Mortgage Payoff or Stocks?

Submitted by Michael Kitces on Friday, June 22, 2012 - 3:00pm
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Should you pre-pay your mortgage, or use your money for stock investing? It’s good to no longer have that mortgage around your neck. But equities’ long-term return generally exceeds the mortgage interest rate. 
The better question is: How much more should you expect to earn from stocks versus accelerating mortgage payments to make the stock-buying alternative worthwhile?
To see why, let’s look at something called the equity risk premium. That’s the excess return of stocks over long-term government bonds, which are risk-free. To compensate for the risk of owning stocks, the investor looks for an equity risk premium – a higher return than what could be received by just owning bonds, which historically has been about five percentage points.
Similarly, the mortgage borrower shouldn't invest in stocks unless expecting to earn an equity risk premium. But since the mortgage can always be repaid to generate a “risk free” return of not paying mortgage interest, the key is to earn an equity risk premium (around five percentage points) over the mortgage interest rate.  Consequently, with a mortgage rate around 4%, you should not prepay your mortgage unless you expect a full 9% return on equities. That sufficiently rewards you for the risk.
As I've written in the past, saving into a portfolio instead of prepaying a mortgage is the equivalent of buying stocks with leverage, which as we know from margin accounts can be risky. Yet many maintain that, as long as stocks have an expected return that's higher than the cost of borrowing, "why not?"
The reason is that it's not sufficient to just get a higher return from stocks than it costs to borrow on the mortgage. The borrowing cost of the mortgage – or rather, the effective return that you get by repaying the mortgage and eliminating the associated interest cost – is a guaranteed, risk-free return. Investing in stocks, on the other hand, is risky. No investor would prudently pick a highly risky return just because it's barely higher than a risk-free alternative.
While Treasury bills returned about 3% over the past century – essentially just keeping pace with inflation and generating a real return of 0% – intermediate to long-term government bonds delivered a return of about 5% before inflation (real return of 2%). Stocks produced a long-term return of around 10% (real return of about 7%). This means long-term investors have demanded an equity risk premium of about five points, the excess of stock returns over longer-term-but-risk-free government bonds that can be held to maturity. (There is some debate about exactly how big the equity risk premium is, with some advocating amounts slightly higher or lower than five points, but we'll use that figure relative to Treasury bonds as a baseline.)
In a world where the 10-year bond yields about 2% (actually 1.7%, but we’ll round), then in theory an investor earning 7% in stocks is reasonably compensated for the risk. However, only the federal government borrows at 2%; the typical homeowner likely has a 4% to 5% mortgage interest rate. This means that the homeowner should direct the saved money toward stocks if there's a reasonable expectation that stocks will earn 9% to 10% in the next decade ... even though some are forecasting a 10-year annual equity return as low as 4%
Of course, any particular investor will determine his or her own expected return for stocks. An investor could select a different equity risk premium. Still, if the mortgage borrower merely expects that stocks will generate a better return than the mortgage interest rate – but not more than five points better (or some other risk premium) – the borrower is not sufficiently compensated for the risk of the endeavor.
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Michael Kitces, MSFS, MTAX, CFP, CLU, ChFC, is a partner and the director of research for Pinnacle Advisory Group, a private wealth management firm located in Columbia, Md., that oversees approximately $1 billion of client assets, and Pinnacle Advisor Solutions, a firm that provides outsourced investment management services for financial advisors. He is the publisher of the e-newsletter The Kitces eport and the blog Nerd’s Eye View through his website Kitces is also one of the 2010 recipients of the Financial Planning Association’s “Heart of Financial Planning” awards for his dedication to advancing the financial planning profession. Follow Kitces on Twitter at @MichaelKitces.
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