I’ve read more than my fair share of personal finance blog posts during the last three years. I’m sure some of you out there can relate :). One topic that comes up repeatedly is whether it is better to pay off your debts or invest with your extra money. The answer to this differs from person to person depending on their personality and what motivates them.
I think most people would agree that if you have any high interest debt, say anything above 5-6%, then you should take the guaranteed 5-6% return on investment and pay off the debt.
But when your interest rate is lower, say in the 3-4% range it becomes a less obvious choice. Mrs. Dragon and I don’t have any non-mortgage debt, and our mortgage is at 3.65%.
Our goals for FI are $600,000 in liquid assets and a paid off house by Feb 2025.
Each of these is a long road, but we’ve decided to prioritize investing over paying off our mortgage and here are all the reasons why (in no particular order).
We are currently a two-income household and we save a lot of money on taxes by investing.
Mrs. Dragon and I are lucky enough to have access to quite a few tax-advantaged accounts. We both have access to a 403(b) and a 457(b). That means that we can each contribute $18k to our 403(b), another $18k to our 457(b), and $5500 to a Traditional IRA. That’s a combined total of $83,000 we can contribute to tax-advantaged accounts.
Also, we have a mandatory contribution of 6.5% of our paycheck that goes to a tax-deferred account and the contribution is completely matched by our employer. This money is in addition to the $83k above since it is a mandatory contribution.
With the purchase of our house, we aren’t going to be able to take full advantage of the $83k this year. However, I crunched the numbers and based on our earned income and projected contributions to retirement accounts we will save over $15,000 this year in federal income taxes!
I’m all for paying off debt, but saving $15k is too good to pass up.
Compounding takes time to work it’s magic. The mortgage has a life of about 10 years, while every investment dollar has a life longer than 30 years.
One of my favorite investing quotes is “Time in the market is much more important than timing the market.” Compound interest is an amazing thing, but it takes years to really give you results. Mrs. Dragon and I are relatively young at 30 years old, and we both have family members who’ve been long-lived. My grandpa (dad’s side) passed away earlier this year at 91 years old and I had a great grandmother (mom’s side) that lived to be 96.
With modern medicine, and barring any tragic accidents, I think it’s safe to say that we will live to be 60 years old. That means that every dollar we invest today can compound for 30+ years in the market. That is plenty of time to let compounding do it’s thing.
Unfortunately, compounding interest also works on debts. Like mortgages. But if all goes according to our plan, the mortgage will be paid off by Feb 2025. That gives the power of compounding only 10 years to work on the mortgage.
Since the lifespan of our investments is much longer than the lifespan of our mortgage, we are trying to get as many investment dollars built as early as we can.
Investing early is key to having long-term financial success. Ideally, you would start when you earn your first money as a teenager, but we can’t turn back the clock. Instead we are pumping money into investments now.
The expected return from the market is more that the known interest rate on the mortgage.
Historical real returns from the stock market have been around 7%. There are plenty of people who will tell you that the days of getting 7% a year in the stock market are long gone. However, even if you don’t think 7% is right, I think most would say a conservative 4-5% is likely over the long-term going forward.
At 3.65%, the interest rate on our mortgage is less than the expected return from our investments. So it makes sense to put the money where it will do the most good.
This point is the one that is most debated in the blogosphere. A lot of people would argue that the return you get from paying off the mortgage is guaranteed, while the stock market returns are not. This is completely true.
However, I’m comfortable taking that risk. It may or may not be right for everyone, but I’m familiar enough with market theory to feel fine about this tradeoff.
Inflation helps you with your mortgage and hurts you with your investments.
If you’ve been into personal finance for very long, then you’ve heard about the silent killer: inflation. It’s always a tricky thing trying to account for inflation because, much like market returns, it’s unpredictable. We don’t know whether it’s going to basically be 0% for several years or jump up into the high single digit range.
But, for this post, let’s just use the historical average of 3% per year. Inflation erodes the purchasing power of today’s dollars. Our timeline for wanting financial independence is about 10 years from now. If inflation averages 3%/year over those ten years then, in 2025, we will need $1.34 to have the same purchasing power as $1 today.
From an investment point of view, that’s not great news. It means that we will need 34% more money than we would need today, which is not a small increase. This means that if inflation isn’t already taken into account in your FI numbers, you are going to need even more money on top of what is probably already a dauntingly large number.
From a mortgage perspective, however, this is awesome news. Dollars today are worth more than dollars in ten years (based on our assumptions). The mortgage is taken out in today’s dollars, but with every year that passes you are paying back those dollars with the weaker future dollars.
So, let’s just say we still had a $50,000 mortgage in 2025. Now, $1.34 in future dollars is only worth $1 in past dollars, but when we pay our mortgage the exchange rate is 1:1. That means that we are actually only paying back $37,313.43 in purchasing power on that $50,000.
Since inflation is helping us out with our mortgage every year but slowing our progress on investments, we want to prioritize getting the ball rolling on the investments.
We need a lot more money for the investments than we do for the mortgage.
As of the last Hoard update, we need $538,565 to reach the investment goal and $97,486 to reach the mortgage goal. This means the investment goal is ~5.5 times larger than the mortgage goal. We are more anxious to start making serious progress against the investments, because it is going to take a lot more time and dedication to accomplish.
It’s sort of the same philosophy as doing your least favorite chore first to get it out of the way. Or eating your steamed brussels sprouts before moving on to your cheesy potatoes.
We could knock the mortgage out in about 1.5 years, but getting the money for the investments will be a lot more work. That’s why we want to start working on it as soon as possible.
There you have it! All the reasons why we are investing instead of aggressively paying off the mortgage. In the end, whatever motivates you to save the most money is the best decision for you. If paying off the mortgage gets you excited to save, then do it. Same thing for investing. Do what works for you.
Do you have reasons for either side of the argument that aren’t listed here? Share them with us in the comments!