage, which costs $750 a month. You put the remaining $1,750 toward retirement savings. At age 65, your retirement nest egg has grown to $1.75 million. Even after subtracting the $300,000 you still owe on the mortgage, your account balance is worth $200,000 more than that of the medium-risk approach and $450,000 more than the no-debt approach.
The difference is mainly because of the effects of compounding. By investing early, you get more time for your investments to grow in value. Anderson acknowledges that his scenarios are hypothetical. For instance, he assumes a 6 percent average return; your portfolio might do better or worse.
What’s more, paying interest only for three decades would require taking out a new adjustable-rate mortgage (ARM) every five or 10 years. And, of course, ARMs carry the risk of rising rates.
Taking advantage of rock-bottom rates
While Anderson advises using leverage, he also suggests a calculated approach to employing debt as a tool. Don’t borrow more than you can afford to repay, and don’t take money that a lender would deem risky.
So don’t take a loan that requires you to pay private mortgage insurance, and don’t pay more than the average rate on a 30-year fixed-rate mortgage, which stood at 3.55 percent as of April 22, according to Bankrate.com data.
“Get to the maximum amount you can borrow at the lowest rate,” Anderson says.
For most homeowners, that would mean borrowing 80 percent of their home’s value. Your goal: Borrow money cheaply and then use your investment portfolio to generate returns higher than your mortgage rate. With rates at rock-bottom levels, Anderson predicts, taking out a loan today will look like a savvy move years from now.
“I don’t think I’m going to wake up and hate myself for that,” Anderson says.