Author Topic: To pay off, or not to pay off? That is the question.  (Read 3871 times)

Greenbeard

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To pay off, or not to pay off? That is the question.
« on: September 30, 2013, 12:27:38 PM »
 I've seen multiple questions about paying down debt before investing.  I'm wondering if there's a simple rule that would cover all cases.

My gut says the rule should be something like:

If you can reliably make more from your investment than it costs to borrow money, then invest, otherwise pay down the debt.

This is essentially the rule I've followed all my life.  When you're talking 18% credit card debt or something like that, it's a no-brainier.  Sometimes it's not so clear cut.  Here's an example where that rule gets fuzzy for my personal situation:

I carry a mortgage on my house, it's the only debt I have.  I have the funds to pay it off, but the interest rate is only 3.75%.  Over the last 5 years I've averaged much higher return than that on my investments.  So it makes sense to me to carry that debt.

Ok, so let's say it makes sense to carry the debt.  I currently have $100k equity in the house.  Given the simple rule, it would follow that I should pull out the 100k equity and invest that too.  Hey, if it makes sense to keep part of the money invested, why not all of it?  I don't necessarily think it's a wise idea, but my simple rule doesn't cover this case.  So I ask myself, why not?

Maybe I can add to the rule and see if it can stay simple, but be more accurate...

If you can reliably make more from your investment than it costs to borrow money, then invest, otherwise pay down the debt.  Stay diversified and maintain a safe level of liquidity.

When I think about the reasons NOT to pay off my mortgage, besides reducing my return, it would also tie up my assets.  Houses are not very liquid.  You can't trade a shingle for a gallon of milk, or pay your car insurance with a window.  So putting too much into your home could make you insolvent.  The reason for keeping an emergency fund is to maintain liquidity.  Some level of liquidity is important.  That level varies based on many things, but everyone should maintain a level of liquidity that lets them sleep at night.

What about borrowing to invest?  I feel that this is a bad idea, but in fact I'm already doing it, so this one is harder for me to rationalize.  The best reasoning I can come up with is to remain diversified.  Essentially the equity in my home is an investment, (albeit an insoluble and low yielding investment).   Pulling out the equity would drive up my mortgage.  If something happens, like I lose my job in a bad economy, I don't want to be forced to sell my investments, possibly at an inopportune time, to pay my mortgage.

So The choices are:

1. Use investments to pay off the house.
2. Borrow more against the house and invest it.
3. Find some balance between the two and justify it.

In the end, I'm crafting a rule to justify what I'm actually doing.  I'm looking for other opinions on this.  What are you doing, and why?

xocotl

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Re: To pay off, or not to pay off? That is the question.
« Reply #1 on: September 30, 2013, 12:42:15 PM »
My gut says the rule should be something like:

If you can reliably make more from your investment than it costs to borrow money, then invest, otherwise pay down the debt.

Don't forget to factor in taxes when calculating how much you make vs the cost to borrow. They can make a huge difference in deciding whether or not it's worth it to pay off debt. Also it can make a difference in both directions. For example, something like credit card debt which you can't deduct, you want to pay off even if you have a guaranteed investment at the same or a slightly higher rate. With deductible mortgage interest, you can still win by not paying it off even if your investment produces a lower return than your mortgage rate, if for example the investment is producing long term capital gains which are taxed at a lower rate than the income you're deducting against with the mortgage interest. Yay tax arbitrage.

Greenbeard

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Re: To pay off, or not to pay off? That is the question.
« Reply #2 on: September 30, 2013, 01:01:13 PM »

Don't forget to factor in taxes when calculating how much you make vs the cost to borrow. They can make a huge difference in deciding whether or not it's worth it to pay off debt. Also it can make a difference in both directions. For example, something like credit card debt which you can't deduct, you want to pay off even if you have a guaranteed investment at the same or a slightly higher rate. With deductible mortgage interest, you can still win by not paying it off even if your investment produces a lower return than your mortgage rate, if for example the investment is producing long term capital gains which are taxed at a lower rate than the income you're deducting against with the mortgage interest. Yay tax arbitrage.

Great point, tax advantages definitely need to factor in when calculating return on investment vs. cost of borrowing.  It's not a straight comparison of annual percentage rates for sure.  In my case, that would argue for borrowing more against my home and investing it, since I can write off the interest.  At least for the first ten years of a mortgage when the interest portion is high.

My mortgage rate is already low, and the effective rate is reduced further when I take the tax implications into account.

Kazimieras

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Re: To pay off, or not to pay off? That is the question.
« Reply #3 on: September 30, 2013, 01:08:30 PM »
You are missing the risk aspect from your evaluation. Paying off a credit card charging 18% is a guaranteed 18% return, which does not exist anywhere else ;) For a home 3.75% may not seem like a good rate of return (and frankly it isn't), however it is 100% guaranteed that you will have the rate of 3.75%. The closest guaranteed rate of return in an actual investment vehicle is 1-2% in a GIC or savings account (assuming you're under the insured deposit limit).

It sucks to have a large chunk of money tied up in an asset like a house, but it does provide a promised stability. If you have a paid off house your exposure to interest rate risk drops significantly. I would consider myself aggressively conservative. Meaning I take decent returning investments, but I cover my bases in case things go horribly wrong. Having a house paid off means that if you were to lose your job your ongoing costs are very little, affording you more time to find a better one. It may not be an optimal strategy, but it does mean my risk has been diversified and is much less. I saw a lot of people in 2008 make some stupid decisions because they were riding that optimal line too close and and consequentially increased their risk for sudden shocks considerably. So if I were you do #1 or 3. I'd probabily do #1 until I could secure a HELOC (meaning you borrow now at a much lower rate) and then invest with those funds.

Greenbeard

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Re: To pay off, or not to pay off? That is the question.
« Reply #4 on: September 30, 2013, 02:29:54 PM »
You are missing the risk aspect from your evaluation.

Another great point.  This is why I posted this question here.

Risk, so hard to quantify, but so important.  Acceptable level of risk is different for everyone.

For a home 3.75% may not seem like a good rate of return (and frankly it isn't), however it is 100% guaranteed that you will have the rate of 3.75%.

With a credit card or personal loan, I agree you are guaranteed the rate of return.  Perhaps not 100% guaranteed for a mortgage.  As pointed out before, the effective rate is reduced by considering the tax implications (interest write-off).  So it wouldn't be 3.75%, in my case, after considering the tax advantage in the first years of my mortgage, I calculated the effective rate as 2.7%.

Also, in order to recover your 3.75% you must sell the house, an no one is going to guarantee the price you'll get, you could lose money.  There is still some risk.

Your point is important though.  Risk needs to play a role in the decision. 

Devils Advocate

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Re: To pay off, or not to pay off? That is the question.
« Reply #5 on: September 30, 2013, 02:32:51 PM »
Greenbeard
 Whether you sell the home or not you still owe the mortgage. So if you pay the mortgage off it is still risk-free return regardless of whether you sell it or not.
DA
« Last Edit: September 30, 2013, 02:34:51 PM by Devils Advocate »

bschwarz

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Re: To pay off, or not to pay off? That is the question.
« Reply #6 on: October 01, 2013, 12:02:49 PM »
DA--Right you are, though it is still a very complex issue.

Kipp

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Re: To pay off, or not to pay off? That is the question.
« Reply #7 on: October 01, 2013, 12:53:03 PM »
I am debating this myself if it is better to pay off a mortgage faster or invest more.  My terms are not as favorable as Greenbeard, I do not have the mortgage yet and rates are rising.  I was hoping to close at the end of the month, however a government shut-down may delay this (Rural Development Loan).

That being said,  I think many people way over estimate the tax benefit of a mortgage.  You do not get your 15% tax rate, or whatever it is, off all of the interest.  Only however much exceeds your standard deduction.  If you are single, it could be a good portion, but as married I do not estimate it to be very much... about $2000 to 2500 for myself at my marginal rate of 15%, so $300 to $375.  This will decrease every year as the loan is paid off and as the standard deduction increases.  I am basing this on the 2012 tax return, I won't itemized this year because there will maybe be one house payment before year end, so by the time I will be able to itemized, the benefit will probably be even smaller with the standard deduction increasing.

Student loan interest provides a better tax benefit than a mortgage as it is an above the line reduction.  So my wife's student loans with a weighted average rate of 3.91% will effectively be 15% less, so about 3.32% after federal taxes... not to mention my state starts with AGI, so that brings it down further to a 3.16% rate.

Back to the mortgage, with interest rates rising I am expecting that to be at 5% when it closes... so a 5% guaranteed return or extra investments beyond employer matches?

Frankies Girl

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Re: To pay off, or not to pay off? That is the question.
« Reply #8 on: October 01, 2013, 02:31:27 PM »
I've had a mortgage for just over 10 years, and I've only been able to use the interest deduction one time when I was already itemizing due to medical bills.

If you're not in a house that is expensive enough to rack up huge amounts of interest, you can't count the taxable benefits to that deduction - because there will be no deduction most of the time.

I am probably paying off my house soon, but I still waffle on the idea of locking up that money in the equity or having the satisfaction of a paid off house at this point, but even if we do ultimately decide to do so, it's still a small percentage of our total assets. Definitely think it's important to not focus too much on your house as an investment.