Should You Pay Off Your Mortgage Early or Invest in Stocks?
Audio Brief
Show transcript
This episode of Ask The Compound features Ben Carlson tackling listener questions on market valuations, mortgage strategies, and the role of real estate in net worth.
There are four key takeaways from this discussion. First, high market valuations are unreliable indicators for timing the market. Second, the decision to pay down a mortgage early should be dictated primarily by interest rates. Third, currency fluctuations can create significant headwinds for international investors. Finally, behavioral adherence to a good enough portfolio often outperforms a mathematically perfect one that you cannot stick with.
Regarding market valuations, historical data confirms that metrics like the CAPE ratio are poor tools for predicting short-term crashes or market tops. For instance, despite reaching historically high valuations in 2017, the S&P 500 continued to return nearly 15 percent annually in subsequent years. Investors should maintain dollar cost averaging regardless of high price-to-earnings ratios, only pausing contributions when liquidity needs or personal goals change, not because of fear.
When it comes to debt management, the math behind paying down a mortgage early depends heavily on the interest rate environment. A useful framework suggests that rates under 4.5 percent should be kept while investing the surplus capital. Conversely, rates over 7 percent should be prioritized for pay-down. The range between 4.5 and 7 percent is a matter of personal preference, though investors should avoid completely abandoning stock market contributions even when prioritizing debt.
For international investors, specifically expats, currency risk is a critical factor. If you hold assets in a currency different from your home economy, performance is driven by both asset returns and exchange rates. A weakening US dollar acts as a drag for those converting back to foreign currencies, which can explain portfolio underperformance even when the underlying stocks are rising.
Finally, the discussion highlights that home equity is a legitimate form of wealth despite its illiquidity. Discounting equity creates a misleading picture of financial health, as it can be accessed later via downsizing or borrowing. Ultimately, success hinges on finding a strategy you can endure through volatility, rather than seeking perfect optimization.
Ben Carlson concludes that understanding your own risk tolerance is far more critical than complex asset allocation.
Episode Overview
- This episode of "Ask The Compound" features Ben Carlson flying solo to answer listener questions ranging from market valuations to real estate strategies.
- The discussion centers on practical financial dilemmas, such as whether high market valuations should pause investing, the math behind paying down a mortgage early versus investing, and how to think about home equity as part of your net worth.
- Ben provides data-driven answers to common anxieties about the current economic climate, including the impact of a weakening dollar on international portfolios and the role of currency risk for expats.
Key Concepts
- Valuations are poor timing indicators: Historical data shows that high market valuations (like the CAPE ratio) do not reliably predict short-term crashes or market tops. For example, after the "twice in history" valuation highs of 2017, the S&P 500 continued to return nearly 15% annually.
- Mortgage pay-down mathematics: The decision to pay down a mortgage early is heavily dependent on interest rates. Ben suggests a framework where rates under 4.5% should be kept (invest the surplus), rates over 7% should be prioritized for pay-down, and the 4.5-7% range is a "dealer's choice" depending on personal preference.
- Currency impact on international investing: For investors holding assets in a different currency than their home currency (e.g., an American expat in Australia buying US stocks), performance is affected by both the asset's return and the exchange rate. A weakening US dollar acts as a headwind for those converting back to foreign currencies, explaining underperformance even if the stocks themselves are up.
- Liquidity vs. Net Worth: While home equity is illiquid and difficult to spend, it is a legitimate form of wealth. Much of American household wealth is tied up in illiquid assets like housing and retirement accounts; discounting this equity creates a misleading picture of one's financial health.
- The "Good Enough" Portfolio: Investment success often hinges less on finding the mathematically optimal portfolio and more on finding a strategy that an investor can stick with through volatility. Behavioral adherence usually trumps perfect optimization.
Quotes
- At 2:40 - "Valuations are not a timing indicator because valuations change over time." - Ben explains why using metrics like the CAPE ratio to time market entry or exit is a flawed strategy, as structural changes in the market can sustain high valuations for long periods.
- At 6:43 - "Don't completely give up on the stock market to make those early mortgage payments. Diversify your savings and do a little of both if you insist on paying down the mortgage early." - This quote highlights the importance of maintaining liquidity and market exposure even when prioritizing debt repayment.
- At 19:15 - "Can you handle taking a lot of risk? Most people can. Some people can't... The good enough portfolio you can stick with is vastly superior to like this perfectly optimized portfolio that you can't stick with." - Ben emphasizes that understanding one's own risk tolerance and emotional makeup is more critical than complex asset allocation.
Takeaways
- Maintain Dollar Cost Averaging (DCA) regardless of valuation: Do not pause or stop regular contributions to the market based on high P/E ratios or fears of a crash; only stop DCA when your financial goals or liquidity needs change.
- Evaluate mortgage prepayment based on your interest rate: If your mortgage rate is above 7%, consider allocating extra funds to principal payments; if it is below 4.5%, prioritize investing in the market instead.
- Include home equity in your net worth calculation: Acknowledge your home equity as real wealth that can be accessed later via downsizing, borrowing, or avoiding rent, rather than treating it as "false wealth" simply because it is illiquid.
