Paying for Certainty

Planning Reflection | January 28, 2022

Since the financial crisis in 2008, interest rates have been extraordinarily low. Mortgage rates remain at historical lows more than ten years later and have been trending downward since the early 1980s.¹ Low interest rates also lead to distortions in equity markets, pushing asset prices higher as investors seek higher returns. Those distortions have recently pushed labor costs and inflation higher as well, and the policy response may be a directional change that moves interest rates higher in the intermediate term.

As interest rates begin to rise, the landscape of investing will change with it, as well as the decision process of reducing or paying off debt.

Debt is fundamentally an obligation to pay someone else on pre-set terms. This means that your creditor can theoretically take legal action against you if you don’t make your payments, including foreclosing on your home. Some people are unfazed by this; others feel very strongly about financial independence.
 
Feelings around debt can be particularly acute when talking about a mortgage. The goal of owning your house free and clear is an aspiration for many people. Debt-free ownership offers an assurance that no one can take your house, creating an element of security and certainty in an uncertain world. In addition to this, a mortgage payment is often a person’s largest single monthly expense, and the idea of eliminating that payment can provide enormous psychological value as well as improved cash flow.
 
When clients ask our advice about whether they should pay down debt, one of the initial questions we ask in return is “How do you feel about carrying debt?” If monthly debt payments make you uncomfortable, this alone can heavily tilt the decision toward debt reduction. On the other hand, if you’re comfortable with the concept of productive debt, it is worth thinking about how certain debt can enhance your financial security in other ways.

The quantitative elements of a payoff or paydown decision ultimately boil down to a question of opportunity cost. Opportunity cost is an economic concept that emphasizes the cost of foregone alternatives, above and beyond the actual dollar cost of a financial decision. If you buy a pint of ice cream for $5, you can’t spend that same $5 on anything else. Similarly, if you pay down debt with $500, you can’t use that $500 for anything else. Assuming you have the means to pay down debt – whether all at once or by increasing your monthly payments – the question becomes what else could you or would you do with those dollars, and is that a better or more productive use of them?
 
Often, the alternative to debt reduction is to consider making a longer term investment. In theory, if you expect your investment return will be higher than the loan’s interest rate, then investing the dollars is better than paying down the loan. Put another way, if keeping the loan costs you $1,000 in interest, but you invest and earn $1,500 over the same time period, you’re $500 better off than you would have been if you’d simply paid the loan down.

This math works great if you know what your investment return will be up front. Unfortunately, we rarely have that luxury in the real world. Investing carries risk, and you can’t know in advance what return you’ll actually get over any particular period of time. Even with a broadly diversified portfolio, we can’t predict how assets will perform next month or next year. As the time period grows, though, so does our confidence that the portfolio will provide growth consistent with historical average rates of return. The longer the term of the loan, the more effective it is to compare the interest rate with the opportunity cost of an alternate investment. Simply put, the lower the loan’s interest rate and the longer its time frame, the more compelling the (mathematical) case for investing your excess cash flow instead of paying down debt.
 
We expect interest rates to eventually rise from recent historic lows. As interest rates rise, stock prices often fall, creating a better opportunity to enter an equity investment in an environment in which it also makes sense to keep existing low interest debt. While this combination makes it doubly compelling to retain existing debt and instead invest excess cash, it simultaneously complicates technical comparisons for new debt that is issued at higher rates. This illustrates the complexity and specificity of the calculations to be made.

Every decision to keep or pay down debt balances both personal and financial benefits, and not every circumstance is created equal. Even though from an opportunity cost perspective it may not make sense to pay off a 30-year mortgage that has a low 3.5% interest rate, the emotional benefit may very well outweigh the potential advantage of long-term investing.

When bringing the decision into focus, current interest rates, likely changes in rates, whether alternate investments are affordable, and a broad range of personal priorities all come into play. Paying off a mortgage can allow the comfort to weather the periodic downdrafts of a retirement portfolio invested in stocks. Other times life changes and flexibility is needed for other areas of spending – a wedding, elder care – and it makes sense to retain cash reserves at a higher level rather than paying off a loan early. The balance of technical and intangible considerations is nuanced, and making a thoughtful choice helps create a more satisfying outcome.

Sources

¹ https://fred.stlouisfed.org/series/MORTGAGE30US