Making decisions about financial priorities can be daunting. Paying off your mortgage early? Dollar-cost average (DCA) into ETFs? Both options have their merits and risks. In this article, I'll delve into the intricacies of each strategy, provide examples, and offer insights to help you make an informed decision.

Paying off your mortgage early

Paying off your mortgage early has several potential benefits, including peace of mind, reduced interest payments, and increased equity in your home. By eliminating debt, you free up cash flow, create a sense of financial security, and potentially reduce overall interest paid.

Mechanics

You can pay off your mortgage ahead of schedule by increasing monthly payments or making lump-sum contributions. Both can be used to reduce principal balance and shorten the loan term.

Benefits

1. Interest savings: Paying extra towards your mortgage can reduce the total interest paid.
2. Debt elimination: Being mortgage-free can provide financial security and peace of mind.
3. Equity building: Accelerating mortgage payoff can increase your equity stake in the property.
   

Considerations

1. Opportunity cost: Depending on interest rates and other factors, funds used for mortgage payoff could potentially earn higher returns if invested elsewhere.
2. Liquidity constraints: Tying up funds in home equity may limit access to cash for other purposes.
3. Tax implications: Changes in tax deductions should be factored into the decision.
   

Simple example

Let's say you have a $200,000 mortgage with a 4% interest rate and 20 years remaining. By making an extra $500 payment each month, you would save approximately $37,074 in interest and pay off the loan seven years and seven months early. Of course, this example (and all of the examples in this article) is purely hypothetical, and actual interest rates can wildly fluctuate.

Dollar-cost averaging

Dollar-cost averaging (DCA) involves investing a fixed amount of money at regular intervals, regardless of market fluctuations. This can potentially help to mitigate the impact of volatility by spreading out your investments over time. Investing in ETFs, which aim to offer diversification and low costs, is a popular choice for a DCA approach. Over the long term, the compounding effect of reinvested dividends and market growth could theoretically lead to financial gains.

Mechanics

As I mentioned above, dollar-cost averaging entails investing fixed amounts regularly, no matter what the market is doing. This approach seeks to mitigate the impact of market volatility over time.

Benefits

1. The potential for higher long-term average returns without timing the market
2. Removes emotion from the investing process
3. Reduces the amount of time spent contemplating the investing process
   

Considerations

1. Long-term commitment to mitigate market volatility.
2. Transaction fees and other expenses may impact returns.

Simple example

Suppose you invest $500 monthly into a diversified ETF portfolio with a (hypothetical) average annual return of 7%. Over 20 years, your investments would grow to approximately $245,973, assuming you reinvest your dividends.

Comparing the two Strategies

Interest rates, investment returns, time horizon, risk tolerance, and tax all play into the decision of “which is right for you?”. Paying off the mortgage offers savings in interest (and tax) and peace of mind, but it may sacrifice potential investment returns. On the other hand, DCA sharemarket investing via ETFs or similar has the potential for higher long-term returns, but it involves market risk and requires discipline to maintain the investment schedule. Plus, you may need to pay tax on any dividend income or capital gains if you choose to sell your shares.

Risk management

Both strategies involve risks that should be carefully evaluated. Paying off the mortgage early may leave you with less liquidity and fewer investment options. Conversely, investing in ETFs exposes you to market volatility and the risk of capital loss. Diversification, asset allocation, and periodic review of your financial plan are essential for managing risk effectively. It's also a good idea to talk to a financial professional when weighing up your two options.

Tax considerations

Tax implications can significantly impact the decision between paying off the mortgage and investing in ETFs. Mortgage interest may be tax-deductible, providing a financial incentive to retain the debt. Also, tax isn't paid on the savings you keep by paying down your mortgage. On the other hand, dividends are taxed at an individual's marginal tax rate, and investment gains from ETFs are subject to capital gains tax , which can erode returns. It also bears noting that these tax insights are general in nature. Consultation with a tax adviser can help optimise your tax strategy based on your individual circumstances.

Emotional considerations

Psychological factors also play a role in financial decision-making. Paying off debt can provide a sense of accomplishment and security, while investing in the market may evoke feelings of uncertainty and anxiety, especially during periods of volatility. Understanding your emotions and maintaining a long-term perspective are crucial for staying committed to your chosen strategy.

Deep-dive example

Let’s say the interest rate on your mortgage is 7% per annum (which is close to current market rate as at time of writing) and let’s say your marginal tax rate is 32.5c. The equivalent return you would need to earn from DCA is 10.37% per annum to get the same 7% return as you would from paying back your mortgage early. And that’s not even accounting for the volatility or emotional stress of the sharemarket.

Alternatively, let's say your mortgage rate is 2% and your marginal tax rate is 32.5c. In this hypothetical, if you’re earning above 3% per annum from DCA then investing may be a better financial outcome.

Based on its performance today, the long-term average of the Australian sharemarket is about 10% per annum. But there’s lots of volatility within that. Some years it goes backwards by 20%+, some years it goes forwards by 20%+. To compensate for that volatility, it's a good idea to weigh up the projected returns in relation to your mortgage rate. That way, you can consider which is the best option for you. For instance, some long-term investors who anticipate a higher return from the share market may opt to DCA even if their mortgage rate is between 2-7%. Conversely, others may want to pay their house down as quickly as possible.

Conclusion

Ultimately, the decision to pay off your mortgage early or dollar-cost average invest depends on your financial goals, risk tolerance, individual circumstances, tax considerations, and current mortgage interest rates. Both strategies have their pros and cons, and there is no one-size-fits-all answer.

Happy investing!

Kurt