Mortgage Payoff?

A friend who stood to collect a windfall of money asked me what I thought of using it to pay off his mortgage. His other option, investing the proceeds for growth or income, were on the table, as well. What to do?

Equity markets are in a turmoil these days as they lose both supply and consumer demand to the COVID-19 outbreak, but for this question I want to consider more normal times. We’ll get back to there, someday.

I’ll use my own circumstance to run the numbers, so assume a $216,000 remaining balance on a mortgage financed at 4% fixed, with twenty-eight years remaining on a 30-year note. The monthly payment amortizes to about $1122 net of tax and insurance expenses.

Assume, too, that our retirement investing is already taken care of. If it weren’t, the right move would be to put the windfall to work there.

In exchange for paying off the mortgage, we can keep the $1122 I’d otherwise hand to my lender every month, or $13,464 annually. That’s 6.23% of the outstanding balance. The money has already been taxed when I earned it, and I’m assured of keeping that payment in-hand as long as I own this house. That makes the virtual dividend both tax-free and guaranteed.

This option carries significant intangible benefits, as well. There’s the peace of mind that comes from knowing that we have a place to live for not much outlay—taxes, insurance, utilities, and upkeep—no matter what.

We could invest the money in the financial markets, instead. Since the money isn’t destined for our retirement accounts, growth isn’t absolutely necessary. Increased current income would also be a welcome outcome. Stocks and bonds, respectively, fit the bill. I’m partial to mutual funds and ETFs rather than direct stock and bond purchase, so I’ll draw my comparisons from them.

We’ll have a more significant opportunity for gain if we decide to invest in equity funds. The US stock market returns roughly 8% annually over the long term. More narrowly focused funds and ETFs perform better than that, so let’s be generous and assume an overall annual gain of 10%. Over the course of a reasonably smooth decade such as the one just finished, we could see our principle rise by $344,000 to over $560,000.

But that gain is taxable. Our current long-term capital gain tax is 15%, or about $52,000 of that gain, yielding a net gain of around $292,000. And although there are no historical ten-year spans when equities returned negative results, this return is by no means guaranteed. Throughout the decade this money is invested, it’s out of reach and there’s still a monthly mortgage payment to be made. Still, a potential six-figure gain is enticing.

Finally, we could invest the money for current income. Recall that the mortgage payoff yields a virtual income gain of roughly 6.25% on $216,000, tax-free. The equivalent taxable yield for taxpayers in the 22% tax bracket is an astounding 7.99%! Any income-producing investment would have to beat that.

The closest we can come is with high-yield bonds, bond funds, and ETFs. For example, the Vanguard HY fund’s (VWEAX) dividends are paying about 5.25% annualized right now, taxable. Bond fund dividends are generally reliable, but not guaranteed.

So: pay off the mortgage and reap a 6.25% guaranteed, tax-free virtual dividend plus peace of mind; shepherd an investment in equities for a decade—on top of any retirement investments I’m already holding for long-term gains—and hope the market adds to my wealth; or sink the money into, say, high-yield bonds for an income of around 5.25% taxable.

It it were my money, I’d pay off the mortgage.

#mortgage #payoff #choices