Henssler Financial usually recommends that homeowners NOT pre-pay their mortgages or pay cash for their houses. From a purely financial standpoint, it usually makes good financial sense to invest in a diversified stock or mutual fund portfolio with extra money rather than pre-pay a mortgage. The reason is that in the long run, you can usually earn more in the stock market than it costs to borrow money to buy a house. Our past article “Should You Pay Off Your House?” provides a detailed explanation of our position. However, lately we hear the question, “Since my stocks are not performing, should I sell my stocks and use the proceeds to pay off my mortgage?” Generally, we recommend that you keep your stocks and continue to make your monthly mortgage payments.
First, consider that our recommendation is for the long-term investor with a time horizon of 10 or more years. Chances are good that the stock market will be higher in 10 years than it is today. For the short-term investor (less than 10 years), these chances are not as certain. Generally, we do not invest in the short-run and believes that money needed for spending in less than 10 years should be out of the stock market and invested into high quality, fixed-income securities. Therefore, long-term investors should not be as concerned about a period of lackluster market performance.
The stock market tends to cause people to react emotionally. When stock prices are high and prices are going up, people want to buy. Yet when stock prices are low and possibly going lower, people want to stay out of the market or sell. Frankly, this is silly. When you arrive at your favorite store to go shopping and notice that they are having a big sale, do you quickly run home and wait for the prices to go back up before you will go shopping again? Of course not. Does it make sense that you would want to buy when stock prices are low and sell when they are high? With that being said, if buying stocks is a good idea for a long-term investor, then a down market is an excellent time to buy.
Within the last few years, most of us have refinanced our mortgages and obtained lower interest rates than we had before. The stated interest rate on a mortgage is not always the effective borrowing rate because the interest paid on a mortgage is generally a tax-deductible expense. Homebuyers can calculate an effective borrowing rate by considering their federal and state marginal tax rates. Keep in mind that itemized deductions are reduced when Adjusted Gross Income (AGI) reaches the phaseout limit. In this case, a C.P.A. would need to calculate the effective borrowing rate. The following example illustrates how to calculate the effective borrowing rate, if the homebuyer’s AGI does not exceed the annual adjustable limit.
For example:
|
Mortgage Rate
|
Federal Tax Rate
|
GA Tax Rate
|
|
6%
|
28%
|
6%
|
Calculation:
|
Federal Tax Rate
|
+
|
GA Tax Rate
|
=
|
Total Tax Rate
|
|
.28
|
+
|
.06
|
=
|
.34
|
|
(1.00 – Total Tax Rate)
|
x
|
Mortgage Rate
|
=
|
Effective Borrowing Rate
|
|
(1.00 – .34)
|
x
|
.06
|
=
|
0.0369 or 3.96%
|
The effective borrowing rate should be compared to the projected return on a portfolio. In the example above, a long-term investor would need his or her portfolio to return more than 3.96%, annually, on average, in order to outperform the mortgage.
To sum it up, from a financial standpoint, investors should be able to make more money by saving extra cash to a diversified long-term growth portfolio instead of pre-paying their mortgage. If this was good advice when stocks and interest rates were up, it is even better advice with stocks and interest rates down.