Argument against paying down mortgage

[destron]

I have been thinking about mortgage prepayment for a while as the question of whether one should invest or pay down their mortgage often comes up in the forums. Because inflation gradually decreases the value of the money you owe on your mortgage, it is a better idea to put off payment as long as your interest rate is close to inflation.

If inflation averages 3% per year, the effective amount you are paying for your mortgage goes down 3% per year. So if your mortgage is $1200/month in year one, it will be

effective mortgage = starting mortgage * (1.0 - inflation rate)^(#years)

So in 10 years at average 3% inflation it will be 1200 * 0.97^10 = $885

Of course, this same inflationary effect eats away at your 'stache. If MMM has a 4% draw down rate of about $2300/month today he needs $700,000. However, we will actually need more than that to retire because inflation causes the price of our goods to go up. If you project retirement in 7 years, you will need:

$700,000 * (1.0 + inflation)^(#years) = $700,000*(1.03^7) = $860,912

When you average out these two factors, it boils down to whether you can get a higher return than your mortgage rate. Since mortgage rates are so low right now, over the course of a 30 year (or 15 year) mortgage on average you will.

Here is an article I found on the subject that goes into the idea in more detail.

http://www.heracliteanriver.com/?p=478

In short, I believe that if you have a $300,000 home with a $150,000 mortgage, it is, in general, better to have a 'stache of $850,000 and continue to pay down the mortgage at the normal rate than to pay off the mortgage and have a 'stache of $700,000.

[arebelspy]

Yes.

Math wise, if you can earn a better rate than your mortgage, it is better to invest.  This will likely be the case for most, since rates are so cheap.

The only reason to pay it off is emotions (peace of mind, hating debt, etc.).

In short, I believe that if you have a $300,000 home with a $150,000 mortgage, it is, in general, better to have a 'stache of $850,000 and continue to pay down the mortgage at the normal rate than to pay off the mortgage and have a 'stache of $700,000.

I absolutely agree.  Not only will you come out ahead financially, having that money liquid makes you safer, IMO.  (Of course others feel safer having no mortgage payment - I wouldn't want all that "trapped" equity.)

It varies person to person, but you're spot on, the math says if you can earn more than your mortgage interest rate, don't pay it early.

[Tyler]

IMO, it also depends on your timeframe.

On a spreadsheet the mortgage will always come out on top.  But while spreadsheets usually have a fixed average investment return, the real world doesn't work that way and the order of returns matters.  If you had taken out that mortgage in 2000, then 13 years later the choice was pretty much a wash in retrospect (based on a lost decade of stock returns).  But if you're patient enough to wait out 30 years, (or lucky enough to start on a dip in the markets) the odds are definitely on your side that the mortgage will make you more money (especially at current interest rates). 

So IMHO, if your goal is to FIRE in the next few years, you may as well pay off the mortgage ASAP and minimize expenses & risk in the process.  But if your timeframe is closer to 15-30 years, the mortgage makes a lot of sense. 

[arebelspy]

All investment time frames are either "the rest of your life" or "until X kicks in" (social security, pension, etc.)

"Until I FIRE" isn't a valid time frame, IMO, because you'll still need sustainable returns before and after ER.

I'd rather have the money liquid in the bank in ER, generating funds to pay that mortgage bill (and put a few extra bucks in my pocket) than have the money locked up if TSHTF.

YMMV, and like I said, it goes back to the emotional thing.

[destron]

...But while spreadsheets usually have a fixed average investment return, the real world doesn't work that way and the order of returns matters.  If you had taken out that mortgage in 2000, then 13 years later the choice was pretty much a wash in retrospect (based on a lost decade of stock returns).  But if you're patient enough to wait out 30 years, (or lucky enough to start on a dip in the markets) the odds are definitely on your side that the mortgage will make you more money (especially at current interest rates). 

A good observation.  You also have to take into account that you are (presumably) dollar cost averaging your investments, not making a large investment in the beginning. e.g. paying $500/month extra towards your mortgage or into an investment account. This works in your favor during a greatly fluctuating market because the stocks you buy while the market is down appreciate more. Also, buying in 2000 would be a worst case scenario.

It is definitely true that many people would feel more comfortable having the mortgage paid off when they are ready to quit.

[Jamesqf]

I'd rather have the money liquid in the bank in ER, generating funds to pay that mortgage bill (and put a few extra bucks in my pocket) than have the money locked up if TSHTF.

Whereas (all else being equal) I'd rather have the house paid off so that I didn't have to come up with mortgage money every month.  Especially if what hits the fan is another market collapse.  Plus it's a bit of diversification if you already have a significant stash investments: I wouldn't put all my money towards an early payoff, though.

But all else has not been equal, and so far I've only put an occasional few bucks extra on the payment, rounding up to an even $100.  But this year or next will be a decision point, as I'll hit the level where the interest paid plus other itemized deductions will be less than the standard deduction...

[No Name Guy]

It's hardly emotional.  Paying off the house early is in fact a sound, logical, prudent move.   In a military metaphor, a strong secure base to fall back on allows one to strike forth boldly, knowing that all is not lost in the event of misfortune.

Stating investing beats getting out of debt / mortgage assumes that investing will always have the higher after tax rate of return.  As has been demonstrated recently, that isn't always the case.  And as stated earlier - yes, what about the order of returns?  Losing 20% this year means you have to earn 25% the following year, then 10% the year after that to be pretty much equal to someone earning a steady 3% / year over those 3 years.   Wanna wager who sleeps better those 3 years? 

I'd go a step further since risk and reward are (or must be) correlated.  I'd say that a person must include the risk premium in the "investment" side of the ledger to see if that beats paying off the mortgage.  That is, reducing expenditures on mortgage interest provides a GUARANTEED rate of return.  Add to that rate of interest on the mortgage the "must get" risk premium of your proposed investments to get the true earnings you must get to make the investment route the more worthwhile choice.  Example:  (numbers plucked from my ass for illustrative purposes only - use your own numbers for your situation.)  Lets say your mortgage is 3.5%.  Let's say your risk premium for an investment portfolio is 3.5% (e.g. they have to pay you 3.5% extra to get you to accept the possibility that you might lose it all, or the income stream is subject to disruption, or.....you know, how the yield chasers went for those RMBS toxic crap versus the "risk free" Treasuries) your investment return on that portfolio must be equal to 7% to make the two choices a push - the riskier 7% return only "beats" the 3.5% sure thing if you choose to ignore the risks you're taking - in this hypothetical, the two returns are in fact equal on a risk adjusted basis.  Of course, do all calculations "after tax" with your own risk premium, interest rate, etc. 

My financial planner tried this on me (e.g. invest in lieu of paying off the mortgage with the lump sum I'd saved up) and my question was:  What products are out there that will provide a guaranteed after tax rate of return equal to or greater than the rate I'm paying on my mortgage, especially on a risk adjusted basis?  She couldn't come up with anything.  Dividends and interest, capital gains, etc are uncertain, therefore must be higher to compensate for the added risk (that's what they're paying you to accept)- and to beat a dead horse, that risk is very real as we've all seen these last dozen or so years. 

Bottom line:  Factor in the risk premium you must earn in this calculus of paying a mortgage early versus not.   

In addition, carrying that mortgage exposes one to the added risks of another real estate market price collapse, especially if their mortgage is a significant fraction of the current value of the house.  What happens if there is another 30% drop in RE prices and you were at 80% LTV pre new crash?  Yup, you're underwater and are now potentially trapped or having to take cash out of pocket if, for some reason, you must sell.  In a paid off situation - yeah, it sucks ass to lose 30%, but by definition, you'll never be underwater and will never have to show up with cash to sell the house (and gee, chances are if RE crashes, those stocks you sunk your money into are crashing as well - correlation and all, so you might be stuck selling low if you need to bail out of the house). 

As to liquidity while getting to a paid off mortgage:  I used a hybrid strategy to pay off the house that preserved liquidity.  I had a dedicated savings account for the "pay off the house early" funds.  That balance was increasing monthly.  The principal on the house was decreasing each month.  Once those two values equaled, it was lump sum pay off time.  Yes I could have earned or saved more if I'd put that money I was putting into the "pay off the house early" savings account into the mortgage payment each month, but at the cost of liquidity.  I accepted the lesser savings for the sake of total flexibility.  That was the right choice for me.  One could easily do a 50/50 (or other split) on this - put 50% of the funds dedicated to paying off the mortgage early directly to a larger monthly payment and 50% into a dedicated savings type account if having total flexibility isn't as important.

And note:  Now that the mortgage is paid in full, I'm using those freed up funds to increase my rate of savings / investments.

YMMV.  Differing risk tolerances / risk premiums of individuals will result in differing correct choices for said individuals.

[James]

Bottom line:  Factor in the risk premium you must earn in this calculus of paying a mortgage early versus not.   

I absolutely agree with this.  I don't think that it necessarily makes paying the house off early a "sound, logical, prudent move" for everyone, but it is a piece of the puzzle that should be pointed out.


Like you said, individual choices vary, and either can be right, it just depends on knowing all the variables and making the right choice for your situation and preferences.

[destron]

Stating investing beats getting out of debt / mortgage assumes that investing will always have the higher after tax rate of return.  As has been demonstrated recently, that isn't always the case.  And as stated earlier - yes, what about the order of returns?  Losing 20% this year means you have to earn 25% the following year, then 10% the year after that to be pretty much equal to someone earning a steady 3% / year over those 3 years.

This is incorrect, though. It only means that over a long term (for instance 15-30 years) your investments have to beat the rate of return. So, if there is a 20% drop one year, you do not need a 25% return the following year. You need to average better than your mortgage rate over the entire period. What 30 year period of the stock market does worse than 3.5%? Presumably you are not buying your first piece of property before reaching FI.

You also have not addressed the argument that inflation decreases the cost of your unpaid principal over time. $100,000 paid off today is worth a lot more than $100,000 paid off in 10 years. With a 3.5% mortgage rate, you are only paying an effective interest rate of 0.5-1.0%, front-weighted.

That is, reducing expenditures on mortgage interest provides a GUARANTEED rate of return.  Add to that rate of interest on the mortgage the "must get" risk premium of your proposed investments to get the true earnings you must get to make the investment route the more worthwhile choice.

Saving your money in a bank account gives you a guaranteed rate of return as well. However, as MMM says, you are also guaranteed to have less money in the long run.

In addition, carrying that mortgage exposes one to the added risks of another real estate market price collapse, especially if their mortgage is a significant fraction of the current value of the house.  What happens if there is another 30% drop in RE prices...

I only wish there would be another 30% drop in real estate prices ;). Having a low LTV ratio does expose you to this risk, I agree.

As to liquidity while getting to a paid off mortgage:  I used a hybrid strategy to pay off the house that preserved liquidity.  I had a dedicated savings account for the "pay off the house early" funds.  That balance was increasing monthly.  The principal on the house was decreasing each month.  Once those two values equaled, it was lump sum pay off time.

I have to say, this seems to me like the worst of both worlds. By keeping your money in a savings account you are actually losing money to inflation, but I think this strategy may work in a part of the country with very low housing costs. Congratulations on paying off your mortgage, though!

[arebelspy]

Destron, at some point you'll learn you can't really reason with people of the opposite opinion, because they're approaching it from a totally different angle (the emotional instead of mathematical, like I mentioned).

Until you hit that realization, keep fighting the good fight.  FWIW, you're not the only one who sees it, so don't despair.  :)

[Tyler]

Good point, Arebelspy.  Some people will never abandon their faith in future stock market returns even when presented with reasonable mathematical evidence that the economy is dynamic and uncertain.  ; )

Just joshin' with ya.  I agree that we all have different viewpoints and reasonable people in the same situation can come to very different conclusions on the best path forward.  Throw in the fact that nobody lives the exact same life, and there's rarely a simple answer for any question about the future.  In the end, just do what helps you sleep best at night. 

[destron]

Destron, at some point you'll learn you can't really reason with people of the opposite opinion, because they're approaching it from a totally different angle (the emotional instead of mathematical, like I mentioned).

Until you hit that realization, keep fighting the good fight.  FWIW, you're not the only one who sees it, so don't despair.  :)

No! Somebody was wrong on the Internet today and I HAVE TO FIX IT!

[arebelspy]

Good point, Arebelspy.  Some people will never abandon their faith in future stock market returns even when presented with reasonable mathematical evidence that the economy is dynamic and uncertain.  ; )

Hah, well played.

(But when did I say anything about stock market returns?)

On the other hand, I'd argue that if you actually think your returns over your whole ER (30, 40, 50 years) won't beat 3% nominal return (aka about a 0% real return) you'd better keep working for quite awhile.

[Tyler]

On the other hand, I'd argue that if you actually think your returns over your whole ER (30, 40, 50 years) won't beat 3% nominal return (aka about a 0% real return) you'd better keep working for quite awhile.

Very true.  ; )

Full disclosure - I have a 15-year mortgage and while I'm debating paying it off I haven't yet.  I'm still evaluating our risk/return/need/serenity balance sheet for our particular situation, and you're absolutely right that not every factor can be expressed as a number.  So I can see both sides of the issue.

[Emerald]

Heh.  I debate this with myself all the time.  There's something very enticing about actually owning my home, and eliminating my biggest monthly expense, that often overrides the math.   

I've decided to spilt the difference, and pay off the house in 15 years while still saving aggressively.

Now carry on with the debate and try to win me to your side. ;-)

[Tyler]

Here's an interesting article with a good point:

http://www.mint.com/blog/investing/paying-down-your-mortgage-vs-investing-more-112011/

"If your goal is to shoot for the moon in your retirement portfolio by ratcheting up the risk with borrowed money, there’s a cheaper way to do the same thing by maintaining a smaller, but riskier, portfolio: Pay down the mortgage, but own more stocks and fewer bonds. You’ll lower your risk of ending up with negative home equity, save on mortgage interest, and achieve the same level of portfolio risk, with the same expected returns."

Thoughts?

[AdrianM]

You may be interested in reading
http://mortgagesecretpower.com

The concept is about how to put money in your pocket, via stealth taxes and inflation using your home.

Now if only Australia had 30 year fixed mortgages.

[gooki]

My 2 cents.

Doing the easiest thing is better than doing nothing at all.

Many people don't know about index fund investing, and dollar cost averaging, and are generally fearful of investing. In such cases paying down the mortgage is an excellent move, when the alternative is to hold it in cash savings or spend it.

And finally if the alternative to paying of debt was such a sure thing, the banks would be putting 'your' money into the share market instead of lending it out.

[arebelspy]

Many people don't know about index fund investing, and dollar cost averaging, and are generally fearful of investing. In such cases paying down the mortgage is an excellent move, when the alternative is to hold it in cash savings or spend it.

Around here that sort of apologist fatalism gets you a well-deserved punch in the face.  We're MUSTACHIANS, and saying "most people don't know a better way" isn't an excuse!

And finally if the alternative to paying of debt was such a sure thing, the banks would be putting 'your' money into the share market instead of lending it out.

This is a common argument, but wrong.  The banks have incentives to lend out money they way they do, especially with regard to mortgages.  Taken into account, it is principally for those reasons (leverage among them) that they loan the way they do.  And often, they just shovel the loan off on a government entity anyways.

[Mike]

I paid down 1/4 of my mortgage balance in the last 2 1/2 years (4% rate).  Now that I can refi to 2.75%, I think I'm just going to leave it alone for the next 15 years and shovel the money I'm saving via the lower payment into the market for my "young man retirement" fund.  It's really hard to beat a loan that will have a negative interest rate once I account for inflation and the tax write-off.

[unplugged]

Can I ask a quick question, as a old timer....yet newbie if that makes sense?

If we don't pay our house off early, where is the best place to put some money? We have a good size 401k but it would be nice to be able to get the money if we ever needed it for a serious emergency etc..? I believe a roth is like the 401k and I wont have access to it?

My husband is adamant that we pay our house off early. I want to at least bounce some ideas off him of a good alternative outside the 401k and roth?

Gookie, I just now saw your post and I think I am one of those that you are referring to.

[arebelspy]

Can I ask a quick question, as a old timer....yet newbie if that makes sense?

If we don't pay our house off early, where is the best place to put some money? We have a good size 401k but it would be nice to be able to get the money if we ever needed it for a serious emergency etc..? I believe a roth is like the 401k and I wont have access to it?

My husband is adamant that we pay our house off early. I want to at least bounce some ideas off him of a good alternative outside the 401k and roth?

You should start a new post.  There's about 8 things wrapped up in there. For example, Roth principal is accessible any time for any reason, but you just can't put it back once you take it out. So if you had money in a Roth, it takes a few more days to get than a checking account, but other than that is just as usable for an emergency.

And if you're asking where to put funds, you'll first need to develop a target asset allocation (AA) in line with your goals, risk tolerance, etc.

The advice to invest instead of pay off the mortgage doesn't mean start some brand new investment you wouldn't otherwise.  That's asking for trouble.  It means keep more funds in your (already
planned) investments. Extra savings goes towards boosting that portfolio, not towards mortgage payments.

Like I said, you'd be best served starting a new post with specific questions that aren't "where do I invest money?" :)

EDIT: Saw your note added about gooki's post.  Yes, you and your husband definitely should take some time to educate yourself.  Even if you decide the best thing for you is to pay off the mortgage ASAP, either way you need to have an investment plan and target AA.

[unplugged]

Thanks so much. I have tried to study this but am still lost. Let me dig around some more.

I do think this is more common that some realize. I mean the 401k is a no brainer. I mean you just walk into the payroll department and boom your done. Paying off a house is a no brainer. You just sent in some money and label it accordingly and you never actually left your house LOL. But researching to see how the other half do it is so confusing. Thanks again.

[destron]

Now if only Australia had 30 year fixed mortgages.

On the flip side, because we have such a low mortgage interest rate, 30 year fixed and the mortgage interest deduction, it inflates the cost of housing. In the end, we end up paying the same because, for most people, the cost of a house is related to their monthly payment on the mortgage, not how much they pay overall.

[Nords]

In short, I believe that if you have a $300,000 home with a $150,000 mortgage, it is, in general, better to have a 'stache of $850,000 and continue to pay down the mortgage at the normal rate than to pay off the mortgage and have a 'stache of $700,000.

I've been around this debate for nearly a decade.  I agree with both the rational Vulcan-logic approach (get a 400-year mortgage) as well as the emotional investor behavioral psychology approach (sleep better at night through less risk).  If your risk tolerance is such that you're not likely to follow through on 30 years of mortgage payments then you should absolutely pay it off early.  Otherwise you're just wasting your money on interest & closing costs.

Those who claim the superiority of either approach are missing the point:  different tactics for different people.  There's more than one way to FI, and different people will tolerate different levels of risk.  Asking someone to exceed their risk tolerance is begging for failure, no matter how compelling the math or logic.  Emotions triumph over math & logic every time, and I doubt that can be changed.  If it could then everyone would be eat healthy, exercise, and be happy-- and a whole bunch of behavioral psychologists would be unemployed.

However this thread can add a few analysis aspects.

First, if you're going to leverage up with a mortgage, then it makes no sense to have anything else in your investment portfolio which yields less (after tax) than the mortgage (after tax) interest.  For most investors this means getting rid of short-term bonds, TIPS, I bonds, and all sorts of CDs.  It's probably best to maintain a portfolio with no bonds and only 1-2 years of cash to cover expenses during a bear market.  Good luck with that, but if you think having a mortgage is a good idea then you also probably think that you're ready to tolerate the enhanced volatility of the rest of your portfolio.  Very few people have the brass-plated cojones for this.  By the way that brass plating wears mighty thin after 30 years or by the second recession, whichever comes first.

Second, run both scenarios (mortgage vs no mortgage) through FIRECalc or a Monte Carlo calculator.  (Let's not get distracted by calculator weaknesses/flaws.  I know they suck, but that's beside the point.)  See how your failure rates change.  A larger portfolio (with a mortgage payment) may be more survivable than a smaller portfolio (without a mortgage payment).  It depends on how badly the portfolio gets hammered by that series-of-returns issue, the size of the portfolio, and the size of the mortgage balance.  The calculator flaws may cancel each other out through their relative results, but I haven't done the research to verify that.

Third, I think that people with reliable inflation-adjusted annuity income should absolutely have a mortgage.  Even people with fixed annuities may benefit from having a mortgage.  If you're confident that you'll have money coming in each month then you can cover your mortgage payment no matter how much the sequence of returns sucks.  By "reliable", I mean military retirees.  (Municipality civil-service retirees and retired airline pilots... not so much.)  Of course I'd also recommend against scampering out to get an inflation-adjusted annuity just so that you can get a mortgage next.  That works against you with expenses & fees.  But military retirees already have their COLA'd pension for other reasons, so they might as well exploit it.

Fourth, don't count on the tax deduction unless you itemize other deductions as well (like huge medical expenses or charitable contributions).  Even with a jumbo mortgage, about 20 years into the 30-year term the annual interest payment drops below most itemized deduction thresholds. 

Fifth, here's a thread that I've been running for over eight years on the subject, including reactions to the 2008-09 bear market:
http://www.early-retirement.org/forums/f28/covering-a-mortgage-without-losing-your-ass-ets-15237.html
I update it every six months or so. 

Having said all of that, spouse and I have 30-year fixed mortgages on both our home (3.625%) and our rental property (4.625%).  Our investment portfolio has no bonds and over 85% equities.  (We're slowly spending down our cash to get it back up to ~92% equities.)  Our FIRECalc success ratio is 67% just on the mortgage arbitrage alone, which of course implies that the failure rate is 33%.  Our mortgages are over 15% of the size of our portfolio, though, so our total portfolio's survival rate climbs by a few percentage points from 95% to 99%.  The mortgage payments (P&I) amount to over two-thirds of my military pension, so I still have money left over for groceries & utilities.  We handily beat the itemized deduction threshold because Hawaii real estate is expensive and they're honkin' big mortgages. 

Even at a 30-year fixed mortgage interest rate of 5.375% (the original rate) we're currently "winning".  At our latest mortgage's interest rate of 3.625% we're just running up the score.  However during the Great Recession we were testing our emotional tolerance for sequence-of-returns volatility.  It was not much fun.

When we first took out the rental mortgage in late 2001, we put all of the money into Berkshire Hathaway "B" shares because I felt that they were undervalued.  It worked out so well that I doubt I'll ever duplicate its success in my lifetime.  (We put our residence mortgage money into the iShares S&P600 small-cap value ETF (IJS)).  We've kept restarting the mortgage clock with each refinance, so today's mortgages will be paid off in 2040-- when I'm 80 years old.

[Tyler]

I think my strategy for all finance discussions from now on is to hold out for a Nords post.

That was extremely informative.  Thanks for typing that up.

[Spork]

I'd like to suggest there is still another good reason to have a paid off house.  For me this is a big one: it keeps you realistic.

Let me tell you a story to illustrate my point.

Let's say you are building a house from scratch.  You are outfitting your kitchen and you've narrowed your choices down to your dream choice and a realistic compromise choice.

The compromise is a laminate countertop.  It's handsome.  It will probably last 30 years.  It costs around $500 installed.  The dream choice is... is... breathtaking.  It is a fine piece of stone... a single monolith... that was mined from the depths of Mount Doom by Gimli the Dwarf.  The finish has been honed 100 times with finer and finer hones until it has a mirror finish.  Every 6 inches it has been inlaid with blood diamonds mined illegally in South Africa.  It is indescribable in it's beauty.  It costs $5000, which is a bargain for this treasure of the earth.

The difference here is initially $4500.  If you're paying out of pocket, that's $4500 of extra sweat coming from YOUR BANK ACCOUNT.  It hurts.

If you are financing, that $4500 is going to cost you about $7500.  (This is assuming a 30 year mortgage at 3.7%).  The price has almost doubled.  But... you'll rationalize it.  Your builder will plug it into a calculator and tell you "that's only $20 a month."  You can TOTALLY handle $20 a month!

But the bad news here is that this choice happens for every appliance, every faucet, every bit of trim, the 3 car garage, the roofing materials and on and on and on.

When you are done, you have spent quite a bit more... and you're paying more in property taxes, more to heat and cool a bigger house, more to maintain a bigger space, more to insure it, more, more, more.

If you are buying/building a house with the idea of paying it off (or in my extreme example, with the idea of paying cash for it up front), you are going to be much more careful with your money and much more grounded to reality.  You're going to make decisions that you painfully think about.  When you finance it, you are often put in the "car buying" seat where the dealer pushes numbers around and talks to you in "how much this costs per month." 

It's not just emotional vs. math.  When you look at it as real money, you spend less.

[arebelspy]

That was extremely informative.  Thanks for typing that up.

Agreed, great post Nords.

That was extremely informative.  Thanks for typing that up.

More of that type of analysis can be found at the early-retirement.org forums.  They're older, on average, than we are (I'd guess the average age closer to mid-late 50s), which means a lot more wisdom.

A few more trolls than here, but years of great advice and thoughts.  The experiences of people who have already been ER'd for a decade+ and seen market crashes while ER'd is quite valuable.

I enjoy these forums more just because I relate to the posters more, but when I started learning about ER a few years ago, I learned quite a bit more over there.

And, of course, Nords' blog is worth subscribing to: http://the-military-guide.com/

[arebelspy]

Let me tell you a story to illustrate my point.

Sorry, but I think that's a terrible analogy.

Most of us will never build a home from scratch.

We purchase a home that fits our needs, maybe remodel a bit. The practical question becomes: I have a surplus of funds. Do I pay down/off the mortgage on this house, or do I invest those funds?

Some theoretical idea of if you were building a house you might choose a different counter top has absolutely zero bearing on this question of pay off existing mortgage or invest.

YMMV, but I just can't see it.

[Spork]

Sorry, but I think that's a terrible analogy.

The exact same thing happens with pre-owned homes.  You have houses that offer more amenities vs fewer, bigger vs smaller... it's the same.

Most of us will never build a home from scratch.

We purchase a home that fits our needs, maybe remodel a bit.

...but many of us do.  And it's extremely easy to get lost in "what fits our needs" when you look at things as "that's just $100 a month".  I cannot tell you the number of times I hear that exact rationalization.  When you're spending real money up front -- you buy less.

[unplugged]

Spork, I think you may be on to something about seeing "real money". I am very bothered by my payoff amount (interest) on our house. My husband even more so. For us, seeing what the numbers look like say by paying it off in 7, is very real. It feels like a way to be on control of our money to some degree. We also remember how cheap our starter home was in the 90's and how it would have been paid off years ago by now. The homes in that neighborhood are falling apart now and covered in mold so I'm glad we moved. But the idea of a paid off house back in our 30's is very real and appealing.

[arebelspy]

Spork, I think you may be on to something about seeing "real money". I am very bothered by my payoff amount (interest) on our house. My husband even more so. For us, seeing what the numbers look like say by paying it off in 7, is very real. It feels like a way to be on control of our money to some degree. We also remember how cheap our starter home was in the 90's and how it would have been paid off years ago by now. The homes in that neighborhood are falling apart now and covered in mold so I'm glad we moved. But the idea of a paid off house back in our 30's is very real and appealing.

Would you rather have a 200k paid off house, or a 200k house with a 100k mortgage and 400k cash in the bank?

It's appealing, but when you look at the big picture of having even more money sitting in the bank that you could easily pay it off, but choose not to, well, that's even more appealing to me.  YMMV.

[Spork]

Would you rather have a 200k paid off house, or a 200k house with a 100k mortgage and 400k cash in the bank?

It's appealing, but when you look at the big picture of having even more money sitting in the bank that you could easily pay it off, but choose not to, well, that's even more appealing to me.  YMMV.

While that is a valid argument.... my point is (to use your example):

Would you rather have a 200k house with a 100k mortgage and 400k cash in the bank or $100k house with no mortgage and $100k in the bank?

It's a different question entirely.

[arebelspy]

The former.

[Another Reader]

No contest.  Who cares about the $100k mortgage if you have $400k in the bank?

I levered up my primary in 2009, added in some other money, and bought four rentals for "cash."  The houses are up 50 percent since I bought them and the cash on cash yield is more than acceptable.  I recently refi'd my primary at 3.125 percent.  That's really refinancing the rentals, except there are no loans directly attached to them.

Leverage is a financial tool.  It carries risk.  However, if you understand how leverage works and are comfortable taking a little risk, it can be very profitable.

[Nords]

Agreed, great post Nords.
And, of course, Nords' blog is worth subscribing to: http://the-military-guide.com/

Thanks!  Most of that came from authors of two other ER books, and a couple of additional engineering/sales guys who ER'd from the tech industry. 

One of the advantages of blogging is that I only have to write the response once, and then I can just keep linking to it.

They're older, on average, than we are (I'd guess the average age closer to mid-late 50s), which means a lot more wisdom.

Heh.  Or at least more experience...

The compromise is a laminate countertop.  It's handsome.  It will probably last 30 years.  It costs around $500 installed.  The dream choice is... is... breathtaking.  It is a fine piece of stone... a single monolith... that was mined from the depths of Mount Doom by Gimli the Dwarf.  The finish has been honed 100 times with finer and finer hones until it has a mirror finish.  Every 6 inches it has been inlaid with blood diamonds mined illegally in South Africa.  It is indescribable in it's beauty.  It costs $5000, which is a bargain for this treasure of the earth.
The difference here is initially $4500.  If you're paying out of pocket, that's $4500 of extra sweat coming from YOUR BANK ACCOUNT.  It hurts.
If you are financing, that $4500 is going to cost you about $7500.  (This is assuming a 30 year mortgage at 3.7%).  The price has almost doubled.  But... you'll rationalize it.  Your builder will plug it into a calculator and tell you "that's only $20 a month."  You can TOTALLY handle $20 a month!
But the bad news here is that this choice happens for every appliance, every faucet, every bit of trim, the 3 car garage, the roofing materials and on and on and on.
When you are done, you have spent quite a bit more... and you're paying more in property taxes, more to heat and cool a bigger house, more to maintain a bigger space, more to insure it, more, more, more.
It's not just emotional vs. math.  When you look at it as real money, you spend less.

You've described the materials that went into our familyroom renovation.  My spouse still can't bear to look at the numbers, but we made very cost-effective decisions.

In our case we spent more for quality, efficiency, and longevity.  An alternative view of the countertop-selection process is "Might as well...":
"... while we have the labor here.  It'll cost a mint to get these guys back, if they're even available!"
"... if we don't have to do this again for 30 years!"
"... because that's never gonna pass code the way it is."
"... and I wish we hadn't opened up that wall in the first place, but let's fix it right this time."
"... because we're doing all the priming and painting, and that'll save a couple thousand bucks."

It's no worse than resisting the pressure to be upsold at a car dealer, or shopping for a home with a realtor.  In our case the decisions we made on insulation, windows, and roofing materials raised the cost quite a bit-- but our house is cooler & quieter than ever.  Our utility bills are lower.  The new room isn't falling apart, so the maintenance is less.  I have rack space for plenty more photovoltaic panels.  And frankly the equity gain is at least as much as the cost of the project-- even more when we factor in the sweat equity.  The property taxes only reflected the initial estimate, not the final result, so no worries there either.  And for some reason our insurance rates didn't even go up, perhaps because this room is more hurricane-ready than the rest of the house. 

I understand that people can lose their ever-lovin' minds during the process, and we're watching more than a few of our neighbors do that too, but it's no worse than the usual consumerism problem taken to six-figure extremes.

[Spork]

The former.

That's a valid choice.  It comes with higher monthly expenses -- beyond the mortgage payment.  It's a trade off. 

...and the latter scales up (as does the former, I know).  This could just as well be "a $250k house with no mortgage and $750k in the bank."

[strider3700]

This argument is missing a major factor in my decision.  I'm not sure how things are in the rest of the world  but in canada you don't get 25 or 30 year fixed mortgages like in the US.  Instead you get 25 or 30 year terms with the mortgage being renewed every so often,  the most common being every 5 years.    my 5 year rate is 3.69%  when I need to renew it in 1 year I'm hoping it will be closer to todays rates of roughly 3.25% but there is no guarantee.  I hear 10 year's are available in the 3.7% range right now but most banks don't even offer them.    I still have 26 years left on the mortgage so I realistically have to renew either 5 or 3 more times depending on what I go for.       The potential to be paying a much higher, ie closer to the historical average,  interest rate really makes the payoff vs the invest and keep the mortgage calculation a lot harder.

If I had a locked in until I own the house 3.5% mortgage I'd probably just keep the mortgage unless the payment was high enough I'd be worried about job loss or something.  As it is I have to worry about the payments in 1 years time  which I'm expecting to be close to current and then the the rates in 6 years which i seriously doubt will be as low as current.       My current strategy is to put as much extra income into my TFSA invested in the markets with the goal of building that up to the point that I can cover the house.   Should interest rates double or triple in 6 years the goal is to have enough to just pay the house off at that point.    Due to the unknowns about market returns as well as interest rates coupled with questionable job security paying the house off is a priority even if it may not make the most sense money wise.       

Making extra payments however makes no sense to me.  If I take my $202k mortgage and pay it down to $30k then lose my job and have no savings I'll still lose the house... that extra $170k in the bank is a very very big cushion.

[No Name Guy]

Would you rather have a 200k paid off house, or a 200k house with a 100k mortgage and 400k cash in the bank?

It's appealing, but when you look at the big picture of having even more money sitting in the bank that you could easily pay it off, but choose not to, well, that's even more appealing to me.  YMMV.

Let's do the math on this: 

Case 1:  200k net worth.
Case 2:  +200k house.  -100k debt. +400k cash.  Total Net Worth:  500k.

Apples and oranges there Areb.  You imply I can't do math, yet you can't even do a straight comparison to make your point.  Why do you assume the person with the paid off home has a lower net worth?

Let's rework case 1 to be more realistic:

Case 1, Apples to Apples:  200k house, free and clear.  300k cash.  Total Net Worth:  500k, same as your levered person.

Checking Cash Flow on the cash + house + mortgage:
Case 1 Apples to Apples:  -3k year property tax, -4k/ year long term maintenance (1% / year).  Income from 300k @ 3% = +9k.  Net +2k year cash flow.

Case 2 Apples to Apples:  -3k year, property tax, -4k / year long term maintenance (1% / year).  Income from 400k @ 3% = +12k.  Principal and Interest Payment on 100k (3.125%, 30 year, fully amortizing using Excel PMT function) = 5.1k / year (428.38 / month).  So, -3k - 4k + 12k - 5.1k = -0.1k / year.

Let's check resilience of those two cases:  Hmmmm....apples to apples case 1 can take a 23% hit to their portfolio and still be only cash flow neutral.  Case 2 is cash flow negative from day one.  Shave 23% off their portfolio and they're almost 2.8k / year in the hole.

[arebelspy]

Why do you assume the person with the paid off home has a lower net worth?

Because that's what we're discussing: investing instead of paying down the mortgage in order to grow your money more, which leads to a higher net worth.

Do you honestly, genuinely believe that if someone has 200k liquid right now, and a 200k mortgage at 3.5%, and they can pay off the mortgage, or invest the money, that in 30 years from today they'll have an equal or higher net worth than if they had invested it?

If so, then you're saying that said investment will earn 3.5% (nominal) over the next 30 years (about a 0% real return).  Meaning they shouldn't ER unless they have about a 1% SWR.  Since most people assume a 3-4% SWR, they're assuming real returns above inflation, which means they have a built in assumption to their ER plan that investing will beat paying off the mortgage.

I can understand arguments about peace of mind, etc. for having a house paid off.  But if you're arguing that 30 years from now someone that pays off the 3.5% mortgage will have an equal or higher net worth than someone who invests it, we're all in a lot of trouble.

[Jamesqf]

Those who claim the superiority of either approach are missing the point:  different tactics for different people. 

And different tactics for the same person at different times.  For instance - not to claim I'm a financial guru, you understand - from about '05 until the market crash in '08, I was putting a bit extra into the mortgage every month, because I thought the market was about ready to top out.  After the crash, I went back to making the basic payment, and put all my extra cash into mutual funds - the old "buy low" principle.  Now it's getting to where I may start paying off a bit more of the mortgage every month.

I also agree about the source of income.  If I'm working, and so pretty sure I'll have enough coming in each month to cover a mortgage payment, that's different than if I'm living off investments, and so have to sell stocks at a low to cover.

[tooqk4u22]

Here is the real math (obviously assumptions matter and can change)

Mortgage:    $200k
Term:            30 years
Rate:            3.50%
PMT:             $898

Here is the present value (3% inflation) of the diffence between the two  at different returns
3.0%       -11k
5.0%         61k
7.0%         208k
9.0%         488k
11.0%       1,002k

The math wins for keeping the mortgage but the most meaningful part of ones decision is to determine an expected rate of return - for most that are either FIRE or near FIRE the returns will likely be on the lower range due to risk management and AA - people with pensions excluded (Nords) as they have the equivalent of a bond to balance it out.

Emotion plays a huge role as it is not risk free so for some people even the 7% expectation may not be enough to justify keeping the mortgage and for others it may be a no brainer.

Sequencing matters too as if the markets fall or rise 20% in the first year then 7% after the gap declines to $83k or rises to $333k - either way mortgage still wins.

[dragoncar]

Another advantage for those with non-recourse loans -- in the event of some uninsured disaster, your exposure is limited to the equity you have invested (so it behooves you to keep it low).

[destron]

Meaning they shouldn't ER unless they have about a 1% SWR.  Since most people assume a 3-4% SWR, they're assuming real returns above inflation, which means they have a built in assumption to their ER plan that investing will beat paying off the mortgage.

I can understand arguments about peace of mind, etc. for having a house paid off.  But if you're arguing that 30 years from now someone that pays off the 3.5% mortgage will have an equal or higher net worth than someone who invests it, we're all in a lot of trouble.

This is really the crux of the issue. If you don't believe that you can beat 3.5% in the market over 30 years, you don't believe that early retirement is possible.

[dragoncar]

Related, but who here thinks I should get a one-year zero-interest cash advance on my credit card to invest in the stock market?  It will cost me a 3% fee, so the APR is really 3%.

Edit: Assume repayment isn't an issue, even if the market dips severely.

Here's another conundrum:  I have some i-bonds paying around 2.8%.  Should I sell these and invest in the stock market?

I'm really struggling with my cash % AA right now, as you can tell.

[arebelspy]

Related, but who here thinks I should get a one-year zero-interest cash advance on my credit card to invest in the stock market?  It will cost me a 3% fee, so the APR is really 3%.

Edit: Assume repayment isn't an issue, even if the market dips severely.

That's a short timeframe, and a question like this distracts from the actual issue and confuses people who don't understand, because they go "yeah! I wouldn't do that, so I should pay off my mortgage!" which isn't the case, unless your mortgage is due in a year.

We're arguing that the market will beat that rate over the next 30 years.  THAT is the crux of the question.  If the credit card transfer was 0%, 3% transfer fee, payable at the same (0%) rate for the next 30 years, that's comparable.

As far as it being due a year from now, if repayment isn't a problem, and you want to do that, it's basically like investing on margin, and again, depends on your risk tolerance level.

Here's another conundrum:  I have some i-bonds paying around 2.8%.  Should I sell these and invest in the stock market?

I'm really struggling with my cash % AA right now, as you can tell.

I'm of the opinion most Mustachians in the accumulation phase should be at a minimum of 80% stocks, up to potentially 100%.  If you have a mortgage, as Nords points out, you shouldn't have stuff returning less than that.  If you do have one, you can consider that as part of your portfolio, and investing in it is like investing in a bond that pays the same rate as your mortgage.

For you, if you have a mortgage that is more than 2.8%, you absolutely shouldn't have I-bonds paying less than your mortgage, then you're just losing money.

Why do you need a cash % right now?  Are you worried about deflation?  Are you saving for something? (In which case it's not really a part of your portfolio.)

There are basic AA questions you need to answer in order to figure out the answers to your quoted questions.

[arebelspy]

Here's another fun way to think about it, that ignores market returns and just focuses on your mortgage versus inflation.

If, over the long run, you think inflation will be lower than your mortgage, then the effective interest rate you're paying in real dollars is your mortgage rate minus inflation. (So, for example, if you have a 3.5% rate and you think inflation will be 3%, the cost of money to you is 0.5% - inflation covers the other 3%, and you just have to pay the principal and 0.5% interest.)

If you think inflation will match your mortgage rate, then your interest rate in real dollars is 0%.  (In essence, inflation pays for all of the interest, and you just pay principal.)

On the other hand, if you think inflation will be higher than your mortgage rate, you are getting paid to borrow the money.  By holding a mortgage instead of paying it off you are getting PAID to do so. (This is ignoring market returns you can get on the money.)

That may help those people that are getting rid of their mortgage because they hate paying interest - in actuality, you are getting paid to hold that mortgage, if inflation is higher than your mortgage rate.

That, to me, is sexy financing, and one of the best hedges against inflation an early retiree can have!

[Tyler]

Thinking from the other side -- how much money is "enough" when you feel comfortable to stop investing on leverage (with your mortgage or otherwise)?  25x expenses?  33x?  1000x?  Is maximizing returns (even if you no longer need them) an inherently virtuous activity? 

For me, I look forward to the time after the accumulation phase.

[arebelspy]

I notice you removed the edit of your post. Reread my post and decided you didn't like it quite as much as the first time?  ;)  There are so many ways to slice it, it really does help to look at it in a few different ways to sort of wrap your brain around all the angles.

EDIT: Looks like you've edited it like 4-5 times now.  I meant the first edit, regarding my previous post before this.  Wording can be so tricky, huh?  :P

For me, I look forward to the time after the accumulation phase.

Absolutely. Less risk, more security.

However that, to me, means looking at the overall picture.  I feel more secure with a mortgage, due to the liquidity issues, inflation hedge, etc.

Just like I'd feel more secure with 80% stocks than 20% stocks.  More volatility, but more chance my portfolio survives.

Because to me, security means not having ER fail financially.  It doesn't mean my portfolio can't drop 50% overnight.  I'm okay with that.  I'm not okay with inflation eating away at my purchasing power for 40 years.  I'm not okay with running out of money.  Etc.  So with those "security" requirements in mind, my portfolio will look much different than someone who can't stomach volititlity and the swings of the market, and "safety" to them is bonds and CDs and an overly large portfolio that starts out with such a tiny SWR that grows large as inflation eats at them, but they don't have to worry about the principal dropping.

So not only will the accumulation phase look different, but final ER portfolios will as well.

Isn't this fun?!  :)

[arebelspy]

Thinking from the other side -- how much money is "enough" when you feel comfortable to stop investing on leverage (with your mortgage or otherwise)?  25x expenses?  33x?  1000x?  Is maximizing returns (even if you no longer need them) an inherently virtuous activity? 

I think this is a fairly interesting question, but probably off topic of the "pay down mortgage or not" theme of this thread, so I'm refraining from answering due to that.  But please feel free to start a new thread with the question (and maybe your thoughts)!