Your mortgage rate is 3.75%. The stock market returns 7-11% on average (depending on who you ask). You'd have to be a fool to pay extra on your mortgage when you can make so much more in the stock market.
This argument can often be heard in situations like the one just described, or when you're offered some kind of low interest financing plan (could be for furniture, student loans, car loans, or anything... not just mortgages) as an alternative to paying in cash.
"Just take that money and invest it in the market instead... The average annual return is 10%."
Unfortunately, that 10% figure is usually cited on the internet as if it were common knowledge and often thrown around without any backup to show how it was calculated. Some sources will use a different number, so it depends on who you believe, but overall it will not be too far off from 10%. This issue is, however, something I will explore further in a separate article, since it's not really the point I want to make here.
So let's pretend for our purposes here that the historical average return for the S&P 500 + dividends is in fact 10%.
The real problem is this...
You should not compare two things with two completely different risk profiles such as paying off debt and investing in the stock market.
With such logic, why would anybody ever want to buy CD's or treasury bonds if you can earn a higher return in the stock market?
Paying off debt is as close to a risk free return on your money as you can get. You know you owe X amount of money. You know you have to pay it... and once you finish paying off the principal, you know for certain that you won't have to pay any more interest.
The returns are pretty much risk free.
Can you say the same thing about the stock market? The average may be 10%, but how do you know that's what the market will return next year, or the year after that, or even the decade after that?
Did you know that there have been a few twenty year periods here and there where the stock market literally went nowhere? ... That the S&P 500 was trading at the same level it was 20 years ago?
Remember the market crash in 2001?
Let's pretend it was the year 2000 and you took out a car loan for $5,000 at 4% instead of paying in cash. You decided to invest the money in the stock market. Next year the tech bubble pops and you lose half your money... Your car loan, however, is still waiting for you. By the time the market recovers, you may already be on your next car. And that's assuming you didn't panic and sell at the low.
Here is something else to think about. As of February 1, 2019, the Cyclically Adjusted Price-to-Earnings ratio (CAPE), also known as the Shiller PE ratio, was 29.65. Source
The CAPE ratio is a price earnings ratio for the S&P 500 based on average inflation-adjusted earnings from the previous 10 years. It measures how historically expensive or cheap stocks are based on earnings.
The historical average is around 16-17. About half as much as the ratio now.
This means that when it comes to value, you would be paying a lot more for stocks than what they have historically sold for.
In his book Irrational Exuberance, Robert Shiller had a scatter plot diagram that showed the returns you would get over the next 10 years based on the CAPE ratio. It showed that when valuations were low, returns were high and vice versa.
When the CAPE ratio was this high (30), the return came out to something like 0%.
Take that piece of information with a grain of salt, but at these levels (as of February 2019), it would be reasonable to assume that the stock market will probably not produce double digit returns over the next 10 years.
That piece of info on the CAPE ratio was just food for thought. I'm not saying those zero returns definitely will or will not happen. The point is that your returns in the stock market are not guaranteed.
I am also not taking a position in this article, despite the title, on whether you should pay off debt or invest. This should be done based on your comfort level, your diversification desires, and your liquidity needs. I just wanted to expose the fallacy of comparing stock market returns to the interest rate on your debt as if they were the same thing.
You want to compare paying off your mortgage against investment returns? Compare them to the rates on your online savings account instead. That's a more appropriate comparison.