Author Topic: Make more sense to payoff the mortgage vs. invest? Help appreciated!  (Read 2941 times)

Mrs. Healthywealth

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Hi all,

I've read the threads where it discusses investing is better than paying off the mortgage.  But, my calculations seem to show the opposite, which is why I need some input from all of you. 

We recently purchased a home,$655,000 ($524k remaining, $131k equity) and I'm thinking of changing from a 30 yr (4.375% rate) to a 15yr (2.8-3% rate). My spouse plans to work 8yrs, then go part-time to be hm more with our 2 kids.  In the following, i'm being very conservative and not considering her PT income after the 8yrs.  We would like to FIRE in 2030, at which time I will have 100% medical insurance paid for by my employer and receive about 30% of my pension. Here's the breakdown:

Current income: $185k/yr--my wife just started, so she will have many more raises, but I'm not including that.

Savings (not including equity):
$10k savings acct
$290k invested

Expenses (includes all the extras for a home and a possible extra cost for the kids):
2017-2019 80k
2019-2030 $69k (decrease due to preschool ending)

Plan1:
Invest and not pay extra towards mortgage
2017-2019: invest $76k
2019-2025: invest $86k
2025-2030: invest $18k
Investments in 2030--At 4% nominal return = $1.28 million
Pension in 2030: $29k
Total from retirement income: $80k
Money cushion: 80k (income) - $69k (expenses) = $11k

Plan 2:
Invest and payoff mortgage in 8yrs.
2017-2025 Invest $47k; Extra payment: $29k (it was easier not to add in the extra $10k after 2yrs)
2025-2030: Invest $48k (just me working, investing $18k/yr and mortgage payment now goes
                  towards investing since it is paid off
Investments in 2030--At 4%nominal return - $1.15 million
Pension: $29k
Retirement income: $75k
Money cushion: 75k - $40k - $35k


Looking at this calculation, paying off the mortgage gives way more wiggle room and left over $$.  Perhaps I made a calculation error.  Would appreciate your thoughts and corrections. 

Thank you!
« Last Edit: June 25, 2017, 05:55:05 PM by Mrs. Healthywealth »

Guide2003

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Re: Make more sense to payoff the mortgage vs. invest? Help appreciated!
« Reply #1 on: June 25, 2017, 03:49:36 PM »
I don't quite understand all the numbers you have on there and didn't run how much you'd pay on your mortgage in a year (I assume 69-40=29k?), but if you assume a 4% investment rate of return and a 4.375% mortgage rate, it seems clear to me that you'd want to pay the house off first. I would think it's only better to keep the mortgage if you are able to do better, after taxes, in market returns, and use the loan as an additional hedge against inflation.

Mrs. Healthywealth

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Re: Make more sense to payoff the mortgage vs. invest? Help appreciated!
« Reply #2 on: June 25, 2017, 04:49:18 PM »
I don't quite understand all the numbers you have on there and didn't run how much you'd pay on your mortgage in a year (I assume 69-40=29k?), but if you assume a 4% investment rate of return and a 4.375% mortgage rate, it seems clear to me that you'd want to pay the house off first. I would think it's only better to keep the mortgage if you are able to do better, after taxes, in market returns, and use the loan as an additional hedge against inflation.

Yes, I pay $31k in just the mortgage per year.  I rounded up for all my expenses just to account for other things that may come up.

The 4% is nominal return--what I optimistically expect after taxes, fees, inflation for the next 13yrs.  Even when i boost it to 5% it doesn't make much of a difference, I think that's because of the 13yr timeline.

I just find it odd that paying off the mortgage comes out ahead given that people usually say to invest vs. pay off mortgage. I wanted to check with other folks about my numbers before I make any changes.

Res Ipsa

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Re: Make more sense to payoff the mortgage vs. invest? Help appreciated!
« Reply #3 on: June 25, 2017, 05:52:32 PM »
If you're only assuming a 4% return, it makes sense to dump money into the house.  And I would certainly change to the 15 yr in a heartbeat to save the extra 1%+ on the rate.  But I also think that a 4% investment return projection is too low, by historical standards. Also, you may want to consider the effective rate of your mortgage after your tax deduction (for example, if your marginal tax rate is 20%, for each $100 in interest you pay you get a $20 tax benefit).  Without full information, if I'm in your shoes, I convert to the 15 yr, make minimum payments on that, then dump as much money as I can into investments (tax advantaged or tax deferred to the extent possible). 
« Last Edit: June 25, 2017, 05:55:23 PM by Res Ipsa »

yachi

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Re: Make more sense to payoff the mortgage vs. invest? Help appreciated!
« Reply #4 on: June 25, 2017, 06:12:38 PM »
Your Plan 1 is faulty.  You won't have that mortgage payment forever, and you're not accounting for that.
I do this calculation often to figure out what I should pay off before retiring.  Our assumption is also that we can withdrawal 4% of our invested assets.  When this is your assumption, you always end up with more cushion by paying off any debt that has a payment greater than 4% of the balance.
You pay 31K on a 524K loan, so your loan payment is 5.9% of the balance.  Once you've paid off half of your loan, your payment will be 11.8% of the balance.
If you change your plan 1 to pay off the balance owed on the mortgage the day before you retire, you'll end up with more money.
One more thing, we've got to adjust the mortgage's balance to account for inflation.  The 1.28 million or 1.15 million you'll have at 2030 is in today's dollars (since your 4% rate accounts for inflation), so you can't just subtract the mortgage balance from your amortization schedule for 2030, you have to discount it back to today's dollars using the inflation you'r expecting.

yachi

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Re: Make more sense to payoff the mortgage vs. invest? Help appreciated!
« Reply #5 on: June 25, 2017, 07:03:33 PM »
I ran some calculations assuming an inflation rate of 2%.  At year end 2030 your mortgage balance should be $360,797.14, but inflation makes that $266,989.88 in today's dollars.  I tried to replicate your Plan 1 and Plan 2, but couldn't.
Plan 1: 290k starting, 76k added in 2018 and 2019, 86k added in 2020-2025, 18k added in 2026-2030, 4% returns: $1,437,562 in 2030, subtract $266,989.88 for mortgage payoff: $1,170,572, at 4% withdrawals: $46,823
Plan 2: 290k starting, 47k added in 2018-2025, 48k added in 2026 to 2030, 4% returns: $1,174,758 in 2030, at 4% withdrawals: $46,990

You're basically in the same position either way with these assumptions. 

SwordGuy

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Re: Make more sense to payoff the mortgage vs. invest? Help appreciated!
« Reply #6 on: June 25, 2017, 10:30:10 PM »
Average US stock market performance in today's dollars after subtracting average inflation is about 7%, not 4%.  I suspect you are confusing the "4% rule" with stock market performance.

Stock market performance is how much does my money earn?   That's 7% in today's dollars on average.

The 4% rule measures SWR, the safe withdrawal rate, or how much can I withdraw and not run out of money.

Second, historical average inflation is about 3% in the US.   So, the stock market return is about 10% in inflated dollars.

I mention this because your P&I (principal and interest) on your fixed rate mortgage will not go up with inflation.  It is fixed.   If your income increases with inflation, it's like getting a 3% discount each year on the P&I.   That $3270 P&I payment in 2017 is effectively $2200 in 2030, after the 3% discount compounds for 13 years.   That works out to just shy of an additional $13,000 safety factor in $2030.   

In addition, you have not considered plan 3:

Pay the minimum on your mortgage and invest until you retire in 2030.  Then sell enough stock in a tax-advantaged manner to pay off the mortgage when you retire.  If the market is down big-time when you retire you might have to sell just enough to make payments for 6 months to 3 years until the market recovers enough to pay it off.
A bit more risk but you'll end up with more money than if you pay the mortgage off earlier.




Mrs. Healthywealth

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Re: Make more sense to payoff the mortgage vs. invest? Help appreciated!
« Reply #7 on: June 26, 2017, 09:54:15 AM »
I ran some calculations assuming an inflation rate of 2%.  At year end 2030 your mortgage balance should be $360,797.14, but inflation makes that $266,989.88 in today's dollars.  I tried to replicate your Plan 1 and Plan 2, but couldn't.
Plan 1: 290k starting, 76k added in 2018 and 2019, 86k added in 2020-2025, 18k added in 2026-2030, 4% returns: $1,437,562 in 2030, subtract $266,989.88 for mortgage payoff: $1,170,572, at 4% withdrawals: $46,823
Plan 2: 290k starting, 47k added in 2018-2025, 48k added in 2026 to 2030, 4% returns: $1,174,758 in 2030, at 4% withdrawals: $46,990

You're basically in the same position either way with these assumptions.

Wow! Thank you for breaking it down, very helpful. I was about to ask you what you meant by mortgage inflation, but this helped me conceptualize it.  My wife asked a good question, "how do we take out that much money from our accounts without being hit with a huge tax bill?"...I don't know how to answer that question.

Mrs. Healthywealth

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Re: Make more sense to payoff the mortgage vs. invest? Help appreciated!
« Reply #8 on: June 26, 2017, 10:05:04 AM »
Average US stock market performance in today's dollars after subtracting average inflation is about 7%, not 4%.  I suspect you are confusing the "4% rule" with stock market performance.

Stock market performance is how much does my money earn?   That's 7% in today's dollars on average.

The 4% rule measures SWR, the safe withdrawal rate, or how much can I withdraw and not run out of money.

Second, historical average inflation is about 3% in the US.   So, the stock market return is about 10% in inflated dollars.

I mention this because your P&I (principal and interest) on your fixed rate mortgage will not go up with inflation.  It is fixed.   If your income increases with inflation, it's like getting a 3% discount each year on the P&I.   That $3270 P&I payment in 2017 is effectively $2200 in 2030, after the 3% discount compounds for 13 years.   That works out to just shy of an additional $13,000 safety factor in $2030.   

In addition, you have not considered plan 3:

Pay the minimum on your mortgage and invest until you retire in 2030.  Then sell enough stock in a tax-advantaged manner to pay off the mortgage when you retire.  If the market is down big-time when you retire you might have to sell just enough to make payments for 6 months to 3 years until the market recovers enough to pay it off.
A bit more risk but you'll end up with more money than if you pay the mortgage off earlier.

Thanks Swordguy. I didn't get it confused, I'm just being conservative after reading Bogle predicting the market to be 1-2% nominal return for the next decade. Although trying to find that article, I found his more recent 4% returns article for next decade: http://www.marketwatch.com/story/john-bogle-says-you-wont-make-much-money-from-stocks-2015-11-05.  Hence, why I was using 4%.

But, it's definitely a  gamble.  As mentioned above, how much in taxes would I pay if I saved all the money, and then took it out in 2030 from my accounts??

Also good point, on having to wait it out if the market is down.

MDM

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Re: Make more sense to payoff the mortgage vs. invest? Help appreciated!
« Reply #9 on: June 26, 2017, 04:24:33 PM »
My wife asked a good question, "how do we take out that much money from our accounts without being hit with a huge tax bill?"...I don't know how to answer that question.
It depends on the type of account from which the withdrawals come: Roth, traditional, or taxable.

Reasonable estimates can be made in various ways, e.g., using either the tax software used for your 2016 return or the Calculations tab in the case study spreadsheet.  In other words, do a "what if...?" tax return using your projected numbers.  The tax bill might not be as large as feared.

Mrs. Healthywealth

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Re: Make more sense to payoff the mortgage vs. invest? Help appreciated!
« Reply #10 on: June 26, 2017, 05:21:07 PM »
I would think of this a different way, in that when you pay off your mortgage, what % of your total portfolio would you want in your house? ....  I do think you should work to pay off the house eventually as it reduces your expenses in retirement, but don't think it makes sense to have more than 50% tied up in the house.

Good point, didn't think about it this way. 

Mrs. Healthywealth

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Re: Make more sense to payoff the mortgage vs. invest? Help appreciated!
« Reply #11 on: June 26, 2017, 05:22:44 PM »
My wife asked a good question, "how do we take out that much money from our accounts without being hit with a huge tax bill?"...I don't know how to answer that question.
Reasonable estimates can be made in various ways, e.g., using either the tax software used for your 2016 return or the Calculations tab in the case study spreadsheet.  In other words, do a "what if...?" tax return using your projected numbers.  The tax bill might not be as large as feared.

Just downloaded the worksheet and plan to play around with it. Thank you for this!