Ask the Readers: Is It Better to Invest or to Prepay a Mortgage?
Published on - June 1st, 2007 (by J.D. Roth) Paul writes with a common question that illustrates how challenging personal finance can be, even when you’re doing the right things. Sometimes it’s difficult to choose between several good options. Here’s his dilemma:
I refinanced my house a few years ago at a great rate (5-3/8%). At the time, we had a lot of equity in the house so we borrowed against it in order to build an addition.
After we were finished, we had a significant amount of money left over, which is currently sitting in “callable” CDs. The CDs are collecting an average of 5.25% APY. I’ve been calling this our “emergency fund”. Doing the math, you’ll see that I’m losing 0.125% on this money (5.375% mortgage rate – 5.25% CD interest).
My financial planner recommended putting it back into the mortgage. I’m leaning more towards investing it (in index funds or something else).
- If I leave the money where it is, I’m losing money.
- If I plonk down this entire lump sum on my mortgage right now, it takes ten years off the loan, but it means I have no emergency fund.
- If I invest this money at an average return rate of just 9% for the 26.5 years left on my mortgage, I end up with almost 10x the amount of money I have now! (Plus the money is easier to liquidate in case I need it.)
This seems like an easy choice, but it’s not. There’s no guarantee of a 9% return, but I feel that these numbers are fairly conservative and support the idea of investing the money vs. putting it back into the mortgage, which is why I’m very surprised at the recommendation to do so by my financial advisor. What’s the best choice here?
This question has stumped smart people for years. Is it better to invest or to prepay a mortgage? Neither answer is wrong — there are advantages and disadvantages to both. But is one choice less wrong than the other? When I covered this subject a year ago, I shared advice from several personal finance books. Here’s what they said:
- Ric Edleman (Ordinary People, Extraordinary Wealth): Never own your home outright. Instead, get a big 30-year mortgage and never pay it off — regardless of your age and income. “Every time you send an extra $100 to your mortgage company, you deny yourself the opportunity to invest that $100 somewhere else.”
- Suze Orman (The Laws of Money): Invest in the known before the unknown. Paying off your mortgage offers a guaranteed return on investment. “You cannot live in a tax return. You cannot live in a stock certificate. You live in your home.”
- Elizabeth Warren (All Your Worth): Save 20% of your income. Use 10% for retirement savings, 5% to accelerate your mortgage, and 5% to save for future dreams. “Paying off your home also does something many financial planners neglect to mention: It gives you freedom. Once that mortgage is gone, just imagine all the freedom in your wallet.”
- Dave Ramsey (The Total Money Makeover): Prepay your mortgage if you can, but only after you’ve saved an emergency fund, and only if you’re putting at least 15% of your income toward retirement. Don’t use a program designed by a broker; use your own self-discipline.
Charles Givens (Wealth Without Risk): “On the first of the month when you write your regular mortgage check, [include extra] for the ‘principal only’ portion of the next month’s payment.” For example, if you have a $1000 payment with $200 designated for principal, pay an extra $200 (for a total of $1200). This effectively cuts the term of the loan in half. Note that Givens’ advice was written in the 1980s when interest rates were much higher.- Dominguez and Robin (Your Money or Your Life): “Pay off your mortgage as quickly as possible.” This book, too, was written when interest rates were higher. Also, the authors emphasize frugality over investing.
Financial authors don’t agree on this subject. Maybe the personal finance gurus writing for the web can clear things up?
- Liz Pulliam Weston at MSN Money: Don’t rush to pay off the mortgage. “You’ve got better things to do with your money, like saving for retirement, building an emergency cushion or even living it up a little.”
- Walter Updegrave at CNN Money: If you’ve funded your retirement, and if it will make you happy, then pay down the mortgage. Otherwise, it makes more sense to invest.
- Laura Rowley at Yahoo! Finance: Using very conservative figures, investing instead of prepaying the mortgage yields an extra $400 per year. If you feel compelled to pay down your mortgage, do it. But realize you’re paying a price to do so. (She offers more details at her blog, as well as tips on how to estimate the investment return you need to earn to make it worthwhile.)
- Bankrate: Pay down your mortgage if your investments would be conservative. Invest if you’re planning to do so for the long term.
- USA Today: It depends on your income, your monthly expenses, your risk tolerance, and your desire to own your home free and clear.
- Kiplinger’s: Invest unless you’re near retirement
- The Dollar Stretcher: Mathematically, it makes more sense to invest, but it all depends on your risk tolerance.
- My fellow pfbloggers, Blueprint for Financial Prosperity and Million Dollar Journey, recommend that a person do a little of both: pay down the mortgage some and invest some. Free Money Finance says: “If you have the discipline to save/invest the money you would be using to pay off the mortgage, it’s likely that saving/investing is the better option. But if you’re more the “average” person out there managing your money, I still believe it’s a better option to pre-pay your mortgage.”
The Rowley article offers some interesting background to this debate:
Why do so many people choose to put extra money into a mortgage when other options would likely increase their wealth? “This is really remnant of Depression mentality that has persisted from generation to generation,” says [one expert]. At the time, most mortgages had one- to five-year terms, with a lump sum payment due at the end.
“Any shock to income meant you couldn’t afford your payment — mortgages were much more susceptible to economic uncertainty,” [the expert says], and roughly one-quarter of Americans were unemployed during the Great Depression. “It’s fine to pay down your mortgage if it gives you peace of mind, but you should recognize what that peace of mind costs.”
If you’re facing a similar decision, you may find this calculator useful: prepaying your mortgage vs. investing.
Researching this entry was educational. I’d always been under the impression that it was better to prepay your mortgage. At best, I thought it was a wash. After reading advice from dozens of experts, however, it seems that unless your mortgage rate is high, it makes more sense mathematically to invest your money in an index fund. (Most experts agree that psychologically you should do what works for you.)
But doesn’t this imply that, if possible, it’s a good idea to convert home equity to stock investments? Kris and I have about $100,000 of equity in this house. Should we re-finance and put the money in an index fund? I can’t imagine doing that. What would the experts say?
Have you faced Paul’s dilemma before? Which did you choose? Which would you choose if you had the option? Why?
Note: For those of you wondering about the effect of taxes, I’m assuming that all evaluations made by these experts take them into consideration. I’m also assuming that they’ve considered inflation.
This article is about Ask the Readers, House and Home, Investing, Real-Life
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Thanks for the referral J.D!
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I lean toward prepayment, but I see the point of investing the money. My fiance and I are just starting to get our finances in real order (i.e., opening IRAS, creating an emergency fund, etc.), but I think we’ll pay our mortgage off early because we are planning to build a house in two years that we will live in for the rest of our lives. For that reason, I think it makes sense to pay it off early, but maybe I’m wrong?
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Nice article! We have been in this dilemma for a while too. We know that based on just number crunching, it is a better idea to invest than prepay the mortgage. But when you add psychology to the equation, things aren’t so simple any more. We are both very debt-averse. The feeling of being completely debt-free is something that will mean a lot to us – I don’t know if we can put a price on that! Which makes it hard to quantify (or justify to other money savvy folks) why we choose to pre-pay our mortgage quite agressively!
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Thanks for the linklove! I think the little of both always helps to assuage fears that you’re going gung ho on the wrong option, even though there isn’t really a wrong option. Ultimately, flexibility is important and having those assets at a cost of 0.125% a year isn’t that big of a deal.
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Given current market conditions, I’m leaning towards prepaying one’s mortgages. If we were in the early 1990s, I’d be leaning towards investing.
As has been pointed out by many others, including criticisms on some of my posts, we cannot assume constant returns. So I look to the market to guage how much this assumption stands to be violated in the next 10 years. My most educated guess is that there’s either not going to be much growth or its going to be unevn, unsteady growth (perhaps even negative).
How much is the Present Day Value of the 10 years of interest saved worth? That’s important to know, because that’s the return on using the money on the mortgage.
I don’t think I’d get worried about the 1/8 difference. Maybe what you’re doing is working best for you now?
If I were in your shoes, I’d be prepaying, but I’m a very risk-averse individual.
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Great article today – and a good topic. What wasn’t covered in the scenario above (one either side) was taxes. If we assume 30% tax on investment returns, it means the actual return on 9% is 6.3%. Of course, there is also savings on the 5.75% of the same amount, making the actual cost 4.025%.
The real advantage is much closer to 2% than 3+% in the scenario given. I’m not sure 2% is worth the psychological advantage of owning my home free and clear. I can’t imagine the freedom that comes with not having a monthly payment – period.
I’d lean toward keeping 3-6 months expenses in an emergency fund and paying the rest on the mortgage. But, that’s just my psychology!
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Having been burned by investing over the last 10 years (my investment account is now worth 1/2 of what it was 8 years ago), we’re sticking our extra money in our mortgate (this doesn’t include what’s going into the 401k for retirement). Housing bubble or no, there’s not much chance of my house being worth 1/2 of what it is now. We just feel like we’ll have a lot more financial freedom with the house paid off in 15 years.
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Long time reader – First time poster.
I think the challenge of the questions is in the details of the math. There are pro’s and con’s for each approach.
Pro’s for “Pay down mortgage”: You live there, you know the return and you don’t have to decide where to put the money.
Con’s for “Pay down mortgage”: You usually can’t get the money back out if you NEED it. No return on the investment. Interest is usually deductible.
Pro’s for “Invest the Difference”: Liquidity in some investments, a cushion for bad times.
Con’s for “Investing” You have no idea what your return will be. You can’t live in a stock certificate.
On the posters comment “Doing the math, you’ll see that I’m losing 0.125% on this money (5.375% mortgage rate – 5.25% CD interest).” It could go either way when it comes to a gain. If your marginal tax is high enough he/she may be making a positive spread and may qualify for lower taxation on something like stock dividends.
IMHO the poster seems to be in a good position as long as they carry the necessary insurance to protect against a large loss.
(My dislaimer: None of this is advice, don’t do anything I have suggested, including breathing. Make your own decisions with the necessary research or advice of a professional. Past performance is no guarantee of future return.)
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I agree with many of the above posters that the psychological benefit of being completely debt-free is more enticing than the potential gains from investing.
I also believe that people often fail to add up all of the costs of creative financing on home loans. For instance, with a three or five year interest only mortgage, you win only if the house increases in value in a short time frame, which is no guarantee right now.
Additionally, you still have to pay the mortgage company to refinance in 3-5 years or sell and pay all of the costs associated with selling.
All that being said, a mortgage payment is probably the best tax shelter available, so as you concluded J.D., this question really is a toss up.
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First of all, there is a good reason why this is such an evenly divided topic, equity markets compete with debt markets for capital. If one market offers a significantly better risk adjusted return to investors, the other market suffers. So each market attempts to remain competitive with the other by pricing accordingly, whether it is stock prices or the interest rate on a new mortgage. This means, indirectly, that interest rates are such that the decision by a borrower to prepay should not be a no brainer across the board.
Sometimes, only time can tell us if one choice is “less wrong” verses another. I don’t believe there is a universally correct answer to this problem. For some the numbers may work better one way, but it is usually not an astronomical difference. This is one of those situations that I like to go with what feels good. Ask yourself which decision might you feel better about when you wake up the next morning, which one are you more comfortable with. If it ends up costing you a little bit of money if you make the wrong financial decision, but you may still benefit psychologically, there is value in being comfortable too. We all know that we can save a lot of money over the years by not running the air conditioner in the summer, but we trade that savings to feel better. The mortgage question is not that different.
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I currently have a similar situation with my school loans. I paid for college all by my lonesome and am now realizing what that means. Currently about 30% of my take home is going to the minimum payments. In my case, I am going to invest and save extra money each month because I have the goal of buying a house in mind. If there was no house in my near future, I would probably do 50-50 or so.
When I do get a house though, I will most likely be trying to get the school loans out of my hair first.
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Maybe I’m missing something, but since mortgage interest is deductible from federal income taxes, isn’t the effective rate on the mortgage more like 4%, thus making even the CD a profitable investment?
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One option here, especially if your current mortgage payments are not a financial burden to you, might be to invest the extra cash by purchasing a rental home. Making sure that you can rent out the investment property for more than the mortgage plus the other carrying costs would mean you would be gaining equity in two homes while only paying for one. If an emergency were to happen BEFORE you had a chance to build up your own emergency fund, you could borrow against the rental home equity up to the amount the rent covered and you wouldn’t be paying anything extra from your own pocket to repay the loan. Of course, this is all stated with the understanding that finding a renter wouldn’t pose a problem in your area and that you have enough “leftover” money to purchase the rental property without having to add your own cash to make the purchase.
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I think it’s better to pay down the principal on the mortgage. I don’t know if I’m nit picking, but pre-payment is not a good idea, but applying directly to the principal is.
You can’t just do the math to get the answer. You’ll be much better off paying down your debt and working your butt off to save up an emergency fund. It’s hard to put a price on the risk you’re exposing yourself to by having the debt over your head as well as the value of learning what it takes to buckle down and really save some of your income.
Learning how to budget your finances and become someone who can really save a portion of your income will pay off more than anything in the long run. Playing the numbers game will not.
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I have been on the three sides to this fence, paying a mortgage, paying more than the mortgage, and owning outright. I must say it can be rather painful to pay more than the mortgage since it takes all your money to do so (for the average person like me). Owning outright feels great since you know you are in a strong position, however, it also puts a strain on your life since all your money is tied up and not accessible (get used to driving older cars if you choose this path). The best part about owning outright versus paying the mortgage is now you no longer have the bank telling you what you can and cannot do, think of this as a lesser landlord/renter type of thing and you will understand how nice it can be when they are out of your life.
One more piece that is never considered but very related is how many people are ‘renting’ their job instead of owning their income. In other words, how many of us are slaves to the 9-5 when we could be making our own futures with our own businesses?
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Aaron is correct, and I’m surprised no one else has mentioned this yet. Once you take into account the mortgage interest deduction, its almost crazy NOT to invest somewhere else!
Not sure why the author mentions 9%, even the much written about 7% is lauded as a conservative rate of return in the market.
Get your money out of your house, actual rich people do it – any reason why you aren’t?
Rob
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I desperately want to pay off my mortgage to be rid of the payment and have less demands on my income. That said, my plan is to optimize my mortgage payment, interest payment and saving/investing funds. That is, I want the lowest mortgage possible so I can invest as much as possible while not overpaying interest during the time I’m expecting to be paying the mortgage interest. But I have a very healthy income which makes this feasible in just seven years. I think going much longer makes the decision harder.
The calculators I’ve seen seem to not offer the ability to calculate return you can achieve from your income once the mortgage isn’t consuming it. That is, I’ll have an extra $1000, $1500, $2000, … a month to invest after I’m free. And all that money is free of the ~%6 mortgage differential.
The first step is to determine exactly how much you can afford to save and invest. Next, calculate how long it’ll take you, at a reasonable return, to save the amount you need to pay off the mortgage, minus some savings and don’t forget the mortgage principle is dropping each month.
I’ve calculated that I can pay my mortgage off in seven years with a 9% return (I’m doing far better than this for now). After I’ve paid it off, I’ll be investing 100% of what was my mortgage payment plus what I was saving/investing for paying off the house. Continuing 9% return and it’ll take me 9 more years (16 total) to reach what would have taken me 18 years while retaining a mortgage. But my growth is accelerating far faster now without the mortgage. And in 20 years, a little before typical retirement age, I’ll have my retirement in the bag. It would have taken me 23 years if I retained a mortgage and after 23 years, still wouldn’t own my home.
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I don’t consider a loan to be a source of emergency funds. This is no different from using a credit card in case of emergency–it’s just a slightly better interest rate. If you take out a loan, repay it. Be glad you didn’t need the whole loan to do what you wanted. Build up your emergency fund with the money you were using to pay back the loan before you knew you had funds remaining. THEN you are in a position to start investing. You can only start to accumulate actual wealth when you have paid back what you owe.
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I work for a high tech company. When sales go down, they lay off 5-10% of the workforce. They tend to lay off people who have been there the longest. While I would like to think my performance makes me imune to getting laid off, they have laid off some of the best engineers and scientists I have worked with – it could be my turn next.
Some of my friends have found jobs quickly, some have taken 6 months to a year to find another job. If I do get laid off, I don’t want to have to grab at the first job that comes along so that I can make my fixed monthly payments. Yes, I have an emergency fund, but the monthly $1,500 mortgage payment will very quickly decimate that.
Given this uncertaintly, I want to drop my fixed monthly costs as much as I can. The only debt that I have is my mortgage. The best way that I can see to get financial security is to pay off the mortgage. Once that I paid off, I think that I can pay the rest of my monthly expenses (food, taxes, child support) with temporary or part time jobs.
If you have a job that you know is secure until retirement (teacher, police, etc) then sure, take more risks. If you have the typical job these days, where there is no job security, and finding a job with the same salary takes a while, then I would definitely try to get your mortgage paid off as soon as possible. In fact, I bought a cheaper house than most of my friends, so that I could pay it off. Once I get it paid off, I can save for a better house if I want, but I won’t risk losing the house if I get laid off.
In the millionaire next door, they talk about how long could you survive if you didn’t get any more income from your job. All of the people with the long survial times, and those with lots of capital, have thier house paid off, and paid it off as soon as they could.
I feel strongly that you should pay off your house as soon as you can.
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Whatever Paul does, he needs an emergency fund, and the stock market is not the place for it.
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This is strictly an economic psychology question. It boils down to, ‘how risk averse are you?’
If you value security and guaranteed return, prepay your mortgage.
If you value risk and the consequently higher return and volatility, pay your mortgage and invest the difference.
That’s why there’s no ‘right’ answer for everyone. Everyone has a different aversion to risk.
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That’s why there’s no ‘right’ answer for everyone. Everyone has a different aversion to risk.
What’s curious to me, though, is how my risk aversion changes based on the situation. For example, I still lean toward paying down the mortgage, despite the math. I’m willing to wager that Kris does, too. (She’s out of town, so I can’t ask her.) Why? Because the mortgage is a sure thing.
Yet given the choice between bonds and stocks, I’d choose stocks nearly every time. Why is that? It’s because the house is a physical asset, something I own. I want to own it free and clear.
I’m not saying this is logical — it’s just how my mind works.
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I would suggest that if your house payment is $1000/month, and you have the opportunity to not pay out $1000/mo anymore, why would you not jump on that and then invest. If you don’t have a mortgage to pay anymore, then you’ve got $12,000/year at least to invest without worrying as much if you lose it. What I mean is that if you own your house free and clear, you can have a higher risk tolerance. If you are set up for retirement then that $1000/mo is now money that you can do what you want with. If you invest while you still have a mortgage and you think of it as an emergency cushion, you would be crushed if you lost all that invested money. Yeah, it would still if your house was paid off, but you wouldn’t have to worry about foreclosure or bankruptcy. That’s my two cents.
Disclaimer: I don’t own a home, but I have a car payment. I am a public school educator and I am working on my Masters. I need to save $376/mo to pay cash for tuition, instead of taking out a loan. With my $300 car payment, I can only save $176. IF my car was already paid off, I would be able to save enough each month for tuition. Those are small figures, but the principal, I think, is the same. I need to pay my car off ASAP so I can stop taking out more loans for school.
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There is no right answer to this.
But seriously, here is the correct answer – run the numbers. If you can, in the stock market, beat ON AVERAGE the return you’d get by prepaying on your mortgage, you should invest.
I strenuously object to Suze Ormon saying “Invest in the known.” This is so completely shortsighted. Your house is not a known – it’s just a place to sit and eat, and sleep. It is not a retirement vehicle!
The fact is that, without even considering the mortgage interest deduction, you can beat the return you get by prepaying on your mortgage. Today’s rates are low – the stock market has an annual return that beats the return you get by prepaying on your mortgage.
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This is a question that we are also talking about and researching. Do we want to pay down our mortgage or do we want to invest that money.
Looking at the original question, I would vote to pay down the mortgage as it sounds like the money Mr. Poster is talking about is money that they already pulled out of the house via equity. I don’t think its a good idea to borrow against one’s primary home to invest. If its the more ordinary question of having extra money (not from a HELO) than I think the answer is different.
My husband and I are considering paying down the mortgage for the following reasons: (1) we are following the Dave Ramsy total money makeover plan and paying off the mortgage is one of his steps, (2) our primary home consists of a main home and a carriage house (2 structures) which living in South Florida requires 4 insurance policies (2 windstorm and 2 hazard policies) if we paid off our mortgage we would drop the insurance covering the carriage house thereby radically reducing our insurance costs.
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I think a big advantage to owning your house outright is that if you do get laid off or have other unexpected hardships, you don’t risk foreclosure if you can’t find a new job for a long time. So part of the decision should be a realistic look at your own job security and your ability to handle a long-term financial hardship.
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Maybe it would help to just rephrase this question a few different ways —
“Is it better to be in debt or to be debt-free?”
“Is it better for your life to truly be your own or is it better to be harnessed to an enormous fixed expense each month?”
“Is it better to move forward or backward?”
“Is it better to have payments or no payments?”
“Is it better to pay attention to the one in a hundred financial experts who tell you not to make accelerated mortgage payments, or is it better to pay attention to the 99 out of 100 who tell you to do this and live debt-free?”
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This is a fascinating post for me, because I’m constantly discussing this particular point with others.
First, let me start by saying that each of my divorced parents (raised by their own Depression-era parents) scrimped and saved and worked and paid off their mortgages early.
Now they both own fairly valuable homes outright…and they have small investment portfolios, as this was the opportunity cost of paying down the mortgage early.
This concerns me because hundreds of thousands of dollars in the walls of their homes won’t generate them any income and, as a result, won’t support them in retirement or help them to afford high future medical bills (if they still want a place to live, that is). There’s simply no way to “get the money out,” as it were, except to take out a loan. The thing about loans, though, is that a loan isn’t a loan against your home–it’s a loan against your INCOME. Try going to your banker after losing your $100K/year job and saying, “I’d like a loan, but I don’t really have an income stream to pay it back…”
Economics teaches us that inflation is the debtor’s friend. If I borrow $1000 today, ten years from now, I’ll be repaying that $1000 with inflation-adjusted wages. Of course, it can be argued that lenders build this in when they offer a loan (i.e. interest rates), but I’d much rather still owe money I borrowed 10 or 20 years ago and have a healthy portfolio that has been compounding for all those years.
I was glad to see that Ric Edelman was mentioned. He wrote something that I’ve always remembered…a mortgage is the cheapest money you’ll ever buy. Not only are the interest rates generally low (and were ridiculously low several years ago), but the interest is tax-deductible. He points out that if one can earn 10% in the market, he’d gladly give 8% from his left pocket to earn 10% in his right.
I don’t currently have a mortgage, but I do have outstanding student loans, with a fixed interest rate less than 3%. I know many recent grads, like myself, who slave to pay these loans off so they can be “debt-free,” meanwhile missing out on the incredible opportunity to be investing that extra money and letting earnings compound. I plan take the full 30 years to pay back my student loans for the same reason why I won’t prepay my mortgage. At 3% interest, the money I borrowed is a steal. And 20 years from now, I doubt I’ll bat an eye at the monthly payment thanks to inflation, salary increases, promotions, and the fact that I have enough money in my portfolio to pay off those loans at any time.
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All things being equal, I like the idea of using the money to purchase a rental unit. We currently have four units and have seen a marked change in the rental market as the bubble bursting effects of foreclosures are creating more renters who are willing to pay higher rents that are still less than their previous mortgages. But, and this is a big but, don’t ignore the part about putting extra cash into the purchase. The renter should pay your mortgage, taxes, insurance, and then some. If it doesn’t work out that way, then its just like any other long term investment – a risk.
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Here are some thoughts from a Canadian perspective.
Up here, we aren’t able to deduct mortgage interest, so we have a bit of a disadvantage compared to our southern neighbors. We are, however, able to deduct interest paid on money borrowed to “invest.”
For any Canadian interested, I suggest taking a look at the Smith Manoeuvre. The basic principal is that you transfer your non-deductible interest (mortgage) to deductible interest (investments). This is done by having a dedicated line of credit, where you take out an amount from the credit line to invest in an amount equal to the principal you have paid down on your mortgage. At the end of each year, as you build up your investment portfolio, you will have paid more and more interest on the credit line, which gives you a tax refund (in theory – depending on your other tax situation). Take that tax refund and apply it to your mortgage. You eventually get the snowball effect – each year you will be able to put a larger and larger payment onto the principal of the mortgage.
Eventually, you will have taken the total principal amount of your mortgage and converted it equally to a balance in a line of credit, with the balance having been invested, and the added benefit of now owning your home much sooner.
At the end, one could then either start paying down the balance on the credit line, or could leave the balance intact so that the tax refunds continue to be generated.
For those of us who are self employed and don’t have the benefit of a company pension plan, it can be a way that we are able to invest more earlier on, while reducing our mortgage more quickly.
The hardest part that I’ve found so far is finding a bank that understands the concept and is willing to help out. It works best if you have a credit line that adds the monthly interest payments to its balance, instead of coming out of your chequing account. My banker suggested that we leave it as is, and then after the monthly interest payment comes out, take that amount back out of the credit line.
It’s a fairly simple concept, but can be a bit complicated to implement. One should definitely have a good financial planner and accountant to help with this – payments made to both are also tax deductible, of course
I haven’t yet started this myself, but will be soon. Our financial planner suggested that instead of waiting 5 – 7 years to find a larger house to start a family that we see if we could do it sooner. So we’ve just moved into a new, larger house. Now that we’re in here, we can start transferring our debt to the good kind – deductible.
For more reading on this concept, check out http://www.smithman.net – I’m not affiliated with them at all, just think that it’s a great idea for Canadians.
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I actually think that its a better idea to invest the money. Assuming that there is already a real emergency fund. When I say better, I mean better for me of course. Eventually you’re going to pay the mortgage off anyway. Are you really going to invest the extra money you save in the payment?
This is different to borrowing extra cash against the equity in the house because there is other risk involved, specifically the risk that you will not be able to afford the higher mortgage repayments should you lose your job etc.
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Great post!
I have been wrestling with this one for a long time, too…
I have chosen to split the difference and use my extra cash to partly fund the portfolio and partly fund paying off the mortgage early. I hope both turn out equally well. I like the 50-50 split so at least I am covered one way if either one falls through… I hope.
MGB
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I’d also like to mention that Liz Pulliam Weston is indeed paying off her own mortgage early. She’s just gotten a few other things out of the way first, like an emergency fund and fully funded retirement accounts. But in her article “So You Want to be a Millionaire,” here is what she says about herself and her husband:
“We chose an old-fashioned, 30-year, fixed-rate mortgage because the low payments allowed us to invest more for retirement while still allowing us to gradually pay off our debt.”
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What JD said is totally right on for me as well. I’m new in my mortgage, young, no family. I am in the probably the best possible situation to take that money and invest it, but I wouldn’t. Not because I’m risk averse. My retirement savings is almost 95% stocks (for now).
It’s because it’s debt. I hate debt, even good debt. I hate my mortage, I hate my student loans, and I really hate my credit cards. I am just guessing, but I would need at least 15% additional return. Not 15% return on my investment, but 15% additional return to the difference between market return and the dollar value of the saved 10 years of interest. That would mean I would need a garunteed investment return of 17-19%. Not likely to happen with any kind of consistency.
Like I said, it’s different because of what we are talking about. With my retirement savings I’m willing to gamble, but not gamble with using debt. Its 100% psychological, makes no sense. Its all because it’s someone else’s money I’m playing with. Which is why I will probably never take advantage of 0% interest credit cards. Even the 5-6% of savings accounts are way too low of a return for me to take more debt.
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I’d always rather gamble with someone else’s money than my own!
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Aaron and Rob bring up deduction of mortgage interest–Rob writes
I’m surprised no one else has mentioned this yet. Once you take into account the mortgage interest deduction, its almost crazy NOT to invest somewhere else
IMO the mortgage interest deduction is way overblown. If you run the numbers it only makes a big difference if you’re a single homeowner, or if you’ve got an enormous mortgage in the early years of amortization.
Remember that you only come out ahead if your itemized deductions are over the standard (last year, ca. $5k for single filers and $10K for married). So for married folks, $10K in mortgage interest has to leave your pocket for good before you start to see any (incremental) decrease in your taxes.
Single people have a lower threshhold. More power to you if you can afford to buy a house on your own in this day and age.
If your mortgage isn’t that big, the MI deduction is miniscule or none. If you’re more than a few years into the amortization curve, the MI deduction starts to rapidly diminish (unless you’ve got a massive, massive loan).
Not worth it.
FWIW, I’d rather pay down my mortgage. The projections on how investments are all “on paper”. Who knows how they’d actually turn out. The bill for my house comes every month, like clockwork, no hypotheticals about it.
One last thought, maybe one I’ve shared before. A friend of mine once quipped, “Buying a house is the American Dream. Paying off the mortgage is the American Fantasy.” Too true!
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Wow. Great post. It’s interesting to see in one summary view many of the different opinions on the matter. I was struck by Suze Orman’s comments. You can’t live in your investments. I also thought she was spot on that paying down your mortgage gives you a guaranteed return on investment whereas investing is highly subject to the investment vehicle you choose.
I’m actually planning on conducting a very large experiment relating to paying off your mortgage in the near future. I’ll be posting about it next week. I’d love to get your feedback when I do.
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I’m a young person and I have a long way to retirement. I’m fairly disciplined and believe that investing would be wiser. Clearly you net more money over the long run.
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In our house, the discretionary savings gets allocated in this order:
1) 100% to emergency fund (until at least 3 months expenses)
2) 100% to pay off high-interest debt
3) 401K to point of company match
4) monthly contribution to a “big ticket fund”, which is savings for occasional large expenses, like semi-annual insurance, vacations, etc.
5) Roth IRA to contribution limit
6) 401K to contribution limit
7) remainder: 50% mortgage prepay and 50% taxable index fund
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Dude! Do not refinance your house to invest the equity. Refinancing your house is not free, and the fees to refinance and the transaction costs associated with investing significantly cut into your returns. I would be surprised if you came out ahead in this scenario. Make sure you run the numbers carefully.
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I don’t know if this was covered, but the article fails to note the effect of having your full mortgage payment to invest after your home is paid off. Sure, you may make a few bucks extra over what you “save” in mortgage interest, but having your full mortgage payment to dump into retirement is likely to very positively impact your retirement savings.
Some did note that investments are definitely not guaranteed. Paying off the mortgage is a sure thing – you will save interest. Investments have usually made money, but we could easily end up with many down years in response to the main up years until we return to the historical mean.
That said, the note on buying investment property and using a mortgage to fight inflation is not a bad idea.
http://www.lewrockwell.com/north/north532.html
Note the section Debtors and Creditors. He makes the argument that it would be better to buy investment real estate than to pay off your own home mortgage. I am not sure I completely agree, but it is an interesting argument.
Brad
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I meant to say 50% mortgage “payment to principal”, not 50% mortgage “prepay”.
@20 Anne:
I couldn’t agree more. Paul needs a liquid emergency fund, and that is neither mortgage prepayment or equities.
@35 ThinkingMan:
It’s only a benefit to gamble with someone else’s money if you’re willing to abandon the debt when the investment goes sour.
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One extra consideration is that mortgage rates fluctuate over time. If your rate is locked for the full term at a low rate, then it may make more sense to invest. However, here in Canada most mortgages have a 25 or 30 year amortization but a 5 year term. If you have a low interest rate now, odds are it will be higher when you have to renew your mortgage as the rate reverts to the mean.
Over the course of the whole 25 years, I would expect your mean interest rate to be fairly close to the historical mean, which is higher than most people are paying now. Therefor, it makes sense to use the mean interest rate in any calculations you do on prepayment vs investing. Right now it may make sense to invest because mortgage debt is cheap. However, it makes less sense if you run the numbers assuming a 1-2% higher mortgage rate over the full course of the mortgage.
Therefor, my personal choice would be to pay the mortgage down as fast as possible when interest rates are low, with the expectation that they won’t stay low. When interest rates rise, I’ll have to make higher payments anyway, but this way I’m paying more on the principle.
Also, I think anyone who would not consider leveraged investing on its own shouldn’t be using a home equity loan to fund investing, because it’s the same basic principle except now your house is on the line. If you do invest with leverage, then funding it with a mortgage may be a good idea since you can generally get a better interest rate.
Finally, those of you talking about the joy of having your house completely paid off are living in a different world. Us working stiffs are talking about the difference between having it paid off in 15 years vs 25. Whatever decision you make has to make sense now, not just when the mortgage is paid off, because a lot can happen in 15 years. For example, I would opt for a low monthly payment with the option to make extra payments or lump-sum payments ever year, rather than just getting a 15 year mortgage. When I lose my job (and I consider it pretty much a certainty that I will be laid off at some point in the next 15 years) I want my monthly burn rate as low as possible.
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This is one of the most talked about subjects in personal finance. I like to focus on this statement:
“This seems like an easy choice, but it’s not. There’s no guarantee of a 9% return…”
I think it is an easy choice. Over the span of 26.5 years a return of better than 6% is very much guarenteed (if investing costs are kept down, and the investment is diversified, both things that the individual can control). The return is likely to be 8% or even 10%.
It’s also possible to deduct the interest on the mortgage from your taxes (for many people at least) and if you pay it off in advance, you lose that tax break.
In summary, the decision (as I see it) is basically between: Do I want 100% return of 4.5% (by paying off the mortgage and foregoing the tax benefits) or do I want 99.9999% return of 8-10%? I’ll take the later any day.
Put another way, if you don’t have confidence in the stock market return over the next 26 years, you should be putting your 401k and Roth IRAs in a 100% stable value fund. It’s the same thing, yet personal finance bloggers seem to think there’s a difference.
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I like to keep it simple. Do I want to get rich quickly or do I want to get rich slowly.
If you want to get rich quickly, then pay off the mortgage fast, build up a cash reserve and be ready to spend that cash on investments such as stocks, business partnerships, joint ventures, capital investments or real estate.
If you want to get rich slowly, then capitalize on what ThinkingMan elluded too, compounding interest. Remember, it’s not just that you’re getting a better interest rate by investing [mutual funds for example], but you are earning interest on the interest. In the long run, this will far exceed the interest you pay on your mortgage.
So what it boils down to is what’s most important to you, get rich sooner or get rich later. Either way, you build wealth, it’s just a matter of when you want it.
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I haven’t read all the replies carefully (there are a lot), so sorry if this is a repeat: RE DEDUCTIBILITY: ONLY the part over the standard deduction counts: you get the standard deduction in any case.
I paid off my house (8% loan, chose to pay off rather than refinance at lower rates) and I consider the money I’m not spending as my “bond income.”
My itemized deductions were only a few thousand over the standard deduction anyway.
That’s a point seldom mentioned.
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@44 Lazy Man: Thanks for putting this so articulately. You’re spot on.
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Simply directly comparing return and interest rates is naive. It’s not that simple. Having debt is a risk and it must be factored into any investment decision.
If you have a paid for house, and you ask most people with common sense if they would borrow against it, just to invest, the answer is no. That should give you an indication that it’s not simply comparing numbers.
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Putting an entire emergency fund in stocks (even index funds) is not a good idea. IDuring a bear market, people are more likely to face the number one emergancy the fund is for: unemployment. It sounds like it might be a pretty large emergency fund though, so it wouldn’t be a terrible idea to invest part of it in stable index funds.
You may not be able to live in paper investments, but a house doesn’t pay for retirement. Unless you sell it, but then you can’t live it in.
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Over the span of 26.5 years
Who says that the last 26.5 years were a good indicator of the next 26.5 years, or any future period of that length? That pretty much ignores all significant downturns except for a blip in the late 1980s and the tech crash in 2000. Normal stock history is a little less “up” all the time.
Brad
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