To start off the year, my wife and I did a pretty in depth financial review. We took a good look at the past, present, and future. Most importantly, setting financial goals for where we would like to be in one, two, and five years.
After talking about our goals and the lifestyle we want to live, we both came to the conclusion that we should prepay our mortgage. If we can pay off the mortgage by the time we’re 30 that will give us a lot of flexibility when we start building our family.
The ability for us to be the one raising our kids is more important to us than any other goal we have including travel, early retirement, a new car, etc…
Last, we have an emergency fund. If something did happen, like a job loss, we can stop prepaying the mortgage and use our emergency fund.
Knowing these facts, is it a smart idea to pay off our mortgage?
First, let’s look at it from a mathematical perspective.
Essentially, paying off our mortgage, that has a 5% fixed interest rate, is the same as earning 5% in an investment account. (There are a lot of tax considerations that can make this more complex like tax brackets, tax deductions, availability of tax deferred accounts, etc… plus inflation. Unfortunately I have not found a calculator that takes into consideration everything that needs to be considered. Therefore, I simplified this calculation as much as possible.)
This 5% return is both good and bad. Good because it’s a guaranteed rate of return. With interest rates so low today, it’s impossible to find an investment that guarantees us 5%.
Bad, because it’s only 5%. We’re losing the opportunity to earn more. Historically, investments such as a total stock market index fund have returned about 10% a year.
Therefore, since our interest rate is so low on the mortgage, mathematically it doesn’t make a lot of sense to prepay our mortgage. If we were to put the money in the stock market, history has shown that we have a really good chance of earning more than 5% if we’re long term investors.
Knowing this information, we still decided to pay off our mortgage.
Flexibility is more important to us than anything. Prepaying our mortgage gives us the flexibility we desire.
Even though we have the chance to earn more money elsewhere, returns are not guaranteed. With interest rates so low and the current uncertainty of our economy, a 5% guaranteed rate of return sounds very appealing.
If we were to choose to invest in the stock market, who knows what our returns would be. There is potential that they could be a lot higher than 5%. However, there is a potential that they can really decrease over the next few years.
In short, we choose not to let the economy decide if our kids will be raised by us or be in daycare, but we made that decision.
Do you agree, should I prepay my mortgage? Are there any other options that I’m not thinking of? How weird is that picture above? Please let me know in the comments.