Most of us are aware of Maslow’s hierarchy of needs with physiological and safety needs being at the foundation of what most human beings are most concerned with in their lives. Unfortunately, most of the time these needs are at odds with what the best financial decisions might be. Opportunity cost is the first area where, as financial advisors, we are asked to help clients navigate the best financial decision even though it might not feel the best at the present time. Opportunity cost is simply choosing one alternative over another and missing the benefit offered by the forgone opportunity.
One of the most common questions we get as advisors is, “should I pay my mortgage off faster”?
This feeling of being debt free or truly owning your home, rather than living in a “bank owned” property as most of us do, fits right into the base of Maslow’s hierarchy. Owning your home gives you a sense of safety and security. It is where you satisfy most of your physiological needs like food, water, sleep, and even your love and belonging needs i.e. your spouse and/or children. So, paying off that mortgage to gain full ownership of that asset seems like a no brainer, right? Wrong.
First off, you will always be making payments on your home (property taxes) or someone else will take it away. So, let’s not believe we outright own any property as we are really leasing it from our city or town. Let’s say you have a 4.5% interest rate on your mortgage. That 4.5% interest rate is tax deductible so your “real interest” rate is more like 3.5%. In this case discounting for taxes rather than inflation. All you need to do is gain more than that 3.5% interest on the funds that you were going to overpay your mortgage with and you will be doing far better in the long run then paying the mortgage. Meaning, if you are averaging 8% in an investment portfolio over the long term then you are sacrificing 4.5% a year strictly on an emotional basis to make yourself feel better. This works on every type of debt there is as we are also asked this quite a bit even on car loans. “Well I just don’t like carrying debt, so I want to pay off this car so I don’t have to worry about it anymore”. In years past where you might have had to purchase a car with a 6-10% interest rate, then the equation becomes much tougher and paying cash for that car could very well be the best option. However, with today’s interest rate climate where car’s are purchased for interest rates closer to 0-2% it’s really a no brainer to use the debt and invest the difference.
Another flaw in this equation can come by what you do with the excess dollars. For example, if you have the $30k to buy a car but instead use financing to secure a 2% loan then that $30k needs to be invested over, at least, the period of time you have the loan or the 2% you are paying for interest will most likely be over the amount you will receive in your checking account. Furthermore, the monthly dollars that you would use to say pay down your mortgage, needs to be captured and invested. If you calculated that you had an extra $500 a month to put to the mortgage but decided not to do it because you buy into the opportunity cost argument, then that $500 a month actually needs to be captured, saved, and invested or this entire equation no longer works.
I couldn’t in good conscious complete this post without discussing the age-old theory of risk and reward. I know it has become so cliché now to say you don’t get as much reward without taking on some risk, but it feeds into this discussion specifically. The interest you’d be saving on your mortgage by paying it down is easily quantifiable and will happen month in and month out on a somewhat linear basis. Granted, due to a 30-year mortgages amortization table it gets better as time goes on, but you can count on those savings and actually calculate what they will definitely be every month. This is the sticking point for most people. When you go to invest that $500 it could do nothing but go down the first 18 months that you are funding the account. However, if you don’t take that risk you don’t have the opportunity to gain the 4-5% (or more) over time.
In conclusion, always run these decisions by a trusted advisor but don’t be afraid to take some risk. The more you let emotion control your financial decision making the more your wealth will be eroded. Stay tuned for another post on “calculated risk” as I believe the ability to take calculated risk throughout your life, whether it be in your investment portfolio or your decision to go rock climbing will significantly impact your quality of life.
- Christopher Wakeman, Managing Partner, Lignum Wealth Management
After graduating in 2002 from Northeastern University, where he majored in business and finance, his passions led him to pursue a career that incorporated both investments and entrepreneurship. Because of this, he searched out American Express Financial Advisors and then Ameriprise Financial, where he spent 10 years gaining invaluable experience and building a client base that he would eventually bring to his own private practice. In 2013, Chris and his four partners felt it was time to create Lignum Wealth Management.
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Lignum Wealth Management is a financial advisor located at 500 Edgewater Dr, Suite 511A, Wakefield, MA 01880. Lignum Wealth Management offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. Lignum Wealth Management can be reached at (781) 334-8100 or at [email protected].