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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i would consider mortgage as an asset group with a rate of return that is fixed (your interest rate). i would build a portfolio with this as an asset and allocate capital(prepaying the mortgage) just as i would between stocks, bonds, cash etc.
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In the Great Depression, many people lost their homes because they didn’t have them paid for. If we don’t have another depression one could argue that is makes more sense to invest, but if we do have a depression – the owners will win the day.
It’s a bet either way, but who is willing to gamble with your mortgage? The only reason people do is because they have a backup plan – it’s called bankruptcy.
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The math is compelling – investing instead of paying off the mortgage is likely the most rewarding option in the long run. It’s a matter of risk tolerance. Nonetheless, my wife and I paid off our $320,000 house last month (at age 30) and we are now completely debt-free. This is great for our peace of mind, notwithstanding the $18,000 a year that we will now be able to invest. Obviously, this is not within reach of everyone, but prepaying is a great option instead of holding bonds or other fixed income investments, since the interest rate is likely higher on the mortgage.
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So many comments! You can’t predict the future, so you can’t predict investment on return no matter what the length of time. However, if you can historically average greater returns than your interest rate for the term specific to you (i.e. the amount of time left to pay off your mortgage without overpayments?), then it’s probably mathematically superior. But are returns on investment taxed? How much tax do you pay on them?
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I’ve be struggling with this. Right now, with my investments in the gutter, I think I would be absolutely sick right now had I taken out a new mortgage 12months ago.
However, you could look at today as an opportunity, as Mortgage rates are low, and it’s likely a good time to invest in some bargains…..
I still feel better knowing my home is paid for! If the markets perform like the experts say it will in my lifetime, I’ve already got enough invested! If they markets crash, at least I still have a place to live!
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I plan on enjoying being debt free by prepaying my mortgage, as well. However, for those who are interested in investing, at least get to the point where you have at least the old norm of 20% equity in your home.
Too many bad loans have let people take on a mortgage with little or no money down, and getting to 20% equity would allow them access to more conservative refinance offers, or home equity lines of credit, etc., as well as removing the need to waste money on PMI.
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@Mike,
I think what you wrote makes a lot of sense. Even though I only put 5% down, I have no PMI and a pretty good rate. I still think I’ll wait until I have or saved 20% equity before I start investing outside of tax advantaged retirement accounts. Thanks!
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‘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.” ‘
Suze Orman is a tool!
Her monetary advice always makes me angry. I can’t watch 5 minutes of her show without throwing the remote control at the television.
You can’t live in a stock, but you can live in a rental and you can always sell stocks.
Think about the return on investment if you stick money in your house (above and beyond your down payment). If you stick $10,000 into your mortgage – your payments don’t get lower. You also have to wait until you sell your house to get it back. How long can you wait to get the money back? In this market you will be waiting a while unless you live in Atlanta or here in Austin.
Keep your money liquid (especially since it’s an emergency fund)
Admittedly, things suck right now, but I would split your emergency funds and keep some in the guaranteed CD, (I prefer High Yield Money Market accounts), and take the rest and stick it in an index fund that out performs the market. There are a number that earn far more than 9%/year.
You will have to do your research, but it shouldn’t be too hard by looking at Morningstar and Google Finance for the comparison chart.
… And don’t listen to that dunce Suze Orman.
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I like how everyone tosses around the “average annual return of 7-10%”.. Doesn’t anyone realize the “average” return of the S&P for the last DECADE is about 2.6%, NOT including taxes and fees… OH, and don’t forget about inflation. In reality your real return would be ZERO to SLIGHTLY NEGATIVE.
The nonsense about lack of access to your home equity is silly. You can set up a HELOC and have access to those funds IMMEDIATLY, as opposed to the T+3 wait you will have when selling securities. I would even think that could serve as your emergency fund..
The best advice I’ve received is this: “There are two kinds of people, those who pay interest and those who get paid interest. That is the difference between those with money and those without”.
JMHO: Pay into your employer’s retirement plan up to the match, put all the rest into paying off your mortgage. When your house is paid off use the excess liquidity to max out your 401K, IRA, and buy some investment real estate if you need the tax shelter.
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Chris, funny, when I do the math, and look at the ten years from 1998-2007, I see a gain of 52% (including dividends), which is a not so bad return of 4.27%/geometric mean.
BUT – when I drop the spectacular 26% of 1998 and add the -12% so far this year, I see a total return of 6%, which is <1%/yr.
I bet you are under 40.
I hear you citing a decade that began with a 3 year bursting bubble of hi tech, and ending with whatever this mess is now. It’s possible that we never regress to the mean again, but I expect a recovery and anyone not invested for the long term will miss out.
On the other hand, A Boston-based financial services research firm, Dalbar, inc, concluded that
“For the 20 years ended Dec. 31, 2006, the average stock fund investor earned a paltry 4.3 average annual compounded return compared to 11.8 percent for the Standard & Poor’s 500 index.”
Which, if we take it at face value, backs up your position. Unless one is committed to the buy and hold, it appears the average investor buys high, sells low, and lags the numbers quoted. Even when we choose a stellar 20 year period, the average investor would have been better off following your advice above.
(And I bet you did not expect me to conclude in agreement with you… life’s funny.)
Joe
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Joe,
Disclaimer: I am under 40
I may be splitting hairs, but if you run the Morningstar report on the Vanguard S&P 500 Index Fund – VFINX – (I don’t trust my own math, apparently) which is about the cheapest you can get, the average yearly return is 2.81%, which is lower than the Lehman Brother’s Agg Bond Index and even the 3-month T-bill.
Color me bitter, but I started investing in 1997. Perhaps in the next 20 years we may see something resembling the historic “average”, though I am inclined to believe we will not.
Check out:
http://seekingalpha.com/article/90892-the-great-consumer-crash-of-2009
I may be falling victim to the “This time it’s different” mantra, but….
Best of luck.
Chris
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I came into windfall and can afford to pay off my mortgage with 1/3 of the money. Should I pay off my mortgage or invest all of it for growth and income?
Thanks.
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Mox – What is the rate on your mortgage? Do you itemize your deductions? i.e. is your interest fully deductible? What is your tax bracket?
Do you (or your wife) work for a company that matches your 401(k) and do you deposit up to the match at least?
You see, if you said that this is chance to have deposits to the 401(k) doubled, and you’d use this money to do that depositing over the next X years, that might be better for you. If the mortgage interest dollars are low enough that you can’t itemize, and your 401(k) is loaded up, paying the mortgage isn’t a bad idea, esp if it’s just 1/3 the windfall. It’s not a black and white answer.
Joe
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Inflation is probably about to heat up big time. This means you can pay back a loan with cheaper dollars than you borrowed. Wages go up. Payments on fixed loans stay the same. Payments get easier. Pay back in the future with cheaper dollars. This is my advice. Personally I’m making two house payments per month just because the thought of debt suffocates me.
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I would like to cut Five years of my martgage, could you direct me to a calculator that tells me how much of extra principle that I need to pay every month.
Regards
George
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George, if you post your numbers, you’ll get a reply here. It really depend how far into the mortgage you are as well as the rate. For example, at 6%, to drop from 30 to 25 years requires only 7.5% higher payments, but to go from 25 to 20, takes payments 11.2% higher.
Do you have excel? If so, the equation is simple. I will post it, if you wish.
Joe
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This was written by Don Taylor of Bankrate.com
The Federal Housing Administration provides a loan guarantee program in lieu of private mortgage insurance so qualified borrowers can get a mortgage loan with a low down payment.
The FHA doesn’t lend you the money, they guarantee the loan, so the lender doesn’t take on a financial risk by extending you credit. The U.S. Department of Housing and Urban Development Web site can help you find HUD-approved counselors in your area who can answer your questions about FHA loans, specific to your situation.
The most popular FHA loan has a minimum cash investment requirement of 3 percent but permits 100 percent of the money needed at closing to be a gift from a relative, nonprofit organization or government agency.
FHA lending guidelines are not as strict as the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac). Sellers must pay part of the closing costs, while some of the borrower’s closing costs can be included in the loan amount.
FHA loans are assumable, meaning you can transfer your loan to the new owner if you sell your house. That allows the new owner to take over your FHA loan without the additional cost of obtaining a new loan. To assume the loan, the buyer has to meet the credit standards for the loan. This feature can make it easier to sell your home.
There are three FHA loan programs:
1. FHA 203(b) fixed-rate mortgage (15- or 30-year loans)
2. FHA 251 adjustable-rate mortgage
3. FHA 2-1 buy-down loans
There’s also an Energy Efficient Mortgages program that allows homeowners to finance adding energy-efficient features to new or existing homes as part of either their home purchase or FHA refinancing.
The biggest disadvantage to FHA loans is the mortgage insurance premium. In most 15- or 30-year FHA loans, the borrower pays 1.5 percent of the loan amount at closing, along with a 0.5 percent annual renewal premium paid annually over the life of the loan.
( Josh said – You speak of the PMI, FHA has a lower monthly PMI rate then the My Community, but with the upfront PMI the payments come out to be the same regardless. If you were to ever give a borrower the choice between a FHA and My Community loan, the borrower will most likely take the FHA. Ask any expert out there, they will 99% of the time tell you the same thing )
Unlike private mortgage insurance, the mortgage insurance premium isn’t canceled when the homeowner’s equity reaches a target level. You may qualify, however, for a partial refund of the upfront mortgage insurance premium if you owned your home for less than five to seven years. It’s five years for loans closed after Jan. 1, 2001 and seven years for loans closed before Jan. 1, 2001 and after September 1983.
You need to shop rates when looking for a FHA mortgage just as you would with a conventional loan because the rates are established by the lender, not the government. FHA loan rates are typically higher than conventional (nongovernment guaranteed) loan rates but shouldn’t be a lot higher unless you have credit problems.
( Josh Said -the My Community mortgage has a much higher rate due to rate and or pricing hits )
Before you start applying for loans you should request a copy of your credit report from at least one of the three major credit bureaus and get a credit score from them as well. Review the report for errors. If you find any, use the dispute-resolution process to correct the report. Bankrate provides contact information for the credit bureaus and a guide to handling the dispute-resolution process.
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I am someone who never quite understood how to respond when someone asks if I am a homeowner. Because as far as I’m concerned – until the deed is in my hands ‘paid in full’ – I do not consider myself to be a home’owner.’ So I respond, I’m making mortgage payments if that’s what you want to know.
Recently I structured out my payment plan for the year including a few ‘off months’ when I anticipate heavier than usual bills / vacation / etc … so that my yearly payments will be done in July with an average of $215 extra against principal. By the end of December I will be up to March and will continue this trend in order to pay off my mortgage 10 or 12 years early.
On that day I will take great satisfaction in saying, ‘yes … I am a homeowner.’ I understand it’s simple semantics … but it’s important to me. Based on this article that will cost me $12,000 or so in potential investment earnings … but I’ll have peace of mind.
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First, I guess I should clarify the $215 extra is per monthly payment – not total. Secondly, I read Jason’s comments below and was struck by his comment because for me the great difference is that – yes, I realize rather than pre-payments I could make huge strides against the principal – but – that equates to equity and wouldn’t help me at all if something happened and I suddenly found myself in dire straits. By getting 6 months to 1 year or more ‘ahead’ I can relax, and strategize next steps without the burden of having NO SAVINGS and staying current in my monthly payments. Right now, I’m two months ahead – after Friday I’ll be 4 months ahead, at the end of next year (God willing) I will be one year ahead which is crucial in the current economic crisis. That would leave me ample time to find a similar position and/or accept a much lower paying position for the time being. Even then, I’d start pumping money back into mortgage as soon as possible while continuing to avoid credit card, thankfully my natural pessimistic nature keeps me relatively debt free (owe $117 on CC).
Jason Says:
June 1st, 2007 at 7:10 am
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.
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Bob – how do make the extra payments? If they are to principal, the next due date does not tick forward. If you are actually sending “two coupons” representing the next two payments, you need to make sure your bank actually credits these upon receipt, otherwise they use your money,but you save no interest. (I say ‘otherwise’, because banks can use either method. You need to check with your bank how they credit the account.
Mine is a fixed 15 yr home equity loan. I send 12 payments today, I have nothing due for a year. If I do nothing else, in one year, I’ll see I’m ahead on principal by the int rate times about 1/2 years payments. So I’m with you, but most mortgages do not work this way.
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A lot of the ideas here are more about budgeting.
The reality is, the tax deduction I get far outways the paying off the mortgage.
Because up till sep2008 I could easily earn much more than the 6.5% I pay onthe mortgqage.
In fact till sep2008 i was avgeraging about 15-20% on funds, and up to 30% on stocks.
Since then, of course my stocks arent doing great… some of my funds arent..
But I am diversified enought that I only lost 10% while I know people who have lost the whole range from 0% to 100%.
Once i get my investing done, If I have spare $$ laying around then I pay extra on the mortgage.
I do about $500 on drip related investing.
I have about $1500 a month I do on general.
I have no intention of paying a mortgage that costs me 6.5% when I can earn much more than that.
Note that in my mortgages I always try to not include the various fees/closings as part of the payments.
Even the BPP (buyers protection) i pay seperately (normally thats required to be part of the mortgage but not nececcesarily).
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Also even if i did want to pay ahead on mortgage it will always be ona 30yr.
I will never do 15yr unless the numbers jive, because so far I can have a 30yr and pay extra during the good times and hold back during bad.
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Dont forget, there are still lenders out there that dont allow prepayment (early payoff).
In my case I never ever go with a mortgage that doesnt allow early payoff and also doenst allow a way of paying extra at any time I choose or similar.
also I give serious preference to online access to mortgage details of the mortgage (though i dont usualy need it after closing).
Also, I never ever buy a house where I have to pay PMI (I have in the past done more than 1-2 mortgages on one house and paid off the smaller one though.
Rarely will I actually pay off a mortgage soley for the paying off.
Investing is always better and a true financial analyst wont want you to pay off the mortgage early unless the numbers work and often investing is better.
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The reality is if you have cc debt or other issues, the mortgage is the last item to be paying on (and also investments).
However, if you are automatic on some investments, then they too are part of the cycle of whatever you have to do.
Mortgage payoff is a good idea but can be dependent on each persons situation.
For most, if the interest rate on your mortgage is high enough then payoff instead of refi or invest might be of value.
But for many,even if I were to do the same dollar amt as the price of the house I can even now, find bonds & cd’s that will give me nearly the same rate.
In fact 2 months ago I just got a 6% 25 year deal (bond), and i consider it a better deal than paying off the mortgage.
Yes I could have paid off the mortgage in full but why? I can use the tax deduction as well.
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Hi,
Paul here (the one who asked the original question so very long ago…
As an aside, I’ve long since decided to NOT pay off the mortgage. Why?
– I’ve got a great rate, still lower than the current “lowest rates”
– I can earn more with the cash in my accounts
– If I lose my job, that cash will allow me to pay my mortgage for several months. If I pay it all toward the principal, I’ll have nothing, and lose the house.
Another thing to consider is the power of inflation vs. the power of compounding. As time moves on, the dollar loses value due to inflation. Dollars properly invested today keep up or exceed inflation. By paying my mortgage off over time, I’ve borrowed money I get to pay back at significantly devalued levels. I.e. In the future, a dollar paid to my mortage may be worth only $.50. Whereas $1.00 paid out today, is $1.00 at today’s rates. And $1.00 invested today, is worth more in the future.
Paul above (not me) said:
“Yes I could have paid off the mortgage in full but why? I can use the tax deduction as well.”
I think this is a bad reason to keep a mortgage. A deduction is not a credit. In other words, you can only deduct a small percentage of the interest paid on the mortgage, not the entire mortgage payment. If you have no mortgage, you don’t *need* a deduction, you have the full amount of the payment in cash, up front, every single month. Saying that having a mortgage is a good thing because of the deduction is essentially saying that paying Fred $10 now is a good thing because next April Sam is going to give me $1.
I’d rather not spend the $10 in the first place. I end up $9 ahead
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Pll has it right, what I meant was I can invest the extra $$ and do better than the mortgage rate I pay.
Ie; why settle for a 6% savings by payoff when I can invest same at 6% or better and often do better and still have the cash.
But since Im not in high end of $$ making anymore (since 2003) I think not paying off is better… and I do get about $5000 in deduction each year on this alone (doesnt include the medical I get to deduct too (yea the % over agi is subtantial).
2006 was $17k in deductions despite being on $40k combined income.
The keeping a mortgage has more to do with investing the same.
But hey, each persons situation may be different enough to justify more of one or the other?
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“But hey, each persons situation may be different enough to justify more of one or the other?”
This is exactly right! Each and every person’s situation is completely different. As J.D. is wont to say, “Do what’s right for you!”.
And, no one here can tell you, or me in this case, what to do, all anyone can do is provide insight and opinion based on the very incomplete situation presented here. No one here knows my entire financial situation, nor are they familiar with what I’m comfortable with. So, while I may be comfortable investing this money in small-cap growth stocks, this may horrify others. (No, I’m not doing this
Ultimately though, it all boils down to doing what you’re comfortable with. I am deeply appreciative, however, of all the thoughts and opinions expressed here. It’s given me a lot to think about and definitely helped me make certain decisions regarding the initial questions I posed.
Paul
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A lot of people are touting a mathematical proof investing over buying, but there is one factor they are not including… risk.
The market pays better because you are paying a premium for risk. Are you sure investments will grow 9% _forever_? What if they bottom out? What if something catastrophic were to happen at a global or even national level? Can you eat investments? Sleep in them? There was a time in Germany where it was cheaper to burn money than firewood.
Being wealthy is a mindset. You live simply, frugally. A person with this mindset eliminates their debt first.
The people who are theorycrafting that investments are going to win out in the end are doing so with fuzzy logic. You have no idea what the future of the stock market will be (period). You have no idea of what the economic may evolve into (ever heard of Steady State economics? – wikipedia it). It’s perfectly plausible that this mad charge of growth and consumption will sizzle out and the huge amount of money invested in the market will produce a reasonable rate of return, one that is sustainable, and a lot less than 9%.
Finally – why bother with maximizing and minimizing. Owning your house _meets your needs_. That should be your first priority.
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It also depends how fast you payoff the mortgage. I’ll give you my circumstance for example. I plan on paying my 30 year mortgage on a 180,000 mortgage in 4 years. After that I plan on plowing money into investments (stocks and 100% paid for real estate). I think I’ll catch and surpass the person that is tied down with that mortgage after about 5 years. Just my 2 cents!
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It depends on the details naturally.
Overall, it does in fact depend on the investment in the end.
If one is unsure about their regular income, paying off mortgage in accelerated fashion is good idea.
But if you are paying 5% on mortgage and can earn 10% then it depend on the $$ amt I would think.
In my own case, it also depends on how much $$ we are talking about.
If i got new $$ that was less than $150K I would not pay off mortgage, but I would invest the $$ in such a way that a portion of the investment growth would pay for the mortgage for me.
Its totally possible to earn sufficent from investment to pay the mortgage and still earn more.
But paying it off can also allow bigger investments when its paid off.
For most its a ‘feel good’ deal.
In my case my mortgage is $50k and I would have to have more than $150k in new $$ to consider paying it off in accelerated fashion.
As it is, per the crash in 2008 I can use the deductions currently.
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Another key factor in everyone’s decision making is “Time”, which relates to “risk”
We all forget, that the most expensive factor for us all- is time, and all of us – have a very limited and finite amount of that.
So plan accordingly.
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Thats it.
It all comes down to time and what it takes to do what you need.
Paying off a mortgage is not a advantage unless you have spare $$ to have around.
If you are not that wealthy the mortgage is in fact a healthy good tax deduction.
If you have the cash, then it really depends on peace of mind.
Otherwise, if you can invest the difference in something that earns you more than u pay on the mortgage then invest instead of payoff.
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Timing is a key element.
If you have 5 years left on the mortgage, then there is little to be gained by paying it off now since the interest on the mortgage was paid up front. Take a look at the table of payments and see how little is now going to interest… add those numbers up and you’ll see that you can easily get an investment that pays more over the next 5 years, plus you’ll be liquid rather than “house rich & cash poor”.
If you still have 20-25 years to go on the mortgage, then consider things like:
a) will you be retired before the mortgage is paid? living on a retiree’s earnings is a whole lot different than living on a wage.
b) will paying it off early (extra payments or refinancing to shorter term) squeeze your budget so you’re no longer adding to savings?
c) are you likely to move soon and end up selling/renting the house?
d) what’s your plan if your income drops?
e) how much longer will you still be able to get a deduction for interest on your taxes (e.g. is your standard deduction more than the interest)?
Right away, you’ll see that many of those questions can best be answered by referring to the amortization table for your mortgage.
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It’s also worth a second look at the advice many have given in the comments:
– Hindsight shows that relying on HELOCs to help you through tight times was crappy advice since many of those HELOCs got yanked out from under the people just when they needed them most.
– “Risky” investments in mutual funds lost 25-50% this past year. This is an exceptionally lower return than prepaying a mortgage.
– “Safe” investments in short term CDs and savings bonds went to a rate barely above 0% (it actually is 0% for savings bonds right now!). This is a much lower return than prepaying a mortgage.
– Unemployment is pushing 9% nationally (it’s over 10% in my state). If your budget was tight because you were prepaying your mortgage and now your family has less income, you no longer have a cushion and probably aren’t prepaying your mortgage now.
– If all you care about is income (rather than net worth), then there are investments paying more than a mortgage – check the “risky” stock market for companies which are paying dividends higher than mortgage rates and, in many cases, have actually increased them. Or maybe you can rent out your house now for more than your mortgage payment?
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Its a good debatable topic and I think it will depend on what situation you are in.
I recommend
for example for a $200,000 Loan try to prepay where you have just $50,000 loan left as at that point the interest you will be paying will be much less most of the repayment you will be making after that will be more toward the payment of Principal.
Invest rest of the money in Another property or any asset which Appreciate with time even Stock market can be considered provided you should not look on ups and downs too often at this volatile market.
Make sure your investment is not emotional but thoroughly researched as its your money and anyone advicing you where to put is not to be blamed if you make more money in short span what you invested in make a move and take the profit and then invest again.
Cheers Amit
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Ask yourself, would you be willing to bet your house on the market? Overall past returns do not guarentee future returns…They all say it. I say find a balance; i.e., balanced portfolio.
Max out 401k’s, ROTH IRAs, have 1 year of savings in reserve (mortgage payments and all other expenses including home repairs), then balance the other extra money in paying down the mortgage, mutual funds and bonds paying at least 2% more than the interest your paying on the mortgage.
Doing this gives you cash reserves for emergencies (you can’t eat the house) and other options for investments if and when interest rates rise. Pay extra toward the mortgage (I’m on a 15 year with 10 left). If interest rate rise above the interest your paying paying on the mortgage, then stop paying down the mortgage and put it into FDIC insured. Remember CD’s paying 18%. I do.
When people look at the tax “write off” on your mortgage, just remember your only getting back a percentage of what you paid to the bank (mortgage co.)
Before you pay off the house make sure you have at least 2 years of property taxes and repairs in reserve.
One last thing. Consider your age. I’m 50.
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The big assumption and flaw in the thinking that investing is better than prepayment is that you are assuming that you are guaranteed a certain amount of return on investment and that the guaranteed return is in the higher single digits. Now tell me who actually pays me a guaranteed return of 7-10% on my investment. No one as far as I know.
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Who guarantees 6-13% that is?
These guys do:
http://www.commercialep.com/currentfixedreturns.html
You all can thank me later…this is a tough subject because while it appears I could sock our entire house payment with these guys for five years and earn 13.15% and in 5 years we would be sitting like kings IF the company stays afloat and this isn’t some Ponzi scheme etc…am I willing to take that RISK vs knowing for sure I can get a 6.5% return on NO longer having a mortgage payment?? I am leaning towards paying it all off THEN we can take on the risk since we still will have a years worth of emergency fund…AnY THOUGHTS??
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My mother (who is 90) and me get 6% easily.
She gets it on several $10k amts on each.
I get it on one major same deal at $50k.
Besides that I do other ‘driplike’ investing and have per that and market problems since sep2008 been getting 5-80% return.
Especially on BAC & GE,AFL .. my return on BAC is huge. THose stocks were bought at all time lows on the assumption it would be 2-5 years before return and I expected less than ideal return.
Yet I was wrong (as was obama) by 1.5 years.
It comes down to Sirnath & others say…
You balance need,want, value, and comfort to your balance of life versus investment.
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I’m pretty risk-averse by nature and I’m trying to figure out what’s the best use for a CD that’s just matured. We have a highly unusual mortgage as a benefit from my husband’s employer. 4.5% for 30 years, but the unusual thing is the repayment structure. The terms of the mortgage require us to pay no principal and only 1/2 the interest (2.25%) annually if the house does not appreciate in value. If the house appreciates, we pay either the amount of appreciation or 2.25%, whichever is less. There is no requirement to pay the principal until the end of the loan (30 years or when we sell the house). This is obviously a great deal for a loan, but I’m not sure what our strategy should be for paying down the principal. We have a CD that just matured that would cover 2/3 of the principal of this loan and we’re trying to figure out how much of it we should pay down versus invest or save as an emergency fund. Any thoughts?
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That kind of deal is why,despite the potential early value why I keep things simple.
Those kind of things can be good, but confusing.
It might take a financial expert in those kind of calculations to figure it out…
If you dont already have a emergency fund, and the equity is not an option for that (like I have) I would somehow look at a fund or bond that would give you the flexibility of access to the $$ and keep it that way.
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HERE’S A DETAILED SIMULATION:
http://solidpersonalfinance.wordpress.com/2010/02/10/pay-off-mortgage-or-invest/
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Charly Boy,
Thanks for the link, however, there seem to be a number of incorrect assumptions made in that “detailed analysis”.
First, I would never blindly invest the market by throwing money into an index fund. They only do okay when the market is doing great, and they slammed when the market is doing poorly. I invest in a much more target manner, and strive to beat indexes (which I’ve consistently done thus far).
Second, he assumes a mortgage rate of first 5%, then corrects for 7% and dates this back to 1993. Interestingly, this is about the same time I took out my first mortgage. No where in his model does he account for refinancing at better rates as they become available. My first mortgage was for about 7%, and I’ve subsequently refinanced twice such that I am now at 5.375%. Both re-financings have saved me huge amounts of money over the long term.
Third, he ignores trading fees and dividends. Trading fees are negligible, so I’ll allow that. In most cases, for recurring automatic investments, a brokerage account can be eligible for free trading.
But dividends I can’t allow him to ignore. Dividends account for huge returns, especially when investing in an index like SPY where a significant number of the companies in the index pay dividends. Every one of those dividends, if re-invested, goes on to buy more shares of the index which can and will, have a dramatic influence on the total return.
Fourth, he ignores the fact that it’s really easy to re-allocate investments over time such that performance will increase even in a down market. Yet the best one can ever hope for by paying off a mortgage is a return rate equal to the mortgage interest rate itself. In other words, if your mortgage rate is 5%, you’ll never get better than a 5% return by paying off the mortgage early. Whereas, even in a lousy market such as this one, I can get a 15% or better return (in fact, one of my portfolios is up over 25% vs. the S&P500 which is down 2% over the same time period, which means I’m flogging the market by 27%!!!)
Fifth, he alludes to the idea that one would have done horribly by investing in SPY over the past 17 years because of the recent economic issue plaguing us and implies that it would have bad idea vs. paying down your mortgage. What he completely fails to mention is the fact that the house your paying off during this time may well, and in all likelihood has, lost significant value. Therefore, you’re actually sinking hard-earned cash into a depreciating asset which will not regain it’s value anytime in the near future. And, you’re paying the same price for that now depreciated asset as you were 17 years ago.
Contrast that with investing in the stock market right now. These assets are also significantly depreciated, but the market has corrected their prices to reflect that depreciation. In other words, you currently get to buy depreciated assets on sale, and the probability that those assets will increase significantly over the next 3-5 years is far more likely than your house.
I don’t find his argument convincing at all, but mostly because he has significant shortcomings with his model. If you have a decent emergency fund set up, and you’re not in any danger of missing payments on your mortgage, even if you lost your job, I think it’s best to invest any extra money for the long term.
That being said, you must do what is right for you, because only you know all about your situation, your tolerance for risk, and what your relationship with money is.
Again, thanks for the link. I was definitely an interesting read, and I’m glad someone has had a crack at modeling this
–
Paul
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Hey J.D., great insight – though I have to come at this from a different angle. I don’t think most people buy a home with a return in mind, but rather for the security and independence provided through home ownership. There’s something to be said for the peace of mind in knowing that if you lose your job or fall ill that your family will maintain a roof over their head. I’m certainly not arguing your logic on which option provides a better return – in truth, I think you’re far over-estimating the return on a home (for instance, most first-time buyers don’t pay enough interest to warrant itemizing, so even the tax advantage is moot). Rather, my point is that home ownership evokes more than return – there’s an emotional attachment, a personal committment, and a sense of pride and accomplishment in owning your home outright that you just don’t get from investments. If return was the primary motivator, one could make a strong argument that renting and investing is a much better deal than buying a home.
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