If you don't have an endless amount of money, deciding whether to invest for retirement or pay down mortgage debt is a common dilemma.
Paying off your debt means reduced stress, lower risk exposure, and a greater ability to withstand personal emergencies. But if you don't pay off your mortgage debt in full, your mortgage payment will be the same. It's just your percent going to paying down principal increases and your interest expense decreases.
If you finally pay down your debt, you will be able to better withstand an economic recession. Recessions tend to come every 10 years or so. The last recession was in 2009-2010, so readers should have their guard up in 2020 and beyond.
Investing means potentially building greater wealth over the long term. Real estate and stocks have been proven winners in the history of our country. The more you invest, the more you can build passive income to potentially retire early as well.
As someone who retired in 2012 at the age of 34, I cannot tell overemphasize how great it is to be able to no longer need to work for a living. I left with about $80,000 in passive retirement income a year to live a humble middle class lifestyle.
When there are market dislocations, like when the S&P 500 declined at one point by 32% in 1Q2020, investing may make more sense.
Invest For Retirement Or Pay Down Mortgage Debt?
The best way to determine whether to invest for retirement or pay down mortgage debt is to determine the following two things:
- The rate of after-tax interest you are paying on your debt.
- The after-tax rate of return you expect to earn on your investment.
In other words, if you can earn a higher return on your investments than the interest on your debt, you should invest and vice versa.
Since 1926, the average return for the S&P 500 is about 10%, including dividends. However, between 1999 – 2018, the average return for the S&P 500 was only about 5.6%. REITs were actually the best performing asset class at 9.9% per annum. See the chart below.
Notice how the average investor only had a return of about 1.9%. This is because the average investor trades too much, buys at the top, and sells at the bottom.
The average investor should invest with a digital wealth advisor like Betterment to let the firm automatically invest for you long-term in a risk-appropriate manner. The fees are only 0.25% of assets under management.
Ranking Which Debts And Investments To Address First
Here is my recommended course of action for paying down debt and investing. Essentially, we should all do both.
- Max out your 401(k) or IRA. Maxing out your 401(k) or IRA is the easiest thing every employee should do. You lower your taxable income by contributing pre-tax dollars and potentially get a company match. The average company match is around 3% of salary or $3,000, whichever is lower. By maxing out your 401(k), you will likely become a 401(k) millionaire by age 60 based on historical stock and bond market returns. Here's my 401(k) guide by age so you can reach financial independence by the time you retire.
- Build six months worth of emergency fund. Save money in an online account like CIT Bank, which offers more than a 1.6% savings rate.
- Pay down all credit card debt. The average credit card interest rate is over 15%. This is highway robbery. Not even the great Warren Buffett has returned a 15% annual compound rate in his illustrious career, and he is worth over $60 billion dollars!
- Pay down the next highest debt. The second worst type of debt is automobile debt given automobiles depreciate over time. Methodically pay down your next highest debt interest rate and keep on going.
- Refinance mortgage debt. Before paying off your mortgage debt, you should highly consider refinancing your mortgage debt because interest rates have declined so drastically in 2019 and beyond. For example, I'm refinancing to a 7/1 ARM at 2.625% with zero costs. Check out Credible for some of the lowest mortgage interest rates online. They are my favorite lending marketplace.
- Pay down mortgage debt. After you have paid off all other debt and refinanced your mortgage, you should consider paying extra principal payments each month to help accelerate your pay off. You want to match your mortgage debt pay off to when you plan to retire. You can easily calculate how much to contribute to reach this goal using a mortgage calculator.
- Contribute to a Roth IRA if you are in a 24% marginal federal income tax bracket or lower. The Roth IRA is not a retirement savings vehicle I'm a fan of for high income earners because you are contributing with after-tax dollars. It is highly likely you will NOT earn more in retirement than while working. But if you are in the 24% marginal federal income tax bracket or lower, then contributing to a Roth IRA is probably OK to diversify your retirement funds. Not everybody can contribute to a Roth IRA either. A married couple earning less than $135,000 in adjusted gross income can contribute up to $6,000 of earned income per spouse ($7,000 per spouse if 50+ years old).
- Actively build your after-tax brokerage accounts. The key to retiring early is building a large enough after-tax brokerage account to spit out passive income. This way, you don't have to wait until 59.5 to withdraw funds penalty-free from your 401(k) or IRA. Below is a guide for how much after-tax investment amounts you should try to accumulate by age.
By following this hierarchy of paying down debt and investing, you are smartly playing offense and defense. Eventually, you want to retire debt-free. By constantly paying down debt, you will achieve your debt-free goals.
The FS-DAIR Approach To Investing And Debt Pay Down
Another completely logical way to attack your investing and mortgage debt is to follow the FS-DAIR methodology I created years ago. Below is the FS-DAIR chart which states that you should use a percentage of your cash flow to pay down debt depending on the debt interest rate X 10. If the debt interest rate is 4%, use 40% of your cash flow to pay down debt and the remaining 60% of your cash flow to invest.
Notice how once the debt interest rate is 10%, all cash flow should be used to pay down debt. It is very hard to achieve a 10% annual return on your investment consistently. You will likely have to take a decent amount of risk. If you can pay down 10% interest rate debt risk-free, that's a no brainer in my opinion.
If you follow the FS-DAIR methodology consistently, you will make tremendous inroads into your debt pay down strategy while also building a solid investment portfolio for the long-term.
Focus On Your Financial Goals
Some people want to retire early and be debt free. Others are happy to carry their mortgage debt for as long as possible given rates are low compared to history. You have to define your own financial goals and be comfortable with your system.
I've personally paid off two mortgages and have not regretted my decision. The mortgage rates were both around 3%. At the same time, I also have about $1,000,000 in mortgage debt because I'm comfortable with my cash flow.
I'm only paying a 2.75% interest rate on my primary residence 7/1 ARM after my mortgage refinance in 2019. Again, check out Credible online to see if you can get a better mortgage rate. Mortgage rates are at close to a 6-year low in 2020 and beyond.
By not paying extra towards my $1,000,000 in mortgage debt, I've invested $810,000 in capital in real estate crowdfunding to take advantage of lower valuations and higher net rental yields in the heartland of America.
So far, I've return about 12% a year since 2017. You can sign up for free with Fundrise, one of the largest and most innovative real estate crowdfunding platforms today. Of course there is no guarantees in investing, but I do believe in the long-term demographic shift away from expensive coastal cities thanks to technology.
Bottom line: Everybody should pay down debt and invest at the same time.