Warning! Your Intuition and Financial Truth May Disagree
- Discover 5 ways to accelerate your mortgage payments.
- Reveals the surprising dangers to paying off your mortgage early.
- Explains step-by-step how to find the correct answer for your situation.
Should I pay off my mortgage early or invest?
You will inevitably confront this question in your pursuit of financial security.
The problem is the answer is far more complex and confusing than generally understood.
The intuitive response is to get out of debt. We all want the security of owning our castle free and clear with one less expense to deal with. The prospect of making monthly payments for the next 30 years is antithetical to freedom.
However, there are times when intuition and finance disagree.
The decision to pay off your mortgage early isn’t just about getting out of debt because complicated equations involving return on investment, time-value of money, and inflation are involved.
Remember, this is finance. You can end up with “Alice in Wonderland” scenarios where debt is the cheapest solution, and a dollar paid tomorrow might actually be preferable to debt freedom today.
Curiouser and curiouser…
In this article, I pull back the curtain exposing the many dimensions to paying off your mortgage early. The objective is to balance your intuition with financial savvy so you can make a smart decision.
The correct answer is not cookie-cutter, but must be custom-fitted to your personal financial situation.
Let’s explore how this complicated process works…
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How to Pay Off Your Mortgage Faster
If you decide to pay off your mortgage early, there is no shortage of advice on how to get the job done.
Unfortunately, it all boils down to the same three little words – “pay more principal”. There is no magic secret. The only real difference is form, not substance.
Paying mortgage principal early is a powerful money saver because small debt reductions compound dramatically over the life of the loan, thus eliminating many times the payment in interest.
For example, this mortgage payment calculator shows you that a 30 year, $100,000, 6% mortgage has a monthly payment of $599.55, with only $99.55 going to principal in the first month.
If you add just $100 to that monthly payment, you literally double the principal paid in the beginning, eliminate 108 payments over the life of the loan, save $39,900 in interest costs, and shorten the payoff time from 30 years to 21 years.
Not bad for an extra $100 per month…
If that sounds appealing, then here are the various strategies for early mortgage payoff starting with the simplest and moving toward the most complex…
- Add Principal to Your Current Monthly Payment: Assuming your mortgage doesn’t have a prepayment penalty (check first), the simplest early payoff strategy is to just add principal to your monthly payment. You could try a one-time lump sum where you put the proceeds from selling a boat, motorhome, or unused jewelry to good use. Alternatively, you can add a little extra every month by sending your raise or bonus directly to the mortgage company. The concept behind this strategy is you got by just fine without the money before, so you'll never miss it if you never see it.
- Biweekly Payment Schedule: Rather than make one mortgage payment per month, try making half the payment every two weeks. Since there are 52 weeks in 12 months, that causes 26 half-payments or 13 full payments instead of the usual 12 – one extra payment per year. Depending on your situation, this can cut up to 6 years off the life of your 30 year loan. Check out the details first because some mortgage holders offer this payment schedule without charge, and others will hit you with a fee. I suggest you try using this bi-weekly mortgage calculator with extra payment capability to test both this early payoff strategy, and the previous one, to see how fast you can be free and clear!
- Refinance to a Lower Interest Rate: Another strategy is to refinance to a lower interest rate mortgage while keeping the term (pay off date) the same. The key is to not take any money out or extend the term when you refinance. Your new loan should offer a lower payment due to the reduced interest cost. When you continue making the same payment as before, all the extra will go to principal payoff. The nice thing about this strategy is it doesn’t require any additional money out of your pocket to achieve the desired result (unlike the two previous alternatives). All the savings comes from reduced interest costs.
- Refinance to a Shorter Term: Rather than pay over a 30 year amortization, try reducing the term to 15 years. The monthly payments will be higher, but the interest rate is usually lower, thus offsetting some of the monthly outflow. Another variation on this theme is to keep your 30 year mortgage, but make your payments as if it were a 15 year amortization. You won’t get the reduced interest rate of a 15 year term, but you also won’t pay refinancing costs either. Some people prefer this variation for its increased flexibility and reduced cost, while others prefer the enforced discipline of the required monthly payment. Either way, you can use this mortgage payoff calculator to estimate the monthly payment required to be free and clear for any date you choose.
- Downsize to a Lower-Cost Home: Changing homes isn’t for everyone, but I would be remiss as your financial coach to exclude this strategy. You could move to a lower cost area or buy a smaller house in the same area. The smaller mortgage principal means you can be debt free faster using the same monthly payment.
The key point to notice about all these early payoff strategies is how they aren't mutually exclusive. You can combine them in various ways to turbo charge results.
For example, you could downsize your home while financing that less expensive home at a lower interest rate on a biweekly mortgage. Then you could sell that boat and jewelry you never use, putting those lump sums toward the mortgage, while also dedicating this year’s raise to additional monthly principal payments.
You'll be amazed how fast you can get out of debt following this prescription.
The only limit to how fast you escape the bondage of mortgage debt is your creativity and dedication to this noble cause.
Pay Off Mortgage Early – The Pros…
Now that we know how to pay off your mortgage early, let’s look at the benefits to following this strategy.
- Save Money: The first and most obvious reason to pay off your mortgage early is it can save you tens of thousands of dollars in interest costs.
- Peace of Mind: The second reason is peace of mind from owning your own home. It gives you a warm-fuzzy feeling to know you have a secure place to live, and you won’t be put out on the street at the first temporary setback in employment.
- Reduced Cost of Living: For most people, mortgage payments are your biggest monthly expense after taxes. Without a mortgage payment, you can save more, work less, or take that dream job you always wanted but couldn’t afford because of the lower salary.
- Get Rid of PMI: When you accelerate paying down principal, your home equity will reach a threshold where PMI should no longer be required. This saves you money long before the mortgage is paid off, and allows you to accelerate the principal pay-down while still making the same monthly payment.
- Asset Protection: Many states have laws that protect home equity in the event of lawsuit or other legal proceeding. Homestead rules can provide substantial home equity protection. Also, retirees sometimes use home equity as an estate planning strategy to protect assets for the surviving spouse should one partner consume all available resources in a prolonged illness or nursing care facility. In short, there are many situations where home equity can represent a more secure asset with special legal privileges when compared to other investments.
- Retirement Planning: A free and clear home takes on additional significance for near retirees. If you are entering retirement with a fixed income (Social Security, pension, fixed annuity), then it can be a real benefit to pay off all debt rather than put money in fluctuating investments. This allows you to reduce financial variables and more reliably match forecasted income to expenses. Additionally, after retiring, that mortgage payment can require pulling money from tax deferred accounts when that money would be better off left to grow. Finally, if your taxable income is reduced in retirement, it can reduce the benefit of the mortgage interest tax deduction, tilting the equation in favor of payoff.
- Guaranteed Return on Investment: With the stock market and real estate going up and down like a roller coaster, it's comforting to put your money toward your home and know with certainty what the ROI will be. You get the imputed rental value of a place to live and the immediate return of eliminated interest expense. The certainty of this return stream is a huge benefit for investors who feel beat-up by unreliable financial markets that supposedly will pay more… but may not.
- Achievable: Paying off your mortgage feels more motivating than most financial goals because it's concrete. It's big enough to get excited about, yet tangible enough that you can wrap your head around it. It's achievable and will make a significant difference in your life. Contrast this with retirement planning, which feels more ethereal and hard to grasp for most homeowners.
In short, there are many benefits to paying off your mortgage early – and some are very compelling!
Payoff Mortgage Early – The Cons…
Before you break out the champagne and burn your payment book, it's important to consider the downside to paying off your mortgage early. This isn’t the slam-dunk decision it appears at first glance because of some complicated financial issues. Let's review them.
- Lose the Tax Break: I start with the tax break issue not because it's the most important, but because it's the most commonly cited and misunderstood. Yes, mortgage interest paid is generally deductible on your tax return if you itemize, but there are some important “caveats” to this deduction worth considering: (1) The rules are complicated and may cause you to lose some of the deduction you thought you were getting. (2) In certain circumstances, you may get as much value by taking the standard deduction as by itemizing deductions, meaning your mortgage interest payments merely replace the standard deduction and provided no real savings. (3) Even if you get the deduction, you're still paying $1 to get a 35 cents (or comparable) tax break – not a very good deal. (4) And the effective value of the deduction diminishes over time as the loan matures and you pay less and less interest with each payment. In short, there are many tax rules and situations where you won’t be able to fully utilize the mortgage interest deduction. The rules are complicated, so talk to your tax professional if this issue is important to your decision.
- Low Return on Investment: A home mortgage is likely the cheapest money you will ever borrow – and the interest is usually deductible, further decreasing the effective cost. For example, if you're in a combined state and federal tax bracket of 35%, then a 6% mortgage could have an effective cost under 4%. This means two things: (1) Higher cost, non-deductible debt should be paid off first, and (2) long-term investment returns will likely provide a higher return on your capital as evidenced by Ibbotson and Associates research showing a diversified portfolio returning in the 8% range.
- Savings Are in Cheap Dollars: A key point to consider is how all the savings you are expecting only come after the mortgage is paid off, meaning those savings must be discounted for inflation. For example, let’s assume you pay off your mortgage in 25 years instead of 30. Using this present value calculator, you’ll see that $1,000 saved 25 years into the future is only worth $375.12 in today’s terms at a 4% inflation rate. In other words, you have to discount all savings by inflation because the payments you avoid will be in depreciated dollars. This is quite important.
- False Sense of Security: You're not going to like this idea, but you never really own your property – even if it's mortgage free. This is a throwback to feudal times where the king (“royal = real” relating to the latin for “king” connecting real estate to royal estate) was the owner of all land and received “tax” for the right of possession. Today, our local governments are the modern equivalent to feudal lords who collect property tax annually. In other words, you always pay rent to someone whether the bank is out of the picture or not. If you're not completely clear about this truth, just stop paying property tax for a few years and see what happens. The truth is your monthly payment is merely a question of degree and to whom – not whether it exists or not. This ugly truth makes the idea of true mortgage freedom an illusion.
- Lost Diversification: This one is “the biggie” so pay close attention… Most investor portfolios are denominated in their domestic currency and thus carry the risk that inflationary government policies will depreciate their investment purchasing power over time. A residential real estate mortgage is the only practical way for most people to short their domestic currency and hedge against inflationary economic policy.
- Interest Rate Below Expected Inflation: Given record low mortgage interest rates as of this writing, it's entirely possible that the interest rate on a fixed rate mortgage (forgetting the fact that it might also be deductible) could turn out to be lower than the inflation rate. If that ended up being true (nobody has a crystal ball), then a bizarre financial situation is created where you are literally paid to borrow money in real terms (after inflation), even though you're paying interest every month. In other words, you make more by owing than by owning. Strange, but true. When you prepay your mortgage, you give away that financial advantage.
In other words, the way mortgage financing works is you borrow (short) your currency and use the proceeds to buy an inflation adjusting asset (real estate).
Few people understand how conventionally financed real estate is little more than a leveraged play on inflation. That's why it's such a powerful wealth building tool more than 90% of the time, and it blows up horribly when the rare deflationary event strikes (i.e. 2008).
When you pay off your mortgage, you are unwinding your short currency hedge. This means you lose the ability to be short today’s more valuable dollars and repay them with depreciated dollars in the future.
Related: 5 Financial Planning Mistakes That Cost You Big-Time (and what to do instead!) Explained in 5 Free Video Lessons
The importance of this financial fact cannot be overstated given today’s record government indebtedness and overt government policy directed toward creating inflation.
I repeat… this is a HUGELY IMPORTANT factor in deciding to pay off a mortgage early or not! It is critical.
But don’t trust me on this issue. Consider these two facts…
- This inflation calculator (which likely understates inflation’s true impact) shows you how the Federal Reserve has destroyed more than 95% of the U.S. currency’s purchasing power since they began monetary policy. If that time period is too long, then look at various 30 year time periods (the life of a mortgage) for similarly dismal stats.
- In a February interview with CNBC, Warren Buffett called mortgaged real estate “as attractive an investment as you can make”. He further stated…
“If I knew where I was going to live for the next 5 years or 10 years, I’d buy a home and I’d finance it with a 30 year mortgage. It’s a terrific deal… If I had a way of buying a couple hundred thousand single-family homes… I would load up on them. And I would take mortgages out on them at very low rates…”– Warren Buffett
Did you get that? Read it twice! Warren is a pretty successful investor who has some clue on these matters, so strong statements like this are worth listening to.
He's telling you about the value he sees in locking long-term, low cost interest financing on an inflation adjusting asset. The last time this strategy paid off was in the inflationary 1970’s when the Savings and Loan industry went bankrupt for being on the wrong side of the transaction. Homeowners literally laughed all the way to the bank with ridiculously cheap mortgage payments on appreciating real estate.
Are you going to be able to do the same on this next time around?
When you prepay your mortgage, you give away that advantage, so tread carefully on that decision.
What’s important to note about this entire list of negatives is how they aren’t intuitively obvious.
The list of positives to paying off your mortgage discussed earlier are easy for anyone to see, but the negatives require a fair degree of financial sophistication – from esoteric tax strategy to long term inflation effects, short hedges on currency, and discounted present value equations.
It's heady stuff – financial geekism – yet it's every bit as valid to your bottom line as the more intuitively obvious reasons for paying off your mortgage early.
That's why there's so much misinformation on this subject. The concepts are complex and sophisticated once you get past the obvious reasons for wanting to get out of debt.
In short, the decision to pay off your mortgage is an intellectual battle where the emotional-intuitive desire to be debt free is matched against the intellectual realities of modern finance.
Unfortunately, this makes the decision process complex…
How Do I Make the Right Decision for My Situation?
If you're somewhat confused right now, then you're in the perfect spot. You get it, and that's a good thing. The confusion results from the tug-of-war between emotion and intellect trying to sort through the complex factors explained.
The next step is to give you a structured way to sort these issues so you can make order out of chaos and formulate a well-reasoned decision as to whether paying off a mortgage early is the best decision for your situation – or not.
The key is to realize there are two steps to this decision process:
- Personal Finance Considerations: This is a decision between paying off your mortgage early or taking care of other personal finance issues first that better reflect your personal values. This decision is prioritized ahead of any investment considerations.
- Investment Return Objectives: This is a decision between paying off your mortgage early or investing the difference. This decision only comes into play after the personal finance issues in the previous step are satisfied first.
Let’s take each of these steps one-by-one…
The First Step Is to Figure Out What's More Important Than Paying Off Your Mortgage
I’m a firm advocate of getting your financial foundation in place before pursuing more advanced financial strategies. Your wealth can only grow as high as your financial foundation can support (similar to how a skyscraper’s height is limited by the depth and strength of its foundation).
Below is an order of priorities for building your financial foundation that may take precedence over paying off your mortgage…
- Guaranteed 50% Return: Many employers still offer 401(k) retirement plans that include employer matches – typically 50% of every dollar you put in up to 6% of annual pay. This guaranteed 50% return on investment is pretty hard to beat, so it usually makes sense to make sure you are maximizing this benefit before prepaying your mortgage.
- Maximize Tax Deferral: Even if your company doesn’t offer a 401(k) plan, it may make sense to maximize tax deferred and tax free retirement savings before paying off your mortgage. Granted, tax issues are complex and vary based on individual circumstances, so it’s impossible to make a blanket statement, but every tax deferred savings opportunity you don’t use is lost forever and can't be recovered because annual limitations apply. In other words, use it now or lose it forever. The investment math often tilts in favor of maximizing every tax deferred investing opportunity available… before paying off the mortgage.
- Pay High-Interest Debt First: Even after maxing out all your retirement savings options, it still may not make sense to pay down your mortgage early when you have other debt. The reason is most other debt will be at a higher interest rate – particularly credit card debt where the interest is much higher and not deductible. Use this debt snowball calculator to figure out the fastest way to get out of debt. The order of precedence is to pay off the highest interest/non-deductible debt first, followed by low interest/deductible debt (i.e. mortgage debt) last.
- Financial Stability: Once you’ve maxed out your retirement plans and paid down your high-interest, non-deductible debt, you may want to consider building a 3-6 month cushion should unemployment strike. Some naysayers claim a home equity line of credit serves the same function, making this step unnecessary. The thinking is that mortgage prepayments increase equity, thus providing a positive return while you don’t need the funds, but can still be withdrawn through a line of credit should you fall on tough times. Either way, developing a safety cushion for difficult times is a prudent step in building your financial foundation.
- Insurance and Financial Security: One of the main goals for paying off your mortgage early is financial security, but there are many dimensions to financial security beyond just being out of debt. For example, medical bills are a primary cause of bankruptcy, so does it make more sense to increase your medical insurance coverage before paying off your mortgage? That’s a tough question because each choice manages risk – but in a different way. Similarly, the Council for Disability Awareness claims you have roughly even odds of being disabled for 3 months or more at some point during your career, with 1 out of 7 workers being disabled for 5 years or more. Would disability insurance give you more financial security than prepaying your mortgage? Again, an interesting question to consider…
- Kids College Funds: Do you have kids? Then funding a 529 college account, prepaid college tuition, and/or Coverdell IRA are additional ways to maximize tax deferred savings that should probably take precedence over paying off your mortgage.
- Underwater Mortgage: If you are upside-down on your house (owe more than it's worth), then really think twice about throwing good money after bad. I’m not going to get into a big discussion about strategic defaults here, but suffice to say there may be more secure assets for you to invest in than a house that is underwater.
Should I Pay Off My Mortgage or Invest?
Once you’ve built your personal financial foundation (maximized tax deferred savings both for college and retirement, paid off high interest debt, and properly insured) then the question becomes, “should I pay off my mortgage or invest?”
Notice how this question only becomes relevant after the prior issues are handled.
The answer to the “pay off mortgage or invest” question is actually quite simple – whatever gives you the highest after tax return on your money is the right decision.
Financial advisers will quickly point to research showing long-term historical returns for a low cost index portfolio around 8% (+ or – depending on assumptions), match that against much lower mortgage rates (as of this writing), and proclaim immediate victory… but it’s not that simple.
Investment returns are highly variable with periodic “lost decades” where even pathetic mortgage interest rates represent a superior return over a traditional investment portfolio.
The problem is the future is not the past and returns vary, but mortgage interest saved is a bird in the hand. With that said, you would be hard pressed to find 20-30 year periods (the life of a typical mortgage) where an investment portfolio would not provide a higher return than recent mortgage interest rates.
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The problem with any investment return comparison is nobody has a crystal ball. Unless you have a direct connection to the Higher Power, then you're stuck right back where you started with a decision between a guaranteed (but low) return for prepaying your mortgage, versus an unknowable but potentially higher return for investing.
In other words, you're left deciding between the certainty of mortgage payoff versus the uncertainty of investing. While financial science provides a relatively clear answer (investing should provide the higher return over the long term), this is really an emotional decision about your risk tolerance, confidence in the future, and belief in the science of investing.
It's why so many prefer to get out of debt despite the relatively compelling math.
Final Thoughts – The Human Variable…
With all that said, there is still one very important element missing from this conversation…
Life doesn’t usually go as planned. We humans aren't computers who implement our brilliant plans with mathematical precision.
Life throws obstacles our way, plans change, stuff happens, and that's just the way life works.
It's foolish to make long-term plans in an intellectual vacuum that fails to account for the random nature of life.
With that in mind, below are some fun ideas worth adding to this discussion…
- Flip the Logic: If you choose to invest instead of paying off your mortgage then consider this question – would you be willing to refinance the equity out of your mortgage (thus increasing your debt) to add to your investment accounts? If not, then you are logically inconsistent. (By the way, I write this with a wry smile because it describes me perfectly – see below…)
- No Discipline: For every 10 people who claim to be making the minimum mortgage payment and investing the difference, I would hazard a conservative guess that more than half fail to follow through on the investment part of the equation. The road to financial mediocrity is paved with the best intentions. In other words, an optional savings program that requires self-discipline is frequently no savings program at all. Contrast this with someone who places a 15 year, biweekly mortgage on their home, thus creating enforced discipline. One happens with certainty regardless of life’s wrinkles… the other is optional.
- Expect the Unexpected: Nobody expects to lose their job, have a major medical problem, become disabled, or invest in a fraud; yet, over the course of a 30 year mortgage, the odds that you'll experience one or more of these admittedly rare and unfortunate events are far greater than you would like to believe. When your home is paid off, it's easier to weather these storms with a minimum of personal adversity. Plan for the unexpected because eventually it will happen.
I suppose the best way to conclude this lengthy analysis is by sharing what I’ve chosen to do with my own mortgage(s).
The truth is, I used to be in the pay-off mortgage early camp. I hate debt and have a high value on freedom. In the late 1990s, I paid off my mortgage only to watch my investment portfolio double the next year while all that capital was tied up in my house.
Ouch! That was expensive…
Admittedly, things could have worked out very differently. I could have paid off the mortgage in 2007 instead and seen a decline in investment values the following year.
However, in general, my investments outperform mortgage interest, so it makes sense for me to prioritize investment capital.
With that said, I also find that I’m not fully rational on this issue.
I would never refinance my home and invest the equity to pursue those higher returns. From a pure logic standpoint, that makes no sense: I’m not willing to liquidate investments to pay off the mortgage, and I’m not willing to increase the mortgage to fund investments.
Hmmm… I guess I’m not as rational as I would like to believe.
The truth is the decision to pay off your mortgage is quite complex.
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Fast forward to current times, and I’m several years into a 30 year mortgage on my current home that, prior to writing this article, I would have refused to pay off.
The interest rate is pathetically low, tax deductible, will likely end up below the inflation rate over the life of the loan, and it gives me some measure of inflation protection with a small short position against the dollar.
So I’ve been at both extremes – pay it off fast, and never pay it off – only to now end up somewhere in the middle of the road going forward.
I now firmly sit on both sides of the fence as follows…
- Because my retirement and kid’s college are fully funded, I don’t need to prioritize those accounts.
- I have no debt besides the mortgage, so no issue about paying more expensive debt first.
- I have all the insurance I need.
- The discussion literally comes down to paying off the mortgage or investing.
- The math is clear that my highest return is with investing, but I’m also emotionally connected to having no debt and love the freedom of minimizing my cash flow needs. For that reason, my decision is to funnel a portion of increased revenues from this business toward prepaying the mortgage, even though it's technically irrational from a return on investment perspective.
- In summary, I’m not willing to dedicate any of my investment capital to paying off my mortgage, but I’m also not willing to leverage my house to increase investment capital. This is irrational, but it's the honest truth on where I stand on mortgage vs. investing. Regarding new income production, I’m fine with dedicating a portion of the revenues from this business toward paying off the mortgage rather than perpetually building investment capital while retaining debt. I guess the logic is that I’m getting a diminishing emotional return on more investment capital when compared with less debt. For economics geeks, it means I have a higher marginal utility on debt reduction than capital increases.
I would like to declare this a balanced perspective in that I’m comfortable with my portfolio “as is”, so I’m willing to “diversify” and lower risk by paying off mortgage debt with extra income, but in the end, I know the truth… it's my emotional desire to be debt free and reduce risk that's driving the decision. I know the math and I should be investing – exclusively.
So there you have it – I’ve personally lived at both extremes of the decision and now stand firmly in the middle.
The decision doesn’t have to be either/or: you can pay a little to debt reduction and save for investing at the same time.
Like everything in life, happiness is often found in the balance. I guess paying off your mortgage early is no exception.
So now that you know my situation, where do you stand?
How has this analysis helped you sort through the decision and what conclusion did you reach? Which issues hold the greatest sway in your decision? Please share in the comments below…
The One Decision That Can Make Or Break Your Financial Future
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Todd, for me it’s a matter of satisfaction knowing the house is paid off. Even though I may have made more by investing, I feel better knowing the house is paid.
My investments could always turn sour. I’d feel better knowing that even if that happened, it happened while I owned my house.
@MichaelCrosby Yep. Completely valid, Michael. There is the personal side of the decision effected by risk profile and preferences, and there is the math side of the decision. Different people will value each differently. There is no right/wrong answer for everyone. It just depends on how you personally weight the factors.
Thanks for joining the conversation, Michael! I appreciate your feedback.
I think you also have to think about the safety issue. If you aggressively pay down the mortgage, you are storing all of that cash in your home, where it sits idley, and earns 0 return. In addition, it is not safe, as the value of the house may decline. Also, it is not safe because it is not liquid. There may be times when people need to tap the equity in their home, but they can not do so at the times when they most need it; illness or loss of job for example. For it is during those times when they would not qualify for a mortgage to take the equity out.
@dandraka There is no perfect solution. No matter where you turn risks exist. Even if you throw it in T-Bills you have the currency depreciation risk. There are so many arguments pro and con and so many perspectives to this discussion – all equally valid.
Cash in a home does not earn zero return. It earns you the return of whatever the principal and interest portion of your payment would be or the cost to rent that same home would be. You either pay mortgage/rent or own a home.
It also earns appreciation. Most of the time home values increase overtime.
So this article is exactly what I’ve been looking for as it reflects my delimma and at the same time my position. I have no debt other than a primary mortgage, maximize retirement saving options 401k, IRA, and an after tax annuity, college funds are taken care of, have free and clear rental properties, and have a balance of cash for life’s unexpected curveballs, and invest in securities in non retirement accounts. I have a mortgage that is roughly 50% of my home’s current value with a 7 year ARM at 2.75%. The direction I’ve taken similar to your middle ground in the article is to pay the mortgage off with 2 payments per month on a schedule that retires the mortgage at the end of the 7 year arm vs paying it off now or stretching it out further when the interest rate will reset and likely be higher. Thanks for publishing the article as it is the best I’ve seen on the subject.
You’re welcome. I’m glad it was helpful.
I am in the same situation with everything covered but the mortgage. I was paying down in two installments a month. I received a lump inheritance that would pay off the house (or should I invest) What retirement number are you and your readers calling funded. I know, there is so much on this topic it is almost another article. Is it 10x salary for example? I am 51, have around 1 million in retirement. I have 125k to pay off mortgage or throw at retirement. Thanks
Awesome post about an issue I’ve been struggling with for a while. i personally am in the pay down my mortgage camp, but I don’t have a great rate (7%) and can’t refinance in these tough banking times, so paying it down seems to make the most sense to me. I’ve even considered getting a 0% interest cash advance from my credit card (but there is a 3% transaction fee, and the rate spikes after a year) just because it would make financial sense, but decided it was too risky – in a way the credit card is my safety net.
Anyway, long comment, but I guess I’m in the same boat as you – I’d rather pay off my debt early even if my mortgage was at 4% because of the emotional return! Great phrasing BTW…
@ericbator Thanks Eric! Glad it helped. I appreciate you sharing your thoughts.
Good post. I agree most people do not understand the tax benefits as well as inflationary hedge in a mortgage. That said, I paid off an investment house and had it appraised in 2008. The appraisal was so good I took out every penny I could get and bought two more homes for cash. Now I have three renters paying down one note. But our residence has a huge note on it. I look it as this is as cheap as money is going to get. Most folks are not disciplined to save. I know it is tempting to spend $ in the account when there are fewer and fewer investments that make sense.
Best comment was Buffett’s. I would love to increase our real estate portfolio dramatically. But it takes creativity to get financing in a market like this.
Thanks for giving us good solid investment advice as well as personal challenges that we all face.
@pakyusuf Thanks Todd. Yes, I am also seriously considering the investment side of this equation at this time as well. The problem is the numbers in my local market still aren’t all that good and I’m loathe to buy non-local based on past experience. Very interesting times. We’ll see…
One of your best articles. Your description of your personal situation is exactly the thought process I went through. The only difference is that I am 66, have no debt, no college fund obligations etc. so its either pay it off or leave it invested. In my mind I am about breakeven on the comparasion. My logic is that the money that I would actually use to pay off the loan is sitting in my cash reserves and earns about 1-2%. The mortgage costs a net of about 3.5% so the loss is about 2.5 to 1.5% per year. Cheap cost to keep the money liquid and in my hands.
@hedy1234 Another interesting way to view the equations for a different life situation. Thanks for sharing your analysis and supporting our community.
the decision taken can be very psychological as well. if i am a good money manager i would rather invest and take a cheap interest mortgage. but as a good money manager i would watch when the interests cannot be offset by the investing returns. in that case choosing a loan without early payment penalty is important.
@kyith Thanks for bringing up the point about pre-payment penalty. I probably didn’t emphasize that point enough in the article.
Todd- great analysis. Personally, a “regret minimization strategy” has helped me. Behavioural economics teaches us the pain of regret associated with a loss is about double the pleasure associated with a gain. Being in the same boat as you (pay down debt vs invest) it’s helped me to ask the question, “Which decision, if wrong in hindsight, will cause me the least regret?”:
Wrong decision #1 (debt pay-down): house paid off but stock market doubled during that time.
Wrong decision #2 (invest): market tanks by 50%
For me anyway, #1 would produce less pain- I’d rather miss the boat than get run over by it.
Having said that I’ve hedged as well: 70 cents of every available dollar goes to debt pay-down; 30 cents goes to investment.
@CW2012 Interesting perspective. Thanks for adding that insight.
LOVE the comment on behavioural economics! Never looked it at that way but can definitely attest to it’s sentiment when considering my time spent at a casino. Money won provides moderate satisfaction, however money lost leads to some pretty rough days.
“I’d rather miss the boat than get run over by it”
Great article, thank you. And, thank you CW2012, “I’d rather miss the boat than get run over by it!” I didn’t know it until I read that, but yes that is the boat that I’m on or should I say that’s the boat I’m going to watch from inland. Pay down my mortgage principal first, yep that does help me sleep at night. I’m sure that tells you that I’m conservative with investments!
What about paying off a mortgage that is nearer its end than beginning? The return on investment grows as the mortgage ages. For instance, a 15 year mortgage on $200,000 with $1500 a month payment. If you pay it off after 5 years, the balance is $170,000. It would be like investing $170,000 and “earning” $1500 a month (about a 10.5% return). Fast forward to just 5 years left on the loan. The balance is $60,000 now. So to pay off now would be like investing $60,000 and “earning” $1500 a month. This would be a 30% return on investment!
@rbeck Only sorta true. You are not factoring in the equity already tied up in the property in your ROI equation. The real equation is a little more complicated. Hope that clarifies…
@Financialmentor Thanks for responding. Yes, I understand. I am just looking at it from the standpoint that at some point the borrower becomes liquid enough to pay off the loan. Up until that point, the borrower does not have the funds to pay it off so this is not an option. But at the point they can, the choice is invest $60,000 in the stock market and hope for an 8% return or invest in their home and get a 30% return for 5 years (or the length of time left on the note). The ROI of monies already invested in the house stay the same no matter which choice is made.
@rbeck Possibly… another choice is to refinance the house, pull out the equity, and invest the difference. There are many dimensions to the analysis.
@rbeck ROI is defined as “(return – investment)/investment.” So paying it off in year 10 gives a return of (90k – 81k)/81k = 11%. And that’s ignoring the time value of money.
@stannius The definition of ROI you are using is also called “return on invested capital”, and is typically used, as I understand it, to compute ROI for internal business investments in capital assets which are wasting assets, or ones that lose most of their value over the course of the investment period. I am curious about how you would calculate the ROI on a 5 year bond with an $81,000 face value, purchased at par, which pays $18.000 a year in coupon payments?
@rbeck It’s not an investment returning $1500 per month because part of that $1500 is a “return” of the “principal” invested (the $60,000). Instead, it is more like an immediate annuity paying $1500 per month for 5 years (60 payments). That’s only equivalent to a 1.44% interest rate (if my caclulations are right)
@stannius @rbeck But you have the principal in the house, provided of course that the value doesn’t go down (any more).
@stannius Thanks for your input. Two points:
1. I don’t see how any of the $1500 a month can be considered a return of principle. The $60k goes entirely to pay off the balance owed on the house, which is all part of the initial purchase price. Therefore, it is all equity (as professorcindy points out). If I sell the house the next day after paying it off, (let’s say for this illustration’s purpose, for the price I paid for the house), then I get the entire $60k back. If I sell it 5 years later, after collecting the 60 “payments”, I get the entire $60k back. In effect, I have invested 60k for 5 years at 30% and then received my 60k back. The risk of course is that the value of the house will not go down.
2. Because of this (me retaining the equity), you can’t compare this to an annuity, for which the buyer gives up their “equity” with the initial payment. Yes, its a 1.44% return (I don’t have my calculator handy so I can’t check your numbers) if the buyer gives up the 60k in exchange for 60 payments of $1500 for 5 years, and then after 5 years has nothing.
@rbeck I probably muddied the waters with my analogy.
What I am trying to say is: You can’t count the entire $1500 as the ROI. Some of that $1500 would have gone towards the principal, and some towards interest. Only the part that goes towards interest is saved.
It would help if we could talk about some more concrete numbers. What is the interest rate on your example loan?
I can work backwards from a 15 year loan of $200,000 with payments of $1500 per month, which gives me an interest rate of 4.21%. However, the balance of such a loan is not $170,000 at period 60 (5 years in) nor is it $60,000 at period 120 (10 years in, 5 years for the end).
@stannius I don’t think you can reduce ROI to just what is saved, its what is earned also in the form of cash flow (among other things). The entire $1500 is a return on investment because the loan principal is now paid off. The part that “would have gone toward the principal” is now free to go somewhere else. That’s the whole point. My argument is simple: At some point near the end of a mortgage loan period, the owner may have enough cash to pay off the loan. They then can compare investment options. They can let it sit in the bank earning almost zero, they can invest it in the stock market and hope for a historical return of 6-8% (although 5 years in my example is a very short period to expect a historical return), they can blow it on a new Corvette or a 6 month vacation around the world, in which case their return would be negative, or they can invest it in their house and effectively earn 30% for the next 5 years.
In regards to your second post, I think more concrete numbers would actually muddy the waters. Its easier for readers if numbers are whole and round, like $60,000, instead of $64,793, for instance. No, my figures don’t correspond to an exact loan, but they are close enough to get the point across.
@rbeck In a way I agree. If I can’t convince you that the whole $1500 is not a return on investment, numbers aren’t going to help. For instance, how can I convince you that the balance being $81,041.19 at the 10 year mark is relevant? When you’re busy comparing it to a sports car or vacation?
@rbeck Your argument may be “simple” but unfortunately it’s simply wrong.
@stannius Convince me with facts, not mere assertions.
@stanniusYour numbers for this annuity are correct if you were trying to arrive at the monthly interest rate. Annually, its about 17.3%
@rbeck Ah, that makes more sense. I was wondering why it was so low. *Wipes egg from face*
So what we’ve proven here is that convincing your mortgage company to accept $60k when the loan balance is $81k has a great ROI.
The annuity equivalent of paying $81k at period 120 on a 4.205% mortgage is… 4.205%.
@stannius So now the ROI IS a function of the principal paid off? I’m not sure why you are so stuck on my 60k example vs your 81k. I will use 81k and your example if it makes you feel better. Paying off a mortgage balance of 81k, the $1500 saved per month equates to a 22% return. If the homeowner were to wait another 2 years to pay it off, then the balance would be closer to 60k, and they would earn the 30% for the remaining 3 years. Sorry if the two extra years at 30% was a misrepresentation.
@rbeck What do you calculate as the ROI of paying your mortgage off with one year remaining? How about with one payment remaining?
@stannius Good question. I figured we would get to that eventually. If say 15k is owed the last year, then the homeowner is trading 15k of cash for $1500 a month for 12 months. That’s 10% a month. Its obscene because of the way mortgages are structured (to give a level monthly payment for the term). With one payment remaining the owner invests $1500 1 month early into the home, and 1 month later saves $1500 by not paying the last payment, so its a 100% return for 1 month. Again, this all assumes the money invested in the home can be recovered in a sale, which is the equivalent of getting principle returned, like with a bond that matures.
@rbeck Wow, annualized that’s 1200%! And imagine if you paid your final mortgage payment 1 day early? Then you earn 100% in one day – a.k.a. 36,500% annualized!
On the other hand, perhaps there’s some flaw in your logic…
@stannius Ok, I’m all ears. I can’t wait for you to explain how 100 times 12 is not 1200. The flaw in your logic is that its impossible to repeat the process 365 days. A person can only pay off their mortgage once.
Todd, definitely an important subject for many of your readers. For my personal situation, I am finding double digit returns on local real estate deals, so the decision to invest versus pay down my mortgage is easy. Your discuss of Real Estate being a hedge against inflation is very insightful and not commonly known. I believe that the Feds will raise rates and create inflation as a way to cut the deficit as soon as they are able (they can’t now as it would increase everyone’s ARM and cripple housing). With this eventuality, who wouldn’t want leveraged RE with inflation north of my current 3.75% mortgage rate?
@David R Sounds like Warren Buffett! You are in good company.
Very nice article that exactly describes my own “irrational” take on this. We are already retired with a fairly small amount left on the mortgage and an additional rental property that has a somewhat higher mortgage (and rate). Somehow I feel that paying off our own mortgage first is preferable because it increases cash flow sooner, and the other property is basically an investment/inflation hedge. We are lucky to have good tenants though; that’s the downside of being a landlord, you can’t be sure you’ll get good tenants.
@professorcindy Thanks Cindy!
very good summary. I’d make more explicit (it’s there) the fact that the avoided payments due to any equity in the home are post tax and should be inflated by one’s marginal tax rate to compare, in addition to adjusting for inflation and time value, for those who are analytically inclined. One should also use observed investor returns, not advertised; investors rather significantly and systematically lag the indexes in reality due to many factors. Also implied but not fully described is the fact that the steadiness of the imputed cash flows have a huge (and very difficult to compare vs return from investments w/ unpredictable time series) positive on portfolio return. Since we can’t realistically describe the market distribution of risky returns this can’t be handled explicitly, by one can approach it conceptually by looking at the benefit of other stable returns on portfolio strategies (e.g. adding bonds to a stock portfolio, using actual realized returns). Lots of pubs on that, it’s clear there’s a port bene from the regularity that is dependent on the actual time series that one experiences on the “riskier” investments, and it’s not trivial. Also, I find it most helpful to think of one’s home as a rental with an exceptionally reliable renter (no vacancy, no nonpayment, no litigation), and then it’s merely a matter of choosing the finance strategy for that rental property. As a “renter” it’s still simply an expense to you to minimize. As a landlord, you want to finance it appropriately for your overall situation and strategy (all the issues cited in the column). Great writeup, probably the best I’ve seen so far.
very good summary. I’d make more explicit (it’s there) the fact that the avoided payments due to any equity in the home are post tax, in addition to adjusting for inflation and time value, for those who are analytically inclined. One should also use observed investor returns, not advertised; investors rather significantly and systematically lag the indexes in reality due to many factors (ranging from fees to timing to weighting to behavioral finance related errors and more). Also implied but not fully described is the fact that the steadiness of the imputed cash flows have a huge (and very difficult to compare vs return from investments w/ unpredictable time series) positive on portfolio return. Since we can’t realistically describe the market sequence of returns this can’t be handled explicitly, by one can approach it conceptually by looking at the benefit of other stable returns on portfolio strategies (e.g. adding bonds to a stock portfolio, using actual realized returns). Lots of pubs on that, it’s clear there’s a port bene from the regularity that is dependent on the actual time series that one experiences on the “riskier” investments, but it’s not trivial. The benefit of a mortgage in an long term currency devaluation, which Reinhardt and Rogoff indicate nearly always happens, is a huge plus that is not well understood by many and is confused with appreciation. Lots of research also indicates this downturn is likely to be quite extended and one should factor that in to one’s personal strategy as well. I find it conceptually helpful to think of one’s home as a rental with an exceptionally reliable renter (no vacancy, no nonpayment, no litigation), and then it’s merely a matter of choosing the finance strategy for that rental property. As a “renter” it’s still simply an expense to you to minimize. As a landlord, you want to finance it appropriately for your overall situation and strategy (all the issues cited in the column). Those w/ day jobs or other regular cashflows may sensibly lean towards carrying favorably termed debt somewhat more than those whose life stage includes reduced or unreliable or non-cash income. Great writeup, probably the best I’ve seen so far.
@Ben Boyle Thanks Ben. You make several excellent points. As a writer, I’m always in a battle between completeness and making something unreadable due to excessive detail. I try to strike the balance and appreciate you bringing up these points. Volatility of returns and actual investor returns vs. theoretical are both excellent points that open the door to entire articles in themselves. Thanks for adding your insights!
Todd, that was the clearest, most unbiased, honest assesment on the subject I have ever read. Obviously, you have been there and done it, as it comes out in your writing. I am sorta-kinda in a related field, have paid off my mortgage and have no debt, so I can sooo relate to the question… I’ve been talking to myself for over a year now and am solidly on both sides of the fence, as well.
Keep up the good work… looking forward to following along in the shadows.
@Shavis Thanks Joe! Much appreciated!
Great article, but I don’t think your position of not paying extra but not extracting equity is at all irrational.
Extracting equity typically involves significant transaction costs, in terms of both time and money. So it can be perfectly rational to not pay extra on an existing mortgage, but not take out a new or second mortgage just to free up equity for another investment. In the case of equity harvesting, the return on the invested funds must compensate not only for the mortgage interest down the line but the transaction costs involved in obtaining the mortgage in the first place. Those costs are in current, “expensive” dollars. This is typically 2-3% of the amount financed, but if you still have a significant balance on the original mortgage (otherwise – you’d have nothing to pay extra on for very long) the amount you will free up to invest is only a portion of the amount financed. Say it’s only 50% of the amount financed – now you have to earn an extra 4-6% on the amount invested just to cover the transaction costs.
I’m in exactly the position you are in, with the exception that my local real estate market has attractive investments. I’m not paying extra on my personal residence mortgage, I’m not doing cash out refinancing either. But I am financing the purchase of cash flow rental properties, thus increasing my short position in dollars. I consider my decisions in this matter to be fully rational.
@Jason_Tucson Thanks Jason. I see the logic in your point. I wasn’t factoring in the transaction costs so much as making a point about how the reflexive logic worked and poking fun at myself in the process. With that said, where I’m actually being “rational”(IMHO) is when it comes to realizing what has a higher marginal value to me – regardless of the pure math.
Thanks for pointing these ideas out and adding to the conversation!
This was such a timely article for us since we had just refinanced our home, our last child graduated from college, freeing up a our monthly budget with more discretionary funds, and I was wondering what to do.
I also was sitting on the fence, but after your very good arguments pro and con, I’ll go the con route and go “all in” with investing. Once I commit to investing (even taking out more HELOCs if needed), those funds are working for us, and we have the option to cash in the investments if need be. However, if we use our discretionary funds to pay down the mortgage, the only option we have to cash out is to refinance again or take out HELOCs.
Mahalo for your wisdom!
@HonoluluAunty Mahalo to you as well, dear Aunty. Glad it was helpful!
Thanks for this excellent writeup. So many people can’t get past the “debt is bad” mindset. And most of the rest have a tendency to ignore the time value of money.
Regarding this topic, this is by far, the most informative article I have read. Thank you!
Everyone’s situation is unique, and I’d like your thoughts on mine. I’ll try to be brief.
In 2009, I was on the verge of collapse – over $65,000 in revolving debt, mortgage at 250% LTV, and a job which only helped me get by. Luckily, I was promoted at the end of 2009 to a job paying nearly double. I have since paid off all of my revolving debt, established a 6 month cash emergency fund, have maxed out my 401K in 2010, 2011, and 2012 (yes, I’m already maxed out for this year), and have established an investment account with equities and mutual funds totaling approximately $60,000. I have no children, and I’ve worked at the same company for 14 years.
I put together a plan last month for paying off my mortgage. I have slowly reduced the principal over the past few years, but I haven’t gone “all in.” I wanted to take care of the above mentioned items first prior to taking on the task of the mortgage payoff.
Under my most aggressive plan, which requires tremendous personal austerity along with very little additional investing with the exception of my 401K, I can have my $144,000 mortgage paid off by November 30, 2013. My house is currently worth approximately half that.
Since my time horizon for payoff is more short-term than your examples, and by paying it off, I not only achieve the emotional financial security, but I also put myself in a position where I can actually move, do you think this idea is wise? I have battled back and forth for over a year, but I made a commitment last month to do this. I have the means to do so, and once completed, I can easily get an additional $800-$1000 rental income on this property when I move to a new house. I’m 32 years old, so the long term benefits of the projected rental income and increase in property value outweigh the short term benefits of doing a short sale – at least in my analysis.
I look forward to your comments, and your article was fantastic! Thank you again.
@spruce815 You’re heading into the area of personalized financial advice which I can’t give on these pages. I also chose to sidestep the issues involved in strategic defaults (as stated in the article) because the issues are unique to each situation and do lend themselves to an article designed to serve every person’s needs. In short, the answers to your questions can’t be correctly addressed in a comment. It is the wrong venue and would require personalized financial advice. Hope that helps.
One of the best written articles on debt vs. investment I’ve ever read. It’s interesting to note your thoughts that economic decisions are not just mathematical ones … they’re emotional too. Since my crystal ball is a bit fuzzy and I can’t see into the future (how about yours?) our financial decisions are almost entirely made by “gut feelings” and not imperial evidence. We simply won’t know the outcome of our decisions until our decisions are a thing of the past. The key then, is how we adjust (and make subsequent decisions) when we learn the outcome of our decisions.
Hi Dave. Thanks for sharing your thoughts. The solution is mathematical expectation. You take an actuarial approach to your decision process no different than an insurance company or a casino. When you operate with a statistical advantage your profits become simply a matter of sample size.
Hope that helps.
I agree in the case where actuarial data is relevant. In our current economic environment, we’ve got chaos in the European markets (Greece on the edge of default & bailing from the EU), unprecedented ramp-up of national debt in the US, a real estate market where 25% of the sales are short sales or banked owned (with still many homeowner’s underwater), inflation is hiding in the corner just waiting for the opportunity to come out, more talk of another middle-east war/engagement (what ever you want to call it) and an unemployment rate that is at or near 16% (depending on who you believe) and is at best unstable – all pushing our economy in the direction of another recession. With so many significant stresses and unknown outcomes to near future events, isn’t it difficult to conclude that a traditional actuarial model would be appropriate to use?
Yikes! Keep the razor blades away when reading thatJ. To answer your
question, it depends what you mean by “traditional actuarial approach”. I would definitely stay away from correlation dependent approaches but there
are other methods beyond the scope of Facebook updates which remain valid.
Agreed … no razor blades! I guess my point is that most individual investors aren’t financial analysts or statisticians … rather they make financial decisions based on how they feel about pending events … or based on the opinion of how others feel about pending events … the question they ask themselves is “do I take opportunity or do I protect? Even when presented with a complete statistical analysis … most decisions are made based on how the recipient “feels” about the analysis – hence my position that many if not most financial decisions are emotion based. The the ability to review the outcome (benchmarking) and adjust based on the expected outcome is critical. Fun stuff! Thanks for sharing your thoughts too … good stuff.
You’re welcome. I appreciate your interest and enjoyed connecting with you.
My take (on my own finances) is this:
1. I pay only the interest (unless the payments hurts my cashflow. In such a case I amortize to bring down the cash outflow to a comfortable level).
2. I use the cash left over to invest.
As far as I see it, if you pay the interest on your debt and those payments you do make does not hurt your finances (i e you still have disposable income afterwards) then don´t amortize at all. Let it be. As long as you keep the ship floating along.
At the same time, I do also like being debt free so I do have the same feelings you wrestle with:). I guess we all have (i e all people with debts to pay).
Brilliant analysis, my situation is 55 have a 37 year mortgage after having been refinanced or would have been foreclosed on. Knowing that we have lost the 95% of the purchasing power of our dollar I have decided to start buying gold silver instead of trying to pay off the mortgage and if by chance I can pay it off with diminished dollars then so be it. As I know I will never last to pay off a 37 year mortgage even biweekly or extra payments at age 55 would be ludicrous.
Comments on my situation are more than welcome; just don’t ask how I got into this mess, please.
Brilliant analysis, my situation is I’m 55 have a 37 year mortgage after having been refinanced or would have been foreclosed on. I have both the first and second mortgage. My biggest fear is the bank will come after me on my second mortgage if I default. I have to admit that was very dumb in this investment and it happened a year before the peak in the markets.
Knowing that we have lost the 95% of the purchasing power of our dollar I have decided to start buying gold silver instead of trying to pay off the mortgage and if by chance I can pay it off with diminished dollars then so be it. As I know I will never last to pay off a 37 year mortgage even biweekly or extra payments at age 55 would be ludicrous.
Comments on my situation are more than welcome; just don’t ask how I got into this mess, please.
I’d love to offer my opinion, but I need some additional information first:
1. Are you upside-down? If not, what is your LTV (loan-to-value) ratio? In other words, divide your mortgage balance by the current appraised value.
2. Do you like the house, and would you like to live there? This question leads to many others, but it is a starting point in determining what you should do.
3. How did you get a 37 year mortgage? This must be an old mortgage. Have you checked to see if you can refinance? Regardless of LTV, there are government programs that can help without going into default. The Home Affordable Refinance Program (HARP) has no LTV limits.
Hope this helps,
Yes I’m upside down, got a mortgage with nothing down. Mortgage balance is 240,000 first mortgage. 2nd is now 75,000. Value is 200,000 to 250,000 depending on the source.
Like the house, but plan to retire in 7 years. I’m 55.
Got the 37 year mortgage after a lawyer helped me from a foreclosure. I was told that the Bank can come after you on the second loan even 10 years later garnishing your pension or social security. So I went from a 30 to 37 year mortgage there was no discount or or removal of debt. Wells Fargo would not negotiate any loss on their end. I only kept it because I have three other people to worry about. I bought the house in May of 2007.
Tried other programs, I was told that I’m too deep in debt in other areas to help. The reason I extended my debt was fear of the currency collapsing knowing now that the whole system is a financial Ponzi scheme, I figured I had to protect myself with precious metals.
I call it the three-legged stool, if one leg is your pension and one leg is Social Security and one leg is your 401(k) they will all be paid in cash and if the purchasing power is going to disintegrate then I have to have the hedge. I’m too far underwater not to protect myself in some way.
I suggest those who haven’t seen the movie watch “The end of the road”. My guess is we have between the end of the year and five years before the collapse of the dollar for those who don’t understand read about the petrodollar; if you read other things you will see the countries around the world are now removing themselves from our reserve currency.
I have studied economics every day since 2008. I can no longer afford to make any mistakes at my age.
Thanks for any help or advice, Jon
Hi Todd, great article here. I was actually looking for a comprehensive article on this point. I have a few points to raise that I hope you can answer
1)You mentioned that having a mortgage is a way of hedging against the home currency in case the resident government undergoes policies which are inflationary. I wondered whether this was correct? If the government underwent inflationary policy, surely that would mean that all asset classes including property would increase commensurately, so the decrease in “purchasing power” which you mentioned with regards to an investment portfolio would only be with regards to the “cash” and “cash equivalents” aspect of the portfolio. You seem to confirm this later on when you said your investment portfolio doubled but you had all the capital tied up in your house which you paid off. It appears that the real issue here is the opportunity/cost i.e. paying off your mortgage at the expense of investing in your portfolio
2) Following on from the previous point. Wouldn’t that also put more money in your pocket as the value of your house has increased and you have no debt (granted that gain would only be realised after selling the property).
3) As you said, there is the risk of inflationary policy, but there also is the risk of deflationary pressures, with the economic uncertainty would it not be better to pay off your mortgage to reduce your risk to uncertain economic policy and market forces?
Would love for you to give your take on my questions
Thank you very much, I look forward to your reply.
@DeboJAdebayo Hi Junior, let me clarify…
1: The inflationary advantage of a home mortgage comes NOT from the asset purchased, but the short position in the home currency by borrowing in today’s valuable dollars and repaying in future cheaper dollars. In other words, there are two sides to the equation – the asset and the debt. The asset rises in value to offset inflation, and the debt declines in value as inflation grows. It is the combination that is powerful.
2: True, but it is only half the equation. See #1 above.
3: True, and it depends on your objective. What you are addressing is risk management. You are definitely lower risk without leverage which would be better in deflation. However, you’ve actually increased your risk of purchasing power loss during inflation by not using leverage (debt). The problem is real estate historically lags inflation on the upside (due to rising interest rates holding back values). Leverage offsets this lag because (using a 50% mortgage in this example to keep it simple) you get 2 units of inflationary increase for 1 unit of purchasing power loss on invested capital.
Hope that helps!
@Financialmentor Hi Todd,
Thanks very much for your reply. In response to your answers I would say this
1) This appears to be a further advantage of holding property that isn’t your own, you are able to amortize the debt over a period of say 30 years with rent. Inflationary pressures would mean that rent prices would increase, the debt would decrease and the value of the property would also increase and in deflationary pressures you can maintain the mortgage repayments with the rent until property prices increase again. Is this sound logic?
2) Further in response to your answer on “risk management,” would the right answer be not to necessarily be adamanat to hold no debt at all but to be mindful of your debt in relation to your equity?
Thanks again for the reply
This is extremely helpful! Thank you for this informative and not overly technical explanation!
We have a mortgage with a 6.25 interest rate and 30k left to pay. PLUS four boys needing college funding (one very soon) and PLUS an opportunity to invest in our 401K with an employer who is matching up to 17K JUST THIS YEAR. (he evaluates yearly on how is the business doing)
We have 30k that needs to go somewhere other than a savings account.
We also are thinking of moving to another neighborhood.
No other debts at all.
It seems wise to take advantage of the 401k matching up to it’s max and put the rest into the mortgage, but we really do want to get rid of that mortgage payment. However, we really wanted to get rid of that mortgage! I wonder if we could pay off the mortgage and get a rock bottom rate home equity loan? We have never even looked into such things and dont’ know the rules.
OR, move to another home with a lower interest rate mortgage.
Still a little confused, but much less than I was before.
I was a little late reading this, but it is an excellent article. I like that you highlighted the cognitive dissonance involved in this question with regards to your aversion to borrowing more to invest. It’s important to acknowledge that we, as human beings, can be irrational.
I am debt free (aside from my mortgage), my kids college accounts are funded, I have maxed out my 401K for many years, and I have recently increased my cash reserves from sale of another property. I have a little less than 30 years left on my 4.15% mortgage, and could use about 25% of my current retirement savings (taken from my cash reserves) to pay it off all at once. I am 40, so have no intention of carrying the mortgage to full term, so I’m inclined to just get it over with now.
Put another way, if I was offered a 30 year bond with a 4.15% rate of return, I’d be happy to put 25% of my investment portfolio in this, assuming the rest of the portfolio is equity based. The US 30 year is currently offering about 2.9%, so the mortgage payoff equivalent seems like a good deal. Is my logic flawed?
Yes, there are taxes to be considered, but I figure the taxes on this hypothetical bond, and the mortgage deduction (I don’t get the full deduction) are roughly even, so I think it’s an apples-to-apples comparison.
So, whaddya think?
@davethecanuck1 The best choice will only be known in the fullness of time. The scientific answer is “whatever gives you the highest after tax return”. The emotional answer is “whatever provides you the greatest emotional satisfaction”. In the end, it is a bet on an unknowable future. If inflation rises you will prefer to have a short position (mortgage) in your currency. That, of course, is the opposite of a bond in your analysis. If deflation continues than you will be glad to be debt free. There are also risk management considerations to take into account (lowering your monthly cash flow needs). As I said, it is a complex equation. Simple answers don’t honor the reality of the situation which is multi-dimensional. In the end, it is as much a personal situation as a financial. Hope that helps.
@Financialmentor Your argument about using a short position on the currency as a hedge is compelling. I’m guessing that inflation will rise over the coming decades, which favors the short bet (mortgage). But the risk management aspect may end up winning out in my case.
Having a lower monthly cash outflow could be crucial in a ‘black swan’ life event. Perhaps instead of thinking of “highest after tax returns” I should be analyzing this like I would an insurance policy. I.e. Clipping my maximum gains in exchange for reducing my maximum risks.
I’ll let you know in 2042 how it’s all worked out for me.
@davethecanuck1 I really like what you said here. I think that is the core of my confused analysis at the end of the article. I have diminishing returns on increasing assets and increasing returns on diminished risks due to the incredible risks built into our economy. In my situation it isn’t really about maximum return on capital as much as minimizing risk of getting knocked backward should a black swan even rear its ugly head. Paying off a mortgage makes zero sense in my situation from an ROI perspective, but is quite appealing from a risk reduction/cash flow perspective.
@davethecanuck1 The thing that always makes this discussion complex is what risk you are reducing: risk of inflation wiping out purchasing power (keep the mortgage) or risk of black swan making reduced cash flow needs desirable (pay mortgage off). Again, this decision is so much more complex than most people understand. Fun stuff!
@Financialmentor Inflationary (buying power) risk is certainly a major long term consideration, but in my case “market crash risk” (a type of black swan) is a bigger immediate risk. I work in the financial/trading industry (tech side) so a market crash could wipe out (temporarily at least) a good chunk of my savings, and also could cost me my job. Basically I have correlated risks between savings and cash flow. In a bad crash, I could be left with no income, and insufficient savings to pay off the house, though I could hopefully have enough left over to make mortgage payments with what savings I am left with.
Paying off the mortgage could be thought of as an investment in an asset who’s value is somewhat uncorrelated to the market crash risk.
Fun stuff indeed.
@davethecanuck1 I think you figured it out. Sounds well reasoned.
…and the longer you wait to pay off the mortgage, the higher the effective “bond” coupon rate rises, because you are paying less “face value” to get the same “return” every month (your mortgage payment amount). So it gets more compelling as time passes.
I found this article to be fairly complete in the analysis of the different options and reasons for and against paying off a mortgage sooner. I do have an additional thought to the information found at the end of your article.
Just as a thought and a possible topic for future articles that write, what are the benefits and drawbacks to tax deferred investments. If we look at tax rates, they are at a fairly low point in history, and most would agree that taxes are going up. So why would we not pay taxes now on an investment only to pay taxes later if we believe if they are going up.
Also in regards to 529 savings plan, what would possible downsides be. In my opinion they are good for a portion of college savings, but they do not have flexibility. If you have a student that does not go to college then there are large penalties to remove the money. Or if you have a student that gets a full-ride then the penalties still apply. What alternatives are available to help pay for college while still giving flexibility and access to cash.
Thank you for your well written articles.
@RaymondWickham Thanks for the good questions. The simple answer on your last question is Coverdell IRA’s although the downside there is they are limited to how much you can sock away. Hope that helps.
Wow that’s a great post. I’m new to your blog. Found out about you through Jesse Mecham’s YNAB podcast. Great episode by the way!
I’ve been thinking a lot about this issue of paying down my mortgage sooner, but now I’m going back to the drawing board with all that was said here. In fact I may go back and read it again!
@NateFancher Thanks Nate! Glad you found us, and welcome!
@Financialmentor Yeah man! Your site needs to be seen by more people. I’m dedicated to spreading the word from my end!
@NateFancher Thank you. I really appreciate your support!
Great post Todd. I’m wrestling with this decision right now, so I certainly appreciate the info. I’m a new subscriber, and am rapidly consuming all of the information on your site- nothing has disappointed so far- please keep the great/valuable info coming. I also purchased a paperback copy of your “How Much Money Do I Need To Retire” book. It arrives next week, and I’m really looking forward to reading it. Take care.
@Finishedat50 Glad you are getting great value from the site. I hope you enjoy the book. Make sure to leave a review on Amazon so I can see your feedback. I read every review. Thanks for all your support.
Good information Todd. I have a question, I have 11 more years on a house I live in ($160,000 balance on roughly $575,000 worth of house). (I owe $30,000 on an investment property worth roughly $160,000). I also invest in my 401k ($130,000 currently). My job is not guaranteed, especially in this current economy. I have no other debt except for a car payment. If you were me what would you do? This good post has my head spinning! Any hypothetical advice would be appreciated. Thanks
This explains perfectly the tug between emotional and rational decision making. I refinanced my mortgage at 3% a year ago rather than pay it off. I wanted that money in the market. I recently bought a second home and decided to pay cash, but have to admit a big part of me wants to have a mortgage and put that money back into the market. Part of the reason is the added costs involved with getting a mortgage, such as title insurance for the lender, and because I am on a lake, having to get expensive flood insurance. But I still wrestle with the choice. As you say, it is personal.
Wow, thanks … it appears that my strategy in retirement is just about right!
TYJACK Glad to hear it.
Awesome guide! I love that you aren’t hardcore on either side. You understand there’s clear economic logic as well as emotional comfort that can make the issue a bit cloudy. But you make great points for holding off on extra payments if you have the discipline to use the money in better ways.
GlenCraig Thanks for your support, Glen! Yeah, this was a fun one to write. I really appreciate you stopping by and sharing your feedback. .
Really informative and well written article. Thank you! Let me add one additional method for paying off the mortgage early. Simply match the principal each month and you will convert a 30 year mortgage into a 15 year mortgage. This method has a couple of advantages.
1. Flexibility. If times are tough then just don’t add extra principal that month.
2. It’s cheaper up front. Over time as the principal portion of the payment increases so will the amount extra that you pay each month, but inflation reduces the value of those dollars and hopefully your income will also have increased making it easier to afford the higher payments.
Thanks for posting an informative analysis AND including the realities of our predictably irrational selves. It is so important to weigh the financial pros and cons along with what our comfort level and behaviour is as human beings. We are not computers. Emotions play an important role in our short term and long term view and decision making.
Though I understand the benefits of leveraging the potential for a low-interest mortgage for investment purposes, being mortgage-free is by far my preference (despite paying property taxes in perpetuity).
Another angle to consider as well is the size of the mortgage itself. I find people are buying homes that are too large for their real needs. The delta between a $400K home and a $200 or 300K home would mean and extra $100-$200K in money available to invest. Reevaluating housing needs from this perspective can be more powerful than any other consideration.
Great guide. Some of the points are US-specific, but you covered pretty much everything I was considering.
And even after all that, I’m still on the fence, but leaning toward pay-it-off.
The situation I’ll be facing: my wife will die. I will get a life insurance payout. Bank/invest it, or pay off [most of] the mortgage? The majority of me says pay it off, get rid of that giant bill, then invest/save/smartly spend income as it comes in. Part of me says to keep the money as money or at least invested money.
Thanks for the insight you’ve provided.
Whoa… now you’ve got me a bit conflicted. We would have been mortgage free this year, but added on to our mortgage for HELOC and other debts, extending it 4 more years from now and that is paying it at a quite aggressive rate. My husband is 61 and so I would like him to be able to retire in 4 years. I don’t feel he can retire while we still have a mortgage. On the other hand we have some room in our retirement accounts that it would be nice to max out. Maybe I need to rethink this and put some to both.
Excellent article, and I am with you on both sides of the fence. I would like to see if you or others can answer a couple of scenario based questions:
Currently, I (40 Years Old) have 2 investment houses, which is my way of investing in my kids education as I all pay for the living, along with a small 529 investment and Gi Bill, and the kids can take care of the rest. I max out 401k and IRA’s and invest another $1k a month or so. recently purchased a new home (272K, 3.5% 10%down, no PMI (VALoan)), which I am not sure I will be in forever. No other debt
If we really want to hunker down, my wife and I can pay off the house in about 7 years, while still maxing 401k; IRA may take a bit of a hit though.
Would you do it? The way I see it, I am not going to make all that much investing in 7 years, and with the market as shaky as it is, If the Fed stop printing $ and the market takes a huge hit, if not deflates…. I would imagine the economy would be more stabilized at that point (cross fingers) I can then invest a significant amount more each month, in just 7 years, while having a house free and clear.
But if the market is stable over the next 7 years….
I’ve a simple way to answer this article.
If your mortgage loan is less than $12,000 in interest and you have extra cash sitting in bank.
Go and pay more towards your mortgage principle.
Why I said $12,000 ? It’s not a magic number. This $12k is coming from fed/state tax break.
Married household automatically gets $12k tax break. So, if your mortgage interest is only $8000 a year, you are still getting $12,000 tax break. If your mortgage interest is more than $12k, lets say $14k in interest, your tax break is $14k. Get it ?
So why pay $8000 in interest to bank, when you are still getting $12k tax break?
So Todd if I have a 200k LOC HOME EQUITY ACCOUNT and I am ready to retire and start drawing on my IRA which is earning 15% right now I could use the LOC to live on for a while until SS kicks in at 66 (I’m 63). That way my LOC (prime + 1/2) is cheaper than using my retirement funds they can continue to grow and when I am supplemented with SS the draw on the IRA will be less. GOOD POINT! BTW my mortgage is paid off.
Just heard you speak about this post on The Wired Advisor Podcast. Very comprehensive post. Similar issues apply in Australia, although the tax considerations are different. The income tax breaks offered by saving into a retirement fund often outweigh the interest savings in paying down the mortgage, but people are usually more comfortable focusing on getting rid of debt.
Great article! I’m 41 years old and my wife is 40. We have not saved a tremendous amount of money, however, we have managed to pay off all of our debt except for our two auto loans (34k). We have a 15 year mortgage @ 2.875%, that is on a bi-weekly payment schedule and we pay an additional principal payment ever month of $143. We started paying on the mortgage in January of 2013. The original loan amount was $225,000 and we currently owe $188,000.
The plan is to pay off both vehicles in 15 months and then I was considering paying off the mortgage early by applying $1,500 extra on the principle every month. We currently have $110k in a 401k. Once the company match kicks in again, I will put in 6 percent to get the full match. We should also be able to fully fund both IRA.
Does it make sense to work at paying off the mortgage in 6 years or increasing investments? My wife and I have a combined income of $149,000 gross. Thanks for your help!
Btw, the house is valued at $325,000, so no PMI.
Well written, and many thoughtful ideas beyond common knowledge.
One more idea about reducing interest payed in a mortgage, which took a while to accept, is the idea of 10 year arm vs 30 year fixed. I went with the 10ARM1 loan because if significantly reduced interest, with the same line of thinking as to invest the difference in higher yielding, mind you more risky, investment. I was pleasantly surprised to read your thoughts, and it reinforced my thinking. On last point about the 10ARM1, is that how many people actually live in their homes for thirty years now a days!
Hi Junior! I am able to help you with your question.
Imagine you have $100000 available to fully fund a home without any mortgage. Imagine also that you would either buy it fully (1) or rent (2).
Now if Fed has an inflationary policy you will be better of in terms of inflation by opting for (1) because while prices of homes tend to rise on inflationary periods (the are real assets), money invested for example in bonds tend to lose.
Now, if you think about it, when you purchase a home with a mortage you make immediately two operations:
1. You get a loan (borrow) of $100000.
2. You invest the $100000 in a real asset.
Now, the operation 2. avoids the loss of money with an inflationary policy. By another words, im real terms you are equally well after 20 years even if there was a lot of inflation.
However, you borrowed $100000 and will be able to pay with cheaper dollars in the future.
What this means is that prices and salaries and properties will, for example, double in price (the property has now a value of $200000 but you still pay only for the $100000.
That’s also why on an inflationary period by becoming a bond holder (lending money) you lost in real terms.
When there is inflation the borrowers win at the expense of the lenders.
The opposite happens when deflation strikes.
That’s why the central banks attempt to develop a somewhat neutral monetary policy. Unfortunately it is never optimal because the risks of deflation to the stability of financial system are very high and there isn’t much economic policy that allows for economists to deal with those events. What I am saying is that economists prefer to have a little inflation than having deflation because it is much more difficult to deal with deflationary processes. Therefore I do believe that most of the time an inflationary process will be around. However, this is a matter of opinion and the conclusions about who wins with inflation or deflation remain true. If you believe there will be deflation for a long period then you should not hold debt.
Hope the explanation helps.
Don’t forget that after your mortgage is paid off, the equity doesn’t compound like invested cash would. So paying a 30 year mortgage off in 15 years and THEN starting to invest is losing out on 15 years of compounded interest.
jbdub82 First, off the equity in your house does compound just like an investment account. Everything compounds in percentage relationships. They are all assets. There is no difference. Additionally, paying off your house means there’s 15 years that your mortgage interest on the remaining balance doesn’t compound against you. So anyway, be careful with this analysis. It’s frequently counter-intuitive.
richGETricher You also have to factor in property taxes and other itemized dedcutions…..Here in CT, property taxes can be more than the interest 😉
I own a home my parents live in. I’m going to pay it down to then take a second mortgage against it to buy my home. Now I’m renting. I’LL get some savings along the way and can’t spend the savings easily. I will have probably a higher interest rate then the measly 3.625 I have to pay now, but gotta get on with life and buy a house. I don’t want to just buy a house I want the house so I don’t have to move in 2-3 and deal with all of that. I hope to pay the first house off in 3-4 years.
Thanks for the great article. The one thing I’ve never seen considered is the tax obligations on invest profits. In a high tax situation that could eliminate much of the advantage of investing vs paying off debt.
Taxes on investment profits are offset by mortgage interest deduction to a large degree.
Long term gains attract lower tax rates.
Finally to the extent that gains are meaningful then paying taxes still means you get to keep.65% of the gains. I’ll take that anytime.
You are correct but it is an issue I have never seen built into the analysis. Even an analysis as good as this one. As pointed out here the full deduction is not always fully realized (AMT might be yet another mechanism that would prevent use of the deduction). Even when the deduction is fully realized taxes on profits of non-sheltered investments can partially or fully negate the deduction. This means that non-sheltered investment returns and mortgage interest rates are more directly comparable. Am I missing something?
No you are not missing anything. If you don’t need the cash liquidity and if you cannot earn more than the interest rate on the loan, ~4%, then payoff makes sense.
This is an old article and I’m not sure if you’re still monitoring it, but my question is this: your analysis is assuming that you’ll own the house for the whole 20 or 30 year mortgage period. What happens if you only plan to own the house for a decade or so. Would recasting by investing a lump sum into the house and lowering your monthly payments, and therefore lowering monthly interest payments, be a better strategy than market investment? It seems to me that since the amount of interest is so much higher during the initial years, you would be better off lowering high interest payments than investing in the market. What do you think?
First off, it’s not an old article. It’s a timeless piece of education that is not date dependent. Additionally, the article does not assume owning the house for the full duration of mortgage to maturity as you stated. The math is the math. Work through the numbers and you’ll see that your concerns do not impact any of the conclusions in the article. It’s all 100% valid regardless of whether you own it to full payoff at maturity or own it for a just a few years. Hope that helps clarify!
Love the article, you have explained it really well and considered all the aspects of debt and investment. My approach is to take advantages of all the tax deferred vehicles first once you exhausted all of them then invest and pay down the mortgage equally so that you have win-win situation. Since no one knows the future it is best to be not taking one side of the equation.
Excellent article and ensuing discussion.
The question of paying off the mortgage Vs investing is an age old question.
Ultimately the answer for me is that it depends.
I am in both camps and take a balanced approach, ie, balance or regular contributions into paying off investment property debt and investing regularly into Superannuation (International and Australian Shares). I own my own residence without a mortgage (Sydney, Australia) and have one investment property in the same city. The investment property is valued around A$1.25m with a mortgage a bit over $300k.
The psychological return of being debt free at some point is important but difficult to quantify.
One approach that I have read about is;
Ask the question, ” If the loan(s) is paid off, would my other sources of income currently provide me with my desired income in retirement? ”
If the answer is no – move more funds to investment
If the answer is yes – move more funds to reducing debt.
Not a simple matter and there is no one right fit for all.
Quality of life is another important factor to be imputed.
Regards from Australia
I don’t remember reading about how a long term job loss plays into this equation. In this tough market (for middle to upper middle class, high paying jobs), if the household’s major breadwinner loses their job, having a totally debt free household could mean the difference between survival and keeping the spouse and the kids stable versus having to uproot your entire family and move to a less expensive situation.
With no debt, a family can for quite a long period of time on one or two lesser paying jobs, buying time until the situation stabilizes. If you have a huge mortgage, you’re done in a few months! Get ready for bankruptcy if said family does not live well below their means as they should.
I lean towards the debt free (including mortgage) mentality and the freedom it brings. I would NEVER claim debt-free status “less mortgage” as that is folly. However, please know that I also have invested heavily towards my retirement for the last 25 years to the point where it is growing and self-sustaining nicely, in addition to paying cash for big toys and cars whenever possible. I also pay off higher interest loans and debt first (common sense) and don’t overlook the value of additional investing prior to paying down the mortgage.
But please admit everyone, even the experts are wrong in this market more often than not. Where are your guaranteed rates of return that exceed 6.0-8.0%??? There are few to none for the “average investor.” So I choose to ignore the tax break, pre-pay my mortgage and get the house paid off as quickly as possible, knowing that I’m already invested for retirement and have cash reserves.
Its been stated many times, it’s complicated and no one solution fits every investor. Don’t forget!!! It’s your house first, investment second! I don’t understand why there is such a strong focus on the home as an investment. Yes, we all want to win in the long run and sell it for more than we paid, but let’s not lose focus on the fact that its simply a roof over your head.
Warren Buffet’s comments mean nothing to me, BTW, because he can afford to be wrong, I cannot.
Thank you for this post. It is exactly what I needed to read. I am coming down on the side of paying off my mortgage. Like you, my retirement, 529s, and insurance are on track and I have no other debt. Even after the pay off I’ll have a year and a half of savings. I enjoy my job but to have the mortgage paid off and no debt gives me the “go pound sand” card to keep in my pocket if that ever changes.
What pushed me over the edge, besides this article, is the thought of borrowing money from the house to invest. The thought of putting the equivalent cash into the market today makes my stomach hurt. So emotionally this is the right decision for me.
I have a question that id appreciate as many opinions as possible 🙂 I am young, 1st time home-buyer. I currently pay an accelerated bi-weekly mortgage still owing a lot ( think 265 or 275 grand) mortgage rate is 2.69 % and we have 3 years left. I don’t make much money less than 40 grand a year. Do I put any extra cash I have into paying the mortgage off, or do I invest. I was thinking of putting 5 grand to my mortgage and investing the other 5 grand or so while doing dollar-cost averaging with 100 per month. I have no pension plan or anything like that through work. I have a TFSA BUT no investments within that. I have 25,000 currently in there WHICH I may need at any time for a car when my old one goes which could be anyday as its 20 years old.
Please any advice would be good as I know NOTHING much about investing.
Thanks a bunch in advance 🙂
I think the article answers your questions. Try reading it again and notice a hierarchy of priorities is established that should answer your question. Hope that helps!
Posting on 6/9/2017
I have no idea as to the timeframe of this article. I just stumbled upon it as I did a google search for the topic. So forgive me for making such a late comment – I’m sure that’s the case since I read one comment stating that they had done something in 2012.
Anyway, I love all the aspects covered within the article and discussions, but as with any question of this type, there’s no silver bullet.
Personally, I’m in the situation where I’m debt-free with the exception of our mortgage. My youngest child has one more year of college and the funds that I’ve been using to pay tuition will then go towards investments or mortgage payoff. I’ve been paying additional principle anyway (not a lot – just a few hundred more each month) as we’re still around year 22 of a 30 year mortgage. My retirement investment is in very good shape, I have a comfortable rainy day fund, etc., so I’m definitely faced with what to do with the extra we’ll have when my son graduates next year. I love being debt-free as well, but I’ve also learned so much in watching my 401K grow (the value of investing early, etc.)
With all of that said, I’m leaning towards a hybrid approach (maybe similar to you). I’m going to invest the bulk (at least 70%), pay off mortgage with the other percentage, but only put more towards principle during the last few years of the early part of the mortgage. After that, everything will go towards investments.
I wish the comments section would tag each comment with date/time – ditto for article. That would help to put some of the comments into context
Thanks for all the insight.
You’re welcome. And the reason for no date references is because the article is not time sensitive. In other words, it’s intentional. There is no need to date this content because it never goes out of date. It’s current right now. Hope that helps.
Well, my wife and I invest religiously for our retirememt. We did a 15 year mortgage and if we refinanced to to a 30 and invested that savings per month I know that over 30 years with an 8% return we would have well over what our homes value would be 30 years from now. But I’m not doing it as all our money would then be in the stock market (besides our 1 year emergency savings) and that’s too much risk me.
Yes, risk reduction is a valid reason to reduce your financial leverage (mortgage) and work more from the equity side.
Not sure how long ago this was written, but thank you. It’s one of the best articles on this topic that I’ve read — and I’ve read many! I’m also in the middle, balance zone and it’s helpful to read that it’s ok not to completely ignore the emotional side of this. I know I *should* be investing more rather than prepaying the mortgage, but I simply don’t want to. And I don’t have to if I don’t want to!
Yep. Money is just a resource toward leading a fulfilling life. It’s okay to do what works for you emotionally even if the math says differently.
Love it! As a mortgage professional I was searching for mortgage prepayment strategies and whether or not someone should pay off their mortgage early of invest. I found your guide helpful and thorough yet still very easy to understand. With large personalities like Dave Ramsey pushing the idea of being debt free at all costs it can be hard to communicate this topic well and provide people an alternative prospective. Thank you.
You’re welcome, Scott. Yeah, there are a lot of high profile “experts” dispensing half-baked “wisdom” that is emotionally appealing, but not completely accurate. I appreciate you joining the conversation.
What about enjoying life now. Investing is great but your time can not be replaced. 30 year investments are great if you want to leave it behind. I’ll take the Corvette and vacation. Smiles the whole way and die broke:)
Ahhhh, the infinite wisdom of youth spoken in prime earning years. If only life were that simple. If only we didn’t tire as we grow older. If only we could organize our finances so we could spend our last penny as we exhaled our last breath (rather than running out of money long before we died and spending our final decade or two destitute and living on cat food in a run-down apartment on the wrong side of town.) Sorry, but Corvette’s and vacations at the edge of brokedom only assures that at the first hiccup broke overtakes the race and and all smiles vanish. But hey! It’s your life so you get to play it out however you choose. Have fun!
I am currently facing this decision. My wife and I are currently making roughly 200k a year together and don’t have kids. We are in our mid-30’s and after making roughly 45k together most of the rest of our lives we are just about to finish building that “foundation” you talk about (paying off high interest debt, maximizing retirement, etc).
To me it seems like paying your mortgage down should be part of the “building the foundation” portion. Yes, the interest rate on my home mortgage is low, but it’s interest on $130,000! As of typing this message I have paid an extra $1,400 on my home loan and have saved $890 in interest. To me, that seems like I “invested” $1,400 and got back $890. I can’t imagine any return close to that via investing.
Perhaps it’s a bit of a middle ground situation. It seems like I should “invest” in my home loan to a point. Basically as long as the return I’m getting in interest savings is higher than the average return on investments. At some point it makes more financial sense to switch away from paying off the loan to investing as the average investment earnings become higher than my loan. Does that logic make sense?
We recently refinanced our home to a 15 year and plan on paying it off in 5 (should our financial situation not change). Does it make any more sense to pay it off first if we’re able to pay it off that quickly?
In my case, I also have student loan debt to consider. Some of it has interest as high as 7% so paying it down also has to be a priority. I’m thinking paying those down to some degree may make sense before investing as well.
I really don’t have anything to add to your decision besides what’s in the article. With that said, I’m pretty confident you’re making a mistake with your numbers. There is no way you’re getting 890 back on 1400 of principal payment unless you’re adding multiple years of interest savings into one lump sum, in which case that’s not how finance works. The return on investment must be expressed annually. Hope that helps you clarify your analysis.
That is extremely helpful as I am looking over the life of the loan. The lender we use (quicken) has a place in our web portal that shows how much interest we saved based on the amount we’ve put in (which shows those numbers). They are definitely using what the savings would be over the life of the loan rather than annually.
Do you know of any calculators or formulas that allows me to do that calculation annually?
Also, would you mind elaborating a bit more about on why it must be calculated annually? Does it go back to the point about inflation?
In my mind if I pay my home off in 5 years instead of 15 it seems like I would be saving a huge amount of interest. I’m still just struggling to understand how the interest savings compare to potential gains in the stock market. Obviously the amount of money it would take to pay off the house in that amount of time would be fairly substantial and could be invested instead.
Thanks a lot for your time!
I’ve run various numbers and now better understand what you mean. I think investing much more than we are (which is basically none as we’re just freeing up old high interest debt).
I’m in the camp of having refinanced my home to cash out equity and invest the difference. However, we chose to cash out at 10% less than the appraised (appreciated) value since I did not feel comfortable that we could resale at that price without being upside down. So I guess that shows that even in the refinance option there is still a path to not go “all in”.
We used money from our home equity line of credit to invest in a stock portfolio. The goal is to have the dividends cover the cost of borrowing and over time we will be left with the initial investment that was funded from the bank. What do you think?
Yikes! That would not be my approach just because I’m a careful risk manager. Your interest rate charged could vary and your dividend income could decline making it possible for both legs of the spread to go against you. In addition, the value of the stock portfolio could decline dramatically. There is no free lunch on Wall Street. If you don’t understand all the ways you can lose money with a strategy then you don’t understand the strategy. I would be very reticent to generate all the fees for a strategy dependent on narrow spreads to work. It violates expectancy principles where you want to take small risks for large gains. Not large risks. It also leverages your home, which is not an asset I choose to leverage. It’s a consumption asset in my mind where the goal is security and quality of life, not wealth growth (to the extent the goals contradict each other, which they do in this case). Hope that helps.
Isn’t Anthony just doing what you are arguing in favor of earlier, banking on that, over the long run, the return on stocks will outweigh interest paid on the mortgage? To quote you:
“long-term investment returns will likely provide a higher return on your capital as evidenced by Ibbotson and Associates research showing a diversified portfolio returning in the 8% range.”
No. There’s a big difference between choosing what to do with cash vs. incurring the interest cost of a home equity line of credit. In addition, there’s a big difference between theory and reality with investing. Theoretically, long term investment returns on a low cost passive index asset allocation portfolio would approach those returns given sufficient time (20 + years), but you could have many years of negative and sub-par performance along the way, possibly in excess of a decade, all while incurring that home equity line of credit interest cost. In addition, studies of actual investor accounts (Dalbar, etc.) show real-world investors tend to under-perform the averages by a wide margin (varies by time period, but -3-5% is a reasonable approximation). Between underperformance risk, interim volatility risk, and actual interest costs incurred on the home equity line of credit, I think that plan is potentially more dangerous than beneficial for most people. Could it work out favorably? Absolutely? I just question if the reward at the end of the rainbow will be justified by the risk that will be incurred along the way. Hope that helps clarify…
Forgive my ignorance (I’m British), but what is the difference, financially, between borrowing more money to invest rather than using spare cash to invest rather than pay off a loan you already have. In that sense, isn’t the above scenario the same as the one outlined in the original piece?
As I say, I am British, so maybe I missed something. For instance, is the interest rate on the home equity line of credit a lot higher than that on a standard mortgage (more than the 8% long term expected return on the investments)?
It has nothing to do with being British. In one case you’re investing equity. In the other case you’re investing with debt. The latter carries interest costs and must be repaid giving a “hurdle rate” that must be achieved before any profit can accrue. This increases risk and means that time works against you because returns must consistently beat your hurdle rate net of taxes in order to come out ahead. They’re different equations.
I did not read through all of the comments, so I apologize if this was already covered. My current situation is that our only debt is our house. We have not paid extra on the principle at all since getting the mortgage ~5 years ago, but we have saved enough money where as we stand today, I could write a check for the balance of our mortgage and pay it off. We are saving for our kids college and also investing in 401k and roth ira. Life insurance is in place as well. The dilemma is that we are looking for a new house because of our growing family and if we pay off the house, that leaves most of our liquid assets tied up in our current house at that point. There is also land for sale that we have thought about investing in, but would not be able to do so if we paid off the house. We currently have roughly 50k in equity in our house. Any thoughts?
I am 72 years old and retired. I receive a pension and social security about 3300 a month. I have no debt except a mortgage
I recently purchased a home for$192,000 and just sold a home for $253,000 no mortgage on this home
I have about $100,00 in savings, money market and a 403B.
My question is should I pay off my mortgage or invest?
Please help me ! Thanks
This one question will give you the answer: “Would you ever borrow money from a bank to invest in the stock market.” I’m sure your answer is hell no as it should be. Well, this is what you are doing if you don’t pay off your mortgage and invest the difference. 9 out of 10 people make money on their houses. 9 out of 10 people lose money on the stock market. How would you feel if you retire only to have the market correct 60%. You will be kicking yourself for not paying of the house earlier. Anyone who calls themselves a retirement advisor is selling snake oil. You don’t tell people to give up a 5% (mortgage rate) risk free return so they can make 7% (average stock market return) in some insanely volatile stock market. This is lunacy. It’s not worth the few extra percentage points investing in stocks. The volatility will just make you sell at the bottom, thus making it a worse off proposition than paying off the house. Advisors never talk about the psychological component to investing.?
Investing may earn you more based on oft-quoted long term averages but, consider this, if the market tanks by 50% in one year, it would take over 7 years of so called “average stock market returns of 10%” to return to the same position you were in just prior to the loss, and that is not even factoring in inflation.
Consider also the possibility of experiencing a period of unemployment during this period whilst still having to meet your mortgage repayments. Suddenly, leveraging your mortgage to invest doesn’t seem so appealing after all.
I believe someone once said “rule number 1: don’t lose money, Rule number 2: don’t forget rule number 1?. You have to admit he has a very good point.
Thank you for this very comprehensive article on this topic! One of the problems I have with the online analyses of this issue (from multiple sources) is they don’t fully take into account the high principal amounts of most mortgages vs. the returns from a stream of income. In my case, that changed the entire analysis. Say I have a $250,000 mortgage at 4.5% interest and a $10,000 student loan at 4.5% interest. I’ve maxed out my 401(K) and don’t have any additional debt. I still have an additional $6,600 per month to invest. I can pay off my mortgage in 3 years with extra principal payments, pay off my student loan immediately, or do neither and invest. For the student loan, the answer is obvious: invest. I have the $10,000 to pay it off today, so I can invest the full $10,000, get a better return in the stock market, and deduct the student loan interest. For the mortgage, the picture is more complicated because I don’t currently have the full $250,000 to pay of the mortgage today. I have a stream of income. So, in year one, I could invest an extra $6,600 a month (~$80,000 per year) and earn a higher rate in the market (let’s be conservative and say 8%, but: 1) the return isn’t guaranteed; 2) I pay taxes on the gain; and 3) the gain on $80,000, even at much higher rate of return, doesn’t outperform the almost $12,000 in interest I will pay that year on the much-larger principal ($250,000) from the mortgage. End of the day, if I invest the extra $80K per year in the market, I will possibly gain $26,000 in interest (which will be reduced by tax anyway). If I throw that money towards the mortgage, I will have paid off my entire mortgage in three years, have saved $265K in lifetime mortgage interest, and have saved $28,000 in mortgage interest over the three year period. Yes, I will have lost $28K in deductible interest as well, but paying $28K to save $9K isn’t that great of an advantage and my theoretical $26K stock market return would also be reduced by taxes. Plus, paying off the mortgage is certain; stock performance is not. I think if you have the full amount (or close to the full amount) to pay off a debt, investing vs. paying off the debt may be a better choice; but if you are talking about investing an income stream, the answer is more nuanced. Is there something I am missing in my analysis?
The math is the math, whether the dollar amount is large or small. I like your analysis because it was quite comprehensive, showing both before tax and after tax considerations as well as discussing the differences between a certain, non-volatile return over a volatile, uncertain return. The only distinction that made no sense to me was your large vs. small argument. For example, one advantage of getting rid of the small debt quick is to simplify by clearing out the clutter and noise in your life. There’s no point in keeping the small debt for the slightly improved return because the dollar difference is de-minimus to someone saving at that level. Better off to just get rid of it. Ultimately your time is the greatest value of all. Hope that helps.
Thank you for sharing such a useful post.. Article is so well done!
Thanks. That’s the goal. We try to make it complete, yet not complicated.
This is the best article I’ve read on this subject. Thank you for breaking it down and making it easy to understand.
You’re welcome. Glad it was helpful!
I really enjoyed this analysis. The one thing I do not see you mentioning is how long it takes to get the money when you need it. I am in real estate and specialize in selling homes. That actually makes me nervous to tie up my money in my house because if I need some of that equity, I can’t get it unless I get rid of my home or take out new debt. Of course you may be in a down cycle when you need to sell stocks, but you can more easily sell $10k – $50k in stocks then you can get that money out of your house. I am thinking far in the future, when I won’t have regular income that would make a HELOC easier to get.
Thanks for the well balanced approach to this conversation. We recently moved and went from a nearly paid off mortgage to entering into a 30 year mortgage and holding on to around 60K because of the conflict illustrated in this article. A friend of mine sells life insurance and is convinced that we should take that 60k and purchase a whole life plan structured to develop cash value. He feels the opportunity cost of paying off the mortgage would be a huge loss compared to whole life. Does the idea of whole life as opposed to investing in the market change this conversation in anyway, positive or negative? Thanks again for the article.
Hah! Gotta love those life insurance sales people. Of course he thinks that! Too funny. You can see my take on whole life insurance as an investment here https://www.financialmentor.com/financial-advice/life-insurance/whole-life-insurance/19216 Hope that helps…
Financially Free, Pharm.D.
Excellent and very thorough article Todd, thank you for the read! My wife and I are 30 years old and just “bought” our first home, and are re-evaluating our entire Financial Independence, Retire Early game plan. Having been debt free for almost a month after paying off our student loans this past December, we decided to re-enter the debt world with a 244k mortgage at 4% interest.
With me being a numbers guy, I am holding strong to our plan to make the minimum mortgage payments and invest our extra 5k each month into VTSAX. Would love to have no mortgage in 3 years, but we can’t justify missing out on the compound interest that will fund our early retirement (goal is within 10 years).
One thing we are hesitant about with having a mortgage is we have extravagant plans to travel the world for 6 months in the near future, for which we most likely will have to quit our jobs. Being unemployed with a mortgage sure is scary… but you only live once, right?!
Glad you got good value from the article. You say you’re a math guy, but your decision doesn’t make math sense from a 10 year expectancy perspective (written end of January, 2018). The 7 -15 year expectancy on VTSAX is (depending on analysis and assumptions) anywhere from low single digits to negative due to historic lows in interest rates and historic overvaluations across major equity markets. There’s much more to FIRE then is commonly discussed in those communities. It isn’t a one decision process for VTSAX like many people would like to believe. Just because something worked really well in the past doesn’t mean it will work anything close to as well in the future. In fact, mean reversion virtually assures the opposite will occur. I hope that helps.
Two and a half years ago I’d saved enough in cash and index funds to pay off my mortgage.
I didn’t do it.
Instead I cooked up a clever-clever plan to slowly pull out of equities over the next eight years – hoping to squeeze a little more from the upside along the way.
I’d won the game but I kept on playing anyway.
What happened was that I found out a lot about myself – especially my ability to tolerate risk
Half of my mortgage repayment fund was sat in cash, half in equities. The idea was that instead of wholesale withdrawal, I’d stage an orderly retreat that would put me 100% in cash by 2021.
But no plan survives contact with the enemy. Especially when the enemy is me.
When I sketched out my scheme, I thought the enemy was a remote nightmare scenario where Mrs Accumulator and I both lost our jobs while equities crashed like a meteor to Earth and interest rates plumed like so much radioactive dust.
And in 2013, the recovery from financial Armageddon 2008-style felt like it had some way to run.
I didn’t want to miss out on the boost that staying strong in equities could give me as I pushed towards my next summit: financial independence.
It was a calculated risk, and many warned me against it. Their concerns mostly related to a deep personal hatred of debt.
If you have it, get rid of it. Don’t take chances. Cut your chains as quickly as you can and get the hell out of there. Don’t saw halfway through the manacles then hang about pulling victory poses in your cell while the guards play cards next door.
It was good advice. However I felt that time and financial wiggle room was on my side.
Change of plan:
The markets climbed. My portfolio was up 20% by the end of 2013. The rise continued as I made my first annual withdrawal early in 2014.
The sun kept shining. News bulletins proclaimed record stock market highs.
It was like watching a rich kid open yet another present: “What have you got me? Oh yeah, another record high is it? Thanks.” (Tosses away).
But I get nervous when things go too well.
And the stock market is a see-saw: As valuations soar, expected returns fall.
With expectations diminished by those record highs, it was time to rethink. Time to rebalance out of equities.
Time to take money off the table faster than a poker cheat in a Yakuza den.
By the time my 2015 withdrawal came along, my allocation to cash was already one year ahead of schedule.
There’d been a sharp, downward jolt September to October 2014. Call it a warning. I didn’t know what was going to happen next but salad days seemed less likely.
Equities marched on to new highs in May 2015. That was the last high they hit.
I pulled out another year’s cash in April.
My equities were now worth about one quarter of my mortgage.
Turmoil hit in June, August and September.
On my bike ride to work, I didn’t look at the rolling fields and trees. I kept playing my risk tolerance game
What if I lost half of everything from here?
A 50% loss would wipe out 12.5% of the mortgage fund. I could make that up in savings in less than a year. Rationally-speaking, there wasn’t a problem.
But there was.
I’d crossed an emotional Rubicon. I was taking risk I didn’t need to take. But it took the recent 15% losses to make me realise it.
What did the downside look like?
What did the likely upside look like?
Meaningless. A few extra grand or so.
Investor know thyself
My risk tolerance had shriveled away now my original objective was achieved.
I was much less brave in the face of losses that I had no business taking.
I sold out the next week.
That was back in November. Six years early. The mortgage fund is now 100% in cash. No one can take that away from me now.
Not even myself.
It was one of the best decisions I’ve ever made. Like popping a pill marked ‘worry begone’. Now I’m back to gazing at the rolling fields and trees (/grizzling over some other aspect of life).
I got lucky. Large losses could have punched a hole in my assets and the wind from my gut. That would have been fine if my risk tolerance hadn’t changed once I’d mentally ticked the mortgage off as ‘done’, but it had.
Since then I’ve taken much bigger losses on my financial independence fund and not felt a thing. Because that’s risk I need to take and the day of reckoning is years away.
Hopefully this earlier skirmish is a lesson I’ll remember when the time comes to take that money off the table, too.
At the very least, I know myself much better than I did. The markets tend to force truth on a person.
As has been said many times, the stock market returns 10% on average a year. Over a mortgage’s lifetime, chances are that the interest rate you pay is going to exceed an average of 8%. By my reckoning, at worst, this is a great opportunity to leverage.
What’s more, very high interest rates (above 8% or so) only really occurred in the 1970s and 1980s.
Of course rates of 5%+ are very normal. If I was stress testing the idea of paying back a mortgage in the current climate and foreseeable future in, I would think 5% Bank Rate would be a reasonable measure to use.
Happily one doesn’t have to lock oneself into a plan for the rest of your life. If/when interest rates do start to rise, the risk/reward will of course become less favourable and the attractions of foregoing mortgage payments will diminish.
Each to their own, but I happen to find your advice to pay off a low rate mortgage ASAP a little dogmatic and scaremongering. I prefer to be a bit more nuanced and rounded.
The standard variable rate UK mortgage rates haven’t been 8% since the late 1990s. So that’s 15-years ago, and when base rates were far higher. That’s 15 years of a 25-year mortgage right there. Yet people talk about rates going up.
Meanwhile, we currently exist in a world of near-zero interest rates, and have done for seven years. The only way mortgage rates are going to 8% in the next 10 years or so (and probably beyond) will be if the Central Banks lose track of inflation, at which point *having* a big mortgage would be desirable (because hyper-inflation erodes debt fast).
Don’t get me wrong, I think there is NOTHING wrong with paying off a mortgage as fast as you can. It is one of the safest investment you can make in terms of guaranteed return, though it does have disadvantages — in particular woeful diversification (all your investment eggs are in one basket — residential property, and just one residential property at that).
And I fully agree there are greater risks with continuing to invest when you could be paying off the mortgage instead, especially outside of employer-matching pensions and the like
But in return, there are potentially greater rewards. It’s a decision. That’s what investing is about.
Sure, we can get to 6-7% for mortgage rates. But “Normal” doesn’t mean “persistent”. It would be “normal” to have some sunny days this summer in London. If only they would be persistent.
Saying something can happen in the future and has in the past is very different from saying it’s wrong to maximise returns on investments now with interest rates near-zero (you can get a 5-year fixed rate, for example, cost just 2.29%, and a ten-year rate at barely 3%).
A ten-year fixed rate mortgage of 3% is 40% of the life of a mortgage. It’s very significant. It also gives you ten years to change course if for some reason mortgage rates leap to 8%, which absolutely nobody thinks remotely credible. (The 10-year gilt yield is currently near 1.5%, and the market still fears deflation).
There’s no need to over-egg the pudding with fantasy interest rates.
You might see 10% a year from investing your borrowed money into the stock market, before costs.
And it’s true, you might. That’s the long run average return here in the UK and the US, give or take a bit.
But you might easily invest your borrowed money just before a bad spell for shares, and only get 5% a year.
There have been several times over the past 110 years when UK equities have failed to deliver a positive real return on investment over 20 years, let alone their expected return.
At such times, you’ll not break even after costs and charges.
Worse, you might invest at a truly terrible time, and lose a lot of money.
Just look at Japan for a worst-case scenario.
Anyone who borrowed to invest when Japan’s Nikkei stock market index hit 38,957 in 1989 is sitting on a 75% loss over the past 20 years. A terrible loss, but even worse if you spent those 20 years paying double because of interest.
Do I think awful Japanese-style returns from shares are likely if you invest today?
No, but I’d be very cautious about borrowing any money to bet on it, beyond perhaps trickling money into tax-sheltered investments instead of paying down a mortgage (which is effectively the same thing as borrowing to invest).
An expected return is not a smooth return
Remember also that the stock market is volatile. You might see average returns of 10% or more for 19 years, only to suffer from a stock market crash the year before your repayment becomes due.
Perhaps in the 21st year the market bounces back, just to rub it in.
Too late — you repayment date has passed!
I can’t think of much worse than borrowing £100,000 on an interest only basis, paying interest on it for 20 years, and then not having enough to repay the capital outstanding at the end.
Sure, you could try to cleverly lock in gains over the decades and so on. Remember though that this will wrack up more costs, and that the usual drawbacks of market timing and over-trading still apply. You’re actually likely to reduce your expected returns this way, according to academics.
Short-term borrowing is madness
Most of the responders having been talking about borrowing to take advantage of long-term returns from the stock market.
It might be marginally profitable, but there are plenty of risks, and you can’t expect to make more than a couple of percent extra a year, even if it all works out.
That’s worth having – but much less than the rough-and-ready initial calculations would imply.
In contrast I’ve barely looked at borrowing to invest over the short-term, because I think there’s no case for it.
Anyone who has lived through the past decade and seen two bear markets where stock markets fell 50% should know exactly why borrowing over five to ten years is simply gambling.
If you invest your own money over the long-term, you can afford to ride out the ups and downs.
But if you’re investing other people’s money over the short-term, you’re at the mercy of the whims of the market — and you could easily end up owing money to your lender after selling (or being forced to sell) your investments.
The takeaway as I see it here is that expected returns from the stock market are fine for long-term investment planning, but not a rock solid basis for planning how you’ll repay debts, further undermining the case for borrowing.
With a cheap enough loan you’ve got a good chance of doing okay over 20 years if you borrow to invest in the stock market and keep costs low, but there are definitely no guarantees.
Over the short-term, it’s madness.
Now, lets not hear any more discussion on this topic.
Holy Cow, I Googled this topic and found this article and was amazed how well you put into words the scenarios my brain has been contemplating…
About to sell my $300K home (nearly paid off) and move to AZ with a “Casita” for my home-based business to have separate quarters to support a couple employees as my company is growing at a rapid pace.
Tax bracket is getting high, so wondered, should I dare, to NOT put my $300K as a down payment on the approx $500K home with a separate office space. Would get a tax deduction for the interest on the home and business space, and then invest the balance of a 20% down into the market….
But the market is overvalued, I suspect, but them I don’t have a valid crystal ball. I tend towards conservatism, hence why the present house is nearly paid off. I fear an inflationary future due to government and corporate dept, leading me to believe a 30-year mortgage locked in at 5% or so would end up being a majorly good idea.
At nearly 57 years old, and just barely saving into the market (I used to not have a good income) these thoughts have been driving me nuts….
You didn’t provide a solid answer, and not sure I still know what on earth I am going to do, but your article, as well as the blog posts, help me realize there is no “final answer” unless one knows the future 🙁
Very nice article, reality-based. Stumbled upon it after wife and I decided to pay down mtg rather than get whole-life insurance. “Pay down principal” sums it up. After reading through and also the comments it seems the question pay down mtg vs invest should get more attention in financial planning that it does. Personally I had previously mulled it over without coming to a conclusion. Now it seems obvious. For most folks it’s: pay down the mortgage. The only exception would be an employer-matched 401K. Now, if you’re an “insider” or have a crystal ball then it may be different but for most people paying down the mortgage is the only sure bet. Also a home is more than an investment, and a home has legal protections from law suits that other investments don’t. Furthermore the value of a home is usually “benefit-neutral”, something that in retirement could be a factor. Great article. Thank you.
People should read your comment closely. I would have a hard time disagreeing. Yes, owning your home outright creates “imputed income” that has value in ways many people don’t realize – whether that’s qualifying for Obamacare thresholds, or student aid, or on and on and on. It often isn’t counted like ordinary income. Plus the security aspect is widely understated. There’s more, but I think your comment said it succinctly.
I have a big problem with your argument. For most people, it takes 25-30 years to pay off a mortgage, most of their working life. The compounding benefits of investing in a tax sheltered account takes years. The long-term average rate of return from investing is higher than the rate on the mortgage debt. In theory, what you say is all good. In reality, retirees cannot eat, pay utility bills etc on the equity on their house, but they can from a diversified portfolio which has had years to grow.
You’re narrowing the nuanced complexity of the issue down to just those points that you choose to look at. Read the article again…
I think if one chooses an arbitrary desired income level then this question can be easily answered. For my fiancé and I, it was $X/Year. We then acquired a few rental properties, kept our full time jobs, invest in our unmatched 403B, ROTH IRA, 529 College savings plan, regular savings and stocks via online discount brokers/Tradekings of the world. We have paid off and refinanced properties to that end. Your article was very thorough and even pointed out the fact that inflation will soon surpass my mortgage interest rate on some rentals. To the point, if you have your X in mind, there will come a point when you will decide that you have enough assets to generate X. Then, all you have to do is take care of those assets and eliminate the mortgages as effectively as possible. When they are no more, you can use the funds to pursue whatever tickles your fancy. No need to keep chasing your tail and higher returns. Personally, its cool to be debt free, a slave to no man except the tax collector 😉
Yep. A lot of people analyze this strictly from the “maximum wealth growth” perspective. They don’t see the other perspective of “enoughness” where security and certainty are a higher priority than “more, better, different”. When your cash flow from assets exceeds your spending needs then you’re infinitely wealthy. More money doesn’t give you more life, and may actually decrease quality of life depending on the risk and time requirements to get more.
Wow, what a refreshing take on this question. Thanks for confirming that there is no single right answer for everyone. It really boils down to your own emotional comfort / risk levels. For myself, I am planning to take the middle ground and go for a 20 year mortgage because that allows me to pay less interest and yet have a little bit more cashflow for investing. I could go for a 30 year mortgage and make extra payments but I doubtful of my discipline to consistently invest the difference.
Thank you for your detailed insights. By the way, would you be able to add date/timestamp to your blog posts and comments? I was trying to figure out how recent some of the comments were, since interest rates have been creeping up and what is relevant now or 2 years ago, may not be as relevant 2 years later.
Thanks for this great article! About to become a first time home buyer here and your article spoke to me a lot about what I feel I should be doing.
One question, is the 8% you are talking about pre or post tax? In regards to the longterm investment is better argument. At current interest rate of about 4.5. If the long term expected ROI is about 8% pretax, it feels like the return would be roughly equal to the interest rate + inflation savings by paying down early. 4.5 + 2.4 (rough avg of last 30 year inflation). One can of course refinance and hope for better return on investment but still.
I feel I have made a huge mistake. For years I have been busy paying down my mortgage like a madperson. I have ignored the huge potential for growth in the stock market in favour of the safe and secure return on paying down debit, earning an effective return of just 2.75%. I now find myself with a very small mortgage, but have not benefited from the huge returns I could have gained if I had invested instead.
I am reassured that my housing is safe and secure, but I don’t FEEL wealthy. If I lost my job tomorrow, I would not be able to eat or keep up with my bills very long before running out of money.
On the flip side, if you see your plan through to completion by fully paying off your house then you’ll see your monthly cash flow needs drop by the amount of the house payment. That reduction in monthly spending will similarly reduce the amount you need to save to retire by magnitudes (apply the rule of 300, rule of 400 as taught in my book “How Much Money Do I Need To Retire”) and it will significantly increase the amount you can save each month because your monthly spending needs are reduced. So, your plan may not feel great now, but you’ve made much greater progress toward financial freedom than is superficially evident. The key is you just have to finish the payoff process so that the monthly cash flow requirement of that monthly payment is done and over with. Once that happens, then several of your wealth growth equations change significantly. Hope that helps!
Thanks Todd, great read. I’ve seen a number of opinions on paying down vs. investing, but I’ve never been able to find anything on paying down an investment property mortgage vs. investing. Presumably, it would follow the script you’ve laid out?
I originally paid down my home mortgage heavily in the early years, but am happy to leave it where it is now ($140K). However, my investment property has a higher outstanding principle ($215K @ 3%), as well as interest payments on a $30K @ 4.45% HELOC that I used for the down payment (tax deductible and covered by the rent my tenant pays).
After a few leaner years, I now have a bit of disposable income to save and still can’t decide whether to invest or pay down the investment property mortgage. After reading your article, I decided to invest, but after reading the comments, am now wavering back to paying down the mortgage as a sure thing and which is leveraged a bit more overall. At least to make a better dent into it.
Thanks for any insight into whether you would have any difference of opinion with regard to an investment property’s mortgage!
There’s really not a lot of difference. The main thing with investment property is you have to factor in your goals or primary objective. If your primary objective is security and an income stream you can never outlive then you’d go for low-to-no financial leverage. However, if your investment objective is maximum wealth growth then you’d go for higher financial leverage (mortgage financing). Always remember that financial leverage is the one type of leverage used in wealth building that cuts both ways. It makes the good times great, and the bad times unbearable. So your application of financial leverage within your wealth strategy is subject to very specific rules as taught in my new book “The Leverage Equation”. If you don’t want to read that book then a simple work-around is to match your application of financial leverage to your primary investment objective. Hope that helps.
Wow, awesome article!! Thank you so much. Very detailed and exactly my struggle, the emotions vs math, and fear of the unknown messing with it all. I’ve just drastically downsized and I’ll share this lesson I learned. Had a $1.2m home on a 15 year mortgage, (I’d determined that the $500k savings in interest very much worth the switch from 30 year to 15 year), however this did not work out well with a job loss, I was unable to finance back to the 30 year and unable to afford the 15 year payments anymore, (but could the 30 year). I’ve since learned that disregarding any rate differences, the 15 year Mortgage is the same as the 30 year with enforced extra principal payments. I’ve now downsized to a $500k home and need to finance $100k, I’m going to get a 30 year mortgage simply because it gives me that option to reduce payments when necessary. I’ve been calculating that I can pay this off in 2 years with large extra payments OR invest. After reading this I am going to choose mostly investing as I don’t have much in the way of retirement or other assets to fall back on. But still will put some extra into the home, to hedge myself somewhat.
This is a brilliant article, and is my automatic go-to whenever I hear someone ask “overpay mortgage or X?” It depends on your current financial situation and what you believe the opportunity cost of overpaying your mortgage is. As of writing, I personally think the equity markets are horrendously overvalued, and so anyone expecting the next 20 years to deliver the same performance as the average 20 year holding period is probably in for a big disappointment.
Interestingly enough, you and I see this question/quandary exactly the same way. I am in the same boat as you are with the exception that I am not yet retired but have zero debt except a mortgage with a 2.875% interest rate and a balance of $248,000. I am electing to have a bi-weekly payment plan and add $1,000 towards the principle ($500 bi-weekly) to pay it off 2-3 years before I exit into retirement.
Great article for even the most remedial reader interested in making sense of which way to invest their hard earned money.
One thing I can’t understand about this whole debate is why doesn’t everyone just look at the mortgage payment as the monthly living expense that it is. If you didn’t own a home, you would be paying rent, which means paying off your landlord’s mortgage instead. No one seems to suggesting paying rent months or years ahead of time, depriving yourself of money to enjoy or invest now. That would be silly. A mortgage is basically like paying rent to the bank anyway.
Likewise, no one is suggesting paying other monthly living expenses ahead of time. For instance, I don’t know anyone with stockpiles of non perishable food, bought on the basis that it will be cheaper than buying it as and when needed over the next 30 years.
Andrew, the reason people don’t just accept mortgage payments as a cost of living is because financial freedom is defined as passive income (net of taxes) exceeding expenses. The objective is to narrow the gap between your passive income and your expenses in the most efficient way possible. You achieve this goal by lowering expenses or raising passive income. The math is the same either way, except raising income also increases your taxes. Also, income increases also involves risk; whereas, paying off your mortgage reduces risk. So ultimately, the most efficient path to the goal is whatever provides the highest after tax return on capital. However, the risk factor shifts the equation. Since rent/mortgage is one of your single largest expenses (with taxes being the other largest expense) it is naturally a primary target for analysis in this context. So it’s not “silly” at all, as you claim. It’s math. It’s about mapping a strategic path to financial independence. I hope that clarifies.