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. â€œYou cannot live in a tax return. You cannot live in a stock certificate. You live in your home.â€
- 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. â€œPaying 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.â€
- 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): â€œOn the first of the month when you write your regular mortgage check, [include extra] for the â€˜principal only' portion of the next month's payment.â€ 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 pfblogger, MapleMoney, recommends 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.