Ask the Readers: Should I Invest or Prepay My Mortgage?
Published on - July 2nd, 2010 (by J.D. Roth) Kelley wrote recently with the sort of dilemma I get asked about all of the time: Is it better to invest or to prepay a mortgage? We’ve covered this topic in the distant past, but it’s time to review the debate for current readers. First, let’s look at Kelley’s e-mail:
My husband and I are on the right track. At age 25, our only debt lies in our home mortgage. We have the six-month emergency fund in place, I currently meet the 3% 401(k) match offered by my employer, and I started a Roth IRA for myself and my husband last year. I started each Roth IRA with $4,000.
My financial advisor recommended for us to max out each of our Roth IRAs each year. My husband disagrees. He thinks paying off the house is a bigger priority. Starting this year, we’ve made an extra payment on our house each month. If we continue doing this, we can have our house paid off in nine years rather than 30 years. However, we can’t do both.
Currently we’ve decided to throw $1,000 into each Roth each year until the house is paid off. Is this the wise decision? Or is it better to put more toward the Roth IRA and less toward the house?
I understand either option is good because I’m saving money. I’m just curious of which route would be wiser.
Kelley’s right: Both of these options are good. This is like choosing between an apple and an orange. Both taste good, and they’re good for you &madsh but is one better for you in the long run?
What the experts say
Three years ago, when we last covered this topic (holy cats! — where has the time gone?), I collected the following roundup of advice from personal-finance books:
- 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.
- 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 at Bargaineering 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.
The bottom line
My conclusion in 2007 (and the one I still hold today) is that unless your mortgage rate is very high, it makes more sense mathematically to invest your money. But most gurus agree that psychologically, you should do what works for you. If paying off your mortgage would take a weight off your shoulders, then pay off your mortgage. Sure, you might be losing a bit in the long-term, but you’re still making a smart choice. As I said earlier, it’s like choosing between an apple and an orange. One may be better for you, but they’re both good.
Ultimately, I kind of like the choice that Kelley and her husband have made. They’re prepaying their mortgage and putting some toward retirement. But enough of what I think. Kelley really wants to know what you think.
Which option is better? Should she and her husband be pumping as much as possible into their Roth IRAs? Or should they be paying down their mortgage as quickly as they can? Have you been faced with a similar dilemma in the past? What did you choose to do? And would you make the same choice again?
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When in doubt. Hedge your bets. 50% option 1 and 50% option 2. This covers other questions like “When I travel abroad should I change my money now or later”. You wont get the optimum outcome, or the worst outcome, you will end up somewhere in the middle. It’s the path of least risk.
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I decided to pay off my mortgage and with a little good fortune I’ll be done in 3 yrs give or take. My choice was between saving more for retirement (I’m currently saving 12% + 4% company match) and the FREEDOM of being completely out of debt and never being tied to my house. I cannot wait!
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In most cases, I’d probably be inclined to go for the Roth.
I think it’s worth pointing out though that if your advisor is paid either a) commission or b) as a percentage of assets you have with him, then he has a conflict of interest here. He makes more money if you go with the Roth than if you prepay the mortgage.
Of course, that doesn’t necessarily make it a bad choice…
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These types of blanket recommendations drive me crazy–because they don’t mean anything unless you know the type & rate & amount of the mortgage. Also it makes a HUGE difference if like now, there are no safe investments making even 5%.
Personally, I’m maxing my Roth 403b & also I’ve been dumping some lump sums into my mortgage since early 2009. Because I get a guaranteed rate of return = my mortgage rate less my tax savings on the interest. When CDs are paying less than 2%, paying down my small (50K) 4.5% mortage makes a lot of sense. I want to have it paid off by the time my kids start college, which is pretty close.
But everyone keeps lecturing me, “why are you paying off your mortage?! You could make more investing!”. Uh, where?
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Since they are already putting some towards retirement, I would continue to pay down the mortgage. The difference between a 30 and 9 year mortgage is a significant amount of interest over the lifetime of the loan. In my opinion, the less interest the bank gets the better. And if it’s paid off in 9 years, they’ll only be about 34 and have all that extra money to put towards retirement. And still have quite a long time to do it.
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I agree that it all depends – I’m in the UK and have a ridiculously low mortgage rate at the moment. Even with pretty low savings interest, my savings are earning twice the rate of my mortgage interest (3% vs 1.3%!), so we’re just socking money into the savings account. When interest rates rise, if the mortgage rate gets to the same as the savings rate, we’ll pay it all over.
But then, we’re really conservative risk-wise, so we’d always prefer a bird in the hand to two in the bush…
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Wow…remind me never to read Ric Edleman’s books.
I personally prefer Ramsey’s approach. Investing for retirement is certainly important, but like all investing, there is ALWAYS risk involved. Paying off your mortgage is a sure thing though. If disaster struck and you lost your income and depleted your emergency fund, you’d be much better off without having to worry about a mortgage payment than you would with a bunch of extra money tied up in a Roth IRA or a 401(k). If you were forced to make an early withdrawal of that money, you’re completely negating any mathematical advantage that you may have gained from investing over paying down the house.
So save a decent chunk for retirement, but throw everything else at the house. Once the house is paid off, you can do whatever you want with that money that you used to send to the bank every month.
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We are at about the same age and stage as Kelley and her husband. We are hoping to have our house paid down in 7 years. Our reasons are:
1) The 2008 stock market hiccup reminded us that investments aren’t a sure thing
2) We want the extra space in our budget in our 30s-50s when we are hoping to have kids
3) Our rate of retirement savings already allows for a comfortable lifestyle in that stage. Putting an extra $15000 a year into retirement savings would mean we’d be taxed at a higher rate during retirement.
4) This is our first debt and it makes me feel a little ill when I consider owing that much money.
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Another twist to add to the mix…
When my kids go to college (starting 8 and 11 years from now), will it be better for us from a financial aid package standpoint to have paid off the house, resulting in having saved less for their college funds, or to stuff that money in their college funds and still have another 10 years of house payments?
I am implicitly assuming that we will qualify for some sort of financial aid package, (perhaps because I am implicitly assuming that both of them will be accepted at the most expensive schools in the nation — hey I’m a parent, of course my child is brilliant!). But I think the question is valid even if we have to foot the entire bill — would it be better not to have to worry about a house payment, or better to have invested the money?
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I’m with Karen, investments are yielding pretty poorly right now. It makes good financial sense to pay off your mortgage and the feeling of freedom you get from no mortgage is worth it’s weight in gold. Also judging by the number of mortgage foreclosures in the US right now… if a few more people had worked on paying off their mortgage – the bank wouldn’t have had to repo their home!!
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If I had listened to the experts- I would have lost everything in the dot com crash!
That being said. At her age I would invest in retirement FULLY and then pay a bit down- only if she had the cash. Most likely she will move many times before she finishes working. Put her money in a Roth- then she can use it in her next home.
At our age (52&60 and retired) we paid off the house. It is worth the peace of mind.
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I like Eliz Warren’s advice. 10% retirement (why not split it half into pre tax 401 and half into a Roth) and 5% into mtg prepay. That’s covering several bases.
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I think it depends on more on future goals. They are 25 years old and could have the home paid off in 9 years. Without a mortgage payment they have a lot more flexibility in their life. What if they have kids and want someone to stay home, will the mortgage prevent that from happening?
What type of mortgage is it? If an ARM definitely pay it off…if fixed that changes things. Is any of it in a HELOC that would be a variable interest rate? Pay off the HELOC and then reevaluate.
Also think about risk/reward and their tolerance level. If the mortgage is 5% and we assume 7-8% return you’re talking 2%-3% which is not a huge spread.
Personally I’ve adopted a hybrid approach over the past few years of paying to retirement and to the mortgage.
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This is an endless debate, which completely fascinates me every time. Some like to consider your mortgage as a negative bond with a guaranteed rate of return. Keeping your mortgage ‘offsets’ the bond portion of your portfolio. A paid off mortgage also increases cash flow.
OTOH, keeping a mortgage allows greater liquidity. With your assets tied up in your house there is an inherent opportunity cost, assuming that you ‘know’ the better opportunity ahead of time.
I tend to put retirement planning first, because your tax-advantaged space is use it or lose it. For the average person:
1. Get 3-12 months expenses in a money market or similar fund (I plan to use I-bonds that are >1 year old).
2. Invest up to the full company 401k match and then max out the Roth IRA.
3. Choose between maxing out the rest of the 401k and making accelerated mortgage payments. Either is a good option. Doing a little of both gives you some diversification, since no one can predict the future.
I would run the numbers based on your expected retirement age and need, and work backwards to see which option works best for you. It may be in your best interest to fill up the tax-advantaged space now, otherwise if you pay back the mortgage early you could be out of room in tax-advantaged accounts and stuck investing in a taxable account only and owe more in future taxes.
@Mike Piper (#1): Hopefully they use a fee-only financial planner.
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@Joe (#6) Absolutely agree about fee-only planners.
Still, fee-only planners who charge a percentage of assets are subject to this conflict of interest. The “pay off debt or invest” question is one reason I’m a big fan of hourly-fee planners rather than assets-under-management planners.
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Agreeing with Karen, each situation would be so case specific as it relates to psychology and economics that I am not sure it wise for Kelley to “ask the audience”.
What is the mortgage balance and interest rate? Would refinancing allow the best of both worlds? Where are they at on their amortization schedule? What is their tax bracket? Are they planning on moving anytime soon?
In the end Kelley would need to quantify her psychological desire to pay off the mortgage and compare it to the hard numbers relating to her specific situation.
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The conclusion i arrived at by creating a spreadsheet to analyze the variables http://goo.gl/IMlz (or download it from http://goo.gl/Z2Y0 as Excel) is this:
The primary factor in determining whether you should payoff your mortgage is your tolerance for risk.
In short, if your tolerance for risk is low, you are better off paying your mortgage down since it is a better long term and safe investment for you.
If your tolerance for risk is high, you’ll be better to invest since your investment return will (possibly) outpace the savings from not paying mortgage interest.
As you reduce risk, and as a consequence, investment return, you reduce the amount of your investment returns prior to paying off your mortgage. As a result, you can catch back up to where you were faster. This seems like a good situation since people that prefer less risk are likely the same group of people that will feel secure not having a mortgage payment.
Also, i recommend not making extra payments to your mortgage every period. If you intend to pay off your mortgage early, save the money in an investment (probably safe, low risk) and pay the mortgage off when you’ve save the entire sum. The only benefit to making extra payments to a mortgage each month is if those payments reduce your payments over time which isn’t typical.
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It’s more about mind than math, right? While it’s easier to see the interest savings from your mortgage, investing NOW is probably mathematically better. The economy and stock market are shaky. Historically, it will level out and grow at an average rate of 8-12%. It’s just not instant gratification. As for investing in retirement (rather than just making investments), I feel like that can be a tough pill to swallow. I get my full employer match, but beyond that, I want to get some financial benefits from what I do with my money BEFORE I retire. At 31, having my mortgage paid off in 8 years means I’ll be 39 when I make that last payment. I’d like to think that gives me some good “young” years to make the most of that financial freedom. Maybe I can even start my own business at home with very little startup capital. Plus, the thing about having low mortgage rates is that there is almost NO tax savings. My annual mortgage interest this year will only be slightly more than my standard deductible. I know we’ll need “a lot” of money in retirement, and I don’t recommend that you skimp on it, even when you’re young, since compounding interest is important, but I feel like we’re too young to put ALL of our eggs in that basket. Enjoy life before retirement!
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I found these lines particularly interesting:
“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 current Canadian system is much closer to this system than I had realized. We normally sign up for a 1-5 year term, and then renew after that time period (lump sum isn’t due). A 30 year (or even 10 year!) mortgage term is very rare.
JD, does your advice on this change for your Canadian readers? Or are the basics the same?
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What I didn’t understand was if their employer 401k max was met. (16,500/year). If that has not been met, I would put the money in the employer plan to protect it from taxes. If I had to choose between the Roth and mortgage, I might consider the mortgage. Being entirely debt free so young would be incredibly liberating.
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i think a lot depends on if you LOVE your house. i love this house – it is my greatest joy and hobby. also a lot of people change houses frequently. I don’t. this is my forever house. my ex and i paid a 15 year mortgage in nine years.
why sink money into something when you are planning to move in a few years?
there is an indescribable sense of security from being debt and mortgage free. i am sitting in a “paid for” house. i pay about $500 a month in taxes and insurance and $250 freedom account for upkeep.
in my neighborhood, a similar property rents for $1300.
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Kelley left out the most critical piece of information: the interest rate on her mortgage.
If you have a 5% mortgage, paying it down early is a risk-free, guaranteed, tax-free 5% return on the money.
The major question to ask is, do you think you can get a better deal anywhere else?
Are your Roth IRAs a better deal? Depends on what they’re invested in. Depends on how well it performs. Depends on your risk tolerence.
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I like to look at diminishing returns. For example:
If I pay an extra $50 on my $290 student loan payment, it will be paid off in 17 years instead of 25 (cutting off 8 years of payments!)
If I pay an extra $100 per month, I’ll be paid off 11 years faster (14 instead of 25).
If I pay $200/month extra, the loan will be paid off in 10 years instead of 25.
If I pay double ($290 extra), I’ll be paid off in 8 years.
And if I paid $1000/month total, I’d be paid off in 4 years.
To me these numbers mean that paying an extra $50-100 each month (especially toward the beginning when I’m paying a lot of interest) gets me a lot of bang for my buck. Just $50 a month saves me 8 years, but the next $50 extra only cuts 3 more years, and the next $50 cuts less than 2 more years, etc.
So I pay an extra ~$100 each month and save the rest.
You can do the numbers for yourself and see the point at which it stops making sense to pay extra.
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Mortgage, mortgage, mortgage. Then you’ll be in your 30s with a paid-for home. Imagine the financial freedom you’ll have!
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As Dave Ramsey says “100% of forclosures had a mortgage”
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Statistically, no one who owned their home outright ever was foreclosed on. That’s quite the safety net, your cash inflows can go down drastically, but your worries won’t be as bad if you no longer can afford an IRA, vs no longer affording your house! If your cash flow goes down before it’s paid off, you have a lot of equity, you can sell for the cash, or get a HELOC.
The couple doesn’t mention what they want to do in their 30s, but no mortgage means extra cash flow each month for perhaps a stay at home parent, perhaps the ability to start a new business, perhaps kick the retirement savings into high gear. They are saving for retirement, I would plug their retirement savings numbers into a calculator, with conservative %s and the earliest date they’d like to retire, and see if it is do-able. If not, maybe cut it so that 25% extra goes to investing, 75% of the mortgage.
And the answer to why pay off a house you may sell one day: if you SELL a house you OWN, you get to keep ALL the proceeds. If you don’t own your house and you sell it, you pay the bank first and get whatever’s left over. Who cares if they are planning to move? The proceeds from selling the current house can be used to pay down the mortgage on the new house.
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My husband and I (28 and 30) are debating this very thing. We’ve decided to pay extra on our mortgage for one simple reason: we don’t have the discipline to keep our hands off our savings, but we DO have the discipline to leave our home equity untapped. That’s just us…
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We paid off our mortgage in 9 years. We were putting the maximum that my husband’s employer allows us to contribute (7%). I have a Sep IRA because I have my own housecleaning business and I worked for 12 years for a school contributing to a 403B until I was laid off. Once the house was paid off, we bought a rental property and held it for 7 years. Two of our children got full academic scholarships, the rental property paid for one child’s college, and we are paying out of pocket for the 4th child. We bought one rental property in Florida last year that we pay extra on the mortgage,and we are closing in July on a 2nd property with two brothers as co-investors that will not have a mortgage. We need a smaller emergency fund because we have only one small mortgage on the rental property. During times when we don’t have a tenant we can always use the property in Florida for vacations. I say pay down the mortgage.
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They don’t mention the loan to value ratio of the house. If they put 0% down, then by all means they should prepay the mortgage. They are likely already underwater. If they were responsible and put down 20%, then they have some equity in the house and should invest.
Also, they should consider making 1 extra payment per year. This frees up plenty of money to invest and will still cut off a significant amount of interest.
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I have an interesting wrinkle on this…
What if you are either:
1 – Not planning on staying in your property till the end of the mortgage? I own a condo, which is great for a single 28 yr old. But not going to work in a few years if I’m married with children.
I mention this, because I understand the benefit of paying off a mortgage in 23 years instead of 30, if you are planning to be there the whole time. If you lose your job in year 24, you don’t have a mortgage payment.
2 – Planning on renting the property when you move out? I am considering this and would rather save/invest my money for possibly a down payment on another property.
In both cases, I feel that I am losing liquidity by prepaying my mortgage and not gaining much. But I’m willing to be convinced otherwise…
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Being dual income, we pay a lot in taxes, so we max our 401K first. We have had our home for 10 years. If I had made the decision to pay mortgage faster, I think I would have been better off given the negative rate of return in the last decade.
I really don’t get the people who say they’re better off investing. Those assumptions are based on long term historical returns. They are talking about a 9 year time horizon here, which is much more volatile.
Market Investments aren’t tangible until you cash them out and buy something. In 2008, I would have been happier with a paid for roof over my head vs watching my brokerage account evaporate. That in itself made us funnel more cash towards the mortgage. (we always prepaid a little and it did add up fast)
My house doesn’t disappear and then come back again in 12 months..it’s there for me to live in the whole time.
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If we’re talking about a scant 9 years to totally pay down the mortgage, that sounds like a smarter move. If Kelley’s family suddenly suffers from job loss or other financial crisis in 10 years, at least they won’t lose their home.
$400 per year or whatever the “cost” is sounds like a reasonable premium for “keep your home” insurance.
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I think the best advice here is: don’t always listen to so-called experts or gurus. Some of that advice is just ridiculous – never own your home? Huh? The thing to remember is ALL of them are basing potential return on investments on past performance. I’m not so sure the stock market will even generate 6-7% annually going forward. Our system is deeply flawed, anyone can see that.
Truthfully, this is more about psychology than math. We’re going through the same thought process as Kelley right now. Do we take the guaranteed 5% by paying off our mortgage or take on a little more risk and try to beat that with stocks? It is a tough decision, I find myself going back and forth almost weekly.
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I agree with #21 that it really depends on how you see the house – is this where you want to live forever? Do you have a lot of ties to the area? Will your occupations allow you to stay there? If you want kids in the future, is the house a good size for that and in a good neighborhood/school district?
It is hard to predict all of this at 25, but if you are pretty committed to the home, I think prepaying has nice benefits. If there’s a decent chance you’ll move in the next 20 years, I would invest. I don’t know what % of income you are saving for retirement right now, but I’d get that to at least 10% before doing anything else.
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My suggestion is the same as the one from Dave Ramsey.
STOCKS IN THE LONG TERM OVER ANY 30 YEAR PERIOD IN THE PAST 200 YEARS HAS AVERAGED 11%.
Prepaying your mortgage early without retirement in mind will save you around 5.5%.
Keeping this in mind, I would say after you have maxed out your 401k and Roth contributions, any money still left over should be divided equally between prepaying mortgage and further investing.
This above suggestion is because you are still 25 years old. If you were say 50 years old I would say prepay mortgage.
But it all depends on how risk tolerant the investor is.
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Why must this be an either/or question? Accelerate the mortgage payments to pay it off in 15 years. Use the other to increase retirement savings. Or maybe you pay off the house in 20. Work it out.
Also, the house isn’t as sure a thing as people might think. Career changes, children or a parent moving in with you could all make you need to change the housing situation. You are in your 20′s, life likely has some curve balls in store for you.
Also, do you have your life and disability insurance in order? It’s easy to get in your 20′s.
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Ok I would say that you are really doing the same thing. Paying down your mortgage and investing are the same thing.
When you pay down your mortgage faster than the amortization period the only benefit you have is more equity in your home. You only realize that equity when you sell your home and that is not always guaranteed. As we have seen recently there is just as much risk in paying down your mortgage than investing in a similar type asset. Now you can improve your cash flow by refinancing your debt after you have built up your equity position to lower your monthly payment, but if you are just paying down your mortgage to pay it off it doesn’t have much added benefit than peace of mind to know when you sell you have some equity cushion. I would rather put my money in more liquid assets where I had more freedom of choice. What to do with your money seems to be the age old question, and alot of that depends on factors that are not uniform to every person. (Age, income, location, cash flow, etc.)
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Do you know where to invest right now?
I don’t.
So I chose to pay off the house.
I’m an airline pilot. every 6 months, my job is in jeopardy, getting a medical exam which could ground me for the rest of my life.
It’s a huge piece of mind to know that this house would be paid off, and I have a place to live, even if I end up flipping burgers somewhere…
Granted, I have 12 months expenses in a emergency fund, and maxed a 401K. That’s what I do first, before anything else.
I go with the guaranteed.
investing is not much better than gambling in Vegas lately…
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We were a duel income family, but my husband lost his job in June. He is eligible for unemployment, but let’s imagine that he is not able to find a job in 6 months and his benefits run out. At that point, my income will have to cover all of the bills we both paid with our incomes… including the mortgage. I will be able to do it, but I’m not sure if I can continue to fund retirement and emergency savings while doing so (I will try) — our budget will be very tight with NO room for extras. If our mortgage had been paid off, this would not be such a worry. Assuming he does get a job, I think we are both agreed that paying off the mortgage will a priority for us.
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Personally I want to pay as little for my housing as possible so I can breathe easier and maybe enjoy life a bit more than if I’m sweating the $1200 mortgage payment every month.
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If they can afford the normal mortgage and can max out the Roth IRAs I would max out the Roths. The markets are down right now so they are basically investing at a discount. The markets will rebound and the returns will be so much higher.
Saving for retirement is a race against time and with the power of compounding the sooner you get in the better.
I also agree with @Jason (31) in that they are young and there will be changes down the road
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Once I’d maxed out my Roth type accounts (RRSP in Canada), I started both paying down the mortgage and investing. When I started paying the mortgage down, my rate was at almost 5% and now it’s at 2.9% (was at 2.6% for awhile) so it’s kind of dumb to keep overpaying on it but there’s almost nothing owing on it and I’m too lazy to change it.
I think it depends on the tax implications for Canadians at least since if you put money into RRSP’s when you’re at a higher income bracket, you save more money on tax – that’s a guaranteed ~20%+ return for most people. I’ve advised my 22 y.o. son to build up his RRSP contribution room and use it when he’s in a higher income bracket.
If the person has self-discipline – which it sounds like she does, they really don’t need the “mind over math” prescriptions that Orman gives.
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You have caps on how much you can contribute to retirement annually – caps on your 401k, caps on your Roth, etc. Obviously the younger you begin contributing the more money you’ll have contributed and more it will have grown by the time you reach retirement. Sure having the flexibility of no mortgage would be nice, but you don’t want to get too late of a start on saving for retirement because you can’t go back and play catch-up due to these annual caps.
First pay off all other debts, get an adequate emerg. fund, get your company match on 401k (you’ve done all these), contribute to your Roth whatever amount brings you up to 12% total retirement savings (this includes your 401k totals) and then prepay your mortgage.
My goal wouldn’t be to pay off the mortgage ASAP, but to have it paid off before I retire. Of course I bought my home at age 36. If I bought my home in my 20s I’d be shooting for having it paid off by age 50, 55 at the latest. I think planning on paying your house off in 25 years or less is a very attainable goal and still give one the flexibility to save for retirement and other needs.
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Thinking about all the almost-retirees lately who lost 60% or so of what they invested and are now being foreclosed on, I would tell her pay the mortgage first.
People tend to think of their own situation more optimistically than they think of the economy as a whole. Everyone thinks they will come out ahead investing. If you pay off the mortgage, you have a place to live in and/or rent out when times get tough. If you invest everything, the market crashes and you have 15 more years of mortgage payments left, times will not be so good for you. What’s so bad about Depression era thinking anyway?
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@Raghu: Whether Dave Ramsey says that or not, it’s absolutely false.
Just in the US, the 30-year periods ending on Dec 31 of 1957-1960, 1966, 1974, 1975, 1977-1995, 2002, and 2008 all had compounded annual returns of less than 11%. (And that’s before accounting for inflation or any investment costs.)
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UTILIZE THE TIME VALUE OF MONEY
Why not do things the easy way, and utilize the time value of money?
Why use present-value dollars to pay off your present-value debt? Once you have a mortgage locked in, the relative value of that loan will continuously drop.
As a real estate investor, I want a situation where I put in a little effort and get a big payback. Let inflation work for you. After 10 to 20 years of owning a house, the value of the dollar goes down as the value of your house goes up.
Think back to when you were younger, and how much more you could buy for a dollar than you can now. Remember 5-cent packages of chewing gum, gasoline for 15 cents a gallon, a steak dinner for 30 cents? I don’t either, but many people say that’s the way it was, so it probably is true.
The point is, the easiest way to pay your mortgage with is to just wait a few years and pay with future dollars, which will be worth a fraction of today’s dollars.
APPRECIATED EQUITY
An even more efficient way is to use appreciated equity to pay off a mortgage. In other words, buy an extra house, rent it out for several years, and finally refinance or sell it. Then use the equity from your second house to pay off the mortgage on the first house.
For example, if you put an extra $200 a month into the principal of your house, how long will it take to pay off the loan?
Answer: A lot longer than selling an appreciated property and using the cash to retire debt.
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I don’t know enough about your situation from what you’ve said, but here are the factors that affected our decisions:
– mobility: If you see yourself in the house for the long-term, then prepaying makes sense. If you see yourself selling it, moving on, and starting another mortgage elsewhere before the house is paid off, it makes less sense.
We’ve lived in 8 places in 17 years.
We prepaid for a while on one house, until we decided it wasn’t our “forever” house.
– retirement plans: If you see yourself getting a pension or having some other form of steady income after age 65 or so, then slow down savings. If you expect to be living off of retirement savings, put everything in there you can, especially in your 20s and 30s.
No pensions here. We max out every retirement savings vehicle we can use.
– timeframe: You’re quite young — if you’re planning to be in the house a long time, you have enough savings, and the mortgage is a big part of your monthly budget, by all means, pay it off. It will free up a lot of your monthly budget for a while to come.
We’re in our 40s, and know the area but probably don’t own the house we’ll need in 2 years or so. Maybe we’ll prepay that mortgage? Also, the mortgage is about 1/2 of our housing cost (insurance + property taxes + utilities for the rest), so it isn’t a big a deal for us as you’d think.
– refinance instead? You’ve already bought your house, but you could also save a chunk of money and refinance your house for a smaller mortgage, which might reduce your interest rate and the size of your mortgage payment going forward. You could also choose a very short term, like 10 years instead of the 30.
We sort of prepaid our mortgages on #2 and #3 by putting down a 45% and 40% down-payment on those properties. That’s why the mortgage is only 1/2 of our housing cost.
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Seriously, if you are 25 and can do it, max out the Roth.
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Before reading any of the other comments, I’ll put down my initial thoughts:
I help people answer this question every single day…and it all comes down to “location, location, location”…of your money. The 3 tests for any investing decision ae SAFETY, LIQUIDITY, and RATE OF RETURN.
Kelley and her husband are doing awesome!! But…I know there’s always a “but”, the biggest glaring hole I immediately see is NO money going into a LIQUID investment? Putting all your money into retirement or prepaying the mortgage leaves you high and dry when big life events happen. And we all know LIFE HAPPENS. 6 months of living expenses is a start, and that’s great. But where’s the college fund? What if you decide, at age 40, to buy a vacation home? What if you lose a job and it takes 1+ years to find another? Here’s my formula I teach:
1. Cash-Cushion (first money goes here – they have this)
2. Eliminate consumer debt (we coach families on debt-repayment plans)
3. Build liquidity – invest, whether it’s stocks, bonds, CD’s…just build those accounts that will be readily available for you between 25-65.
4. Pay off your house.
I know emotion plays a big role, and if you can do all of these at the same time, terrific! But when your income goes away, and you’ve plopped $100,000 inside of your house to pay it down…but it’s just not quite completely paid off…you STILL have a payment to make, and now you cannot qualify to get that money back out of your house to feed the family, pay for car insurance, still take the family trip you’d been planning for 8 months, etc. etc.
My 2 cents…but you guys are doing awesome at 25. Congrats!
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I like your idea of splitting it, but I would put at least half the maximum on the IRAs, possibly more. 3,000 out of 4,000 for instance, and extra payments for the rest.
You might focus on the fact you’ll have to pay more interest on your mortgage if you wait longer, and that’s true, but don’t forget that when you’ve completely paid off your mortgage and freed your cash flow, your IRAs will still be capped. You won’t be able to put more than the maximum every year.
You have a bit more freedom with your mortgage, you can make extra payments as big as you want, as often as you want. You don’t have to make an extra payment every month, but if you don’t know, you can always make bigger payments later, without an upper limit.
So I would keep slitting it up between the two, but focus more on the IRAs. Unless you pay an insane amount of interest on your mortgage, that is.
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