Reader Case Study - pay off mortgage early or invest?

[IowaStache]

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[Future Lazy]

My understanding of the "Should I pay off X or invest instead?" question usually comes down to rate of return on debt vs. rate of return on investments.

For example a 16% credit card rate vs. 7% investment earnings is a no brainer - kill that card.

It's a bit more nuanced with a house. For example, the base of paying down your debt early is what you get back in interest you didn't pay (3.5%) plus whatever your increase in property value is. So, putting $1000 extra toward the mortgage when prop values are only going to go up 1% means a 4.5% return... But if property values are going to go up 4%+, you get 7.5%, which is 0.5% better than market average, so...

Simply: (loan rate %) + (% increase in prop value) = Total ROI on extra mortgage payments

Based on that information, do you think that paying off your house will earn you more in the long run than investing?

[wtjbatman]

From reading your post, but not knowing anything else about you, I can guess what the best answer for you is. Pay off that mortgage.

Yes you are going to earn more than 3.5% on your investments, so the math says keep the mortgage and invest your savings. And for a lot of people that's what I would recommend. But you mentioned your wife wants it paid off. And you talk about the peace of mind of having it paid off. You also talk about purchasing a business in the next 4 or 5 years, and wanting to be debt free by then.

I believe more of this whole "living below your means/saving for retirement/FIRE" concept is psychological than some people think. Paying off your mortgage is going to give you the peace of mind that a 7% investment return may not.

[davef]

Tough Question. I am not sure how much help I will be, since I was kind of in the same dilemma a few years ago. The difference was I was at 5.25% at the time on my home. For two years, I dumped every extra cent I had into the house, and paid down my loan from 164k to 72k. Then after a change in employers, I found myself 2,000 miles away. Though I was able to take that first house and rent it out, I found myself wishing I had some of that $$  so I could put 20% down on a new place in Oregon. Within a couple years, I saved that 20% and bought here at 3.125% and have since been investing it all. soo...

Add to your cons section
1. funds invested in principle tightly locked away and inaccessible without home equity line of credit
2. Decreasing tax write off (Home Interest is currently a write-off, as is rental interest, in  a different way)

My advice would be to invest at least 1/2 of it in the market so you don't end up needing cash like I was.
p. s. - My net returns in the market were 12% in 2013 and 7% in 2014

[MDM]

My understanding of the "Should I pay off X or invest instead?" question usually comes down to rate of return on debt vs. rate of return on investments.

Yes, that's the "Math" side OP mentioned.

It's a bit more nuanced with a house. For example, the base of paying down your debt early is what you get back in interest you didn't pay (3.5%)

Yes.  Nuances include tax deductibility of the mortgage interest, etc.

plus whatever your increase in property value is. So, putting $1000 extra toward the mortgage when prop values are only going to go up 1% means a 4.5% return... But if property values are going to go up 4%+, you get 7.5%, which is 0.5% better than market average, so...

Simply: (loan rate %) + (% increase in prop value) = Total ROI on extra mortgage payments

No.  The loan rate % part is ok but, due to leverage, not the prop value part.  For example,
- House purchase price $100K.  $20K down payment.
- Principal starts being paid off.  Meanwhile the house value rises to $150K, and the house is sold for that amount.
- If $5K more principal has been paid, ROI = $50K/$25K = 200%
- If all remaining $80K has been paid, ROI = $50K/$100K = 50%

Of course, leverage works against you if the house price falls.

[Future Lazy]

My understanding of the "Should I pay off X or invest instead?" question usually comes down to rate of return on debt vs. rate of return on investments.

Yes, that's the "Math" side OP mentioned.

It's a bit more nuanced with a house. For example, the base of paying down your debt early is what you get back in interest you didn't pay (3.5%)

Yes.  Nuances include tax deductibility of the mortgage interest, etc.

plus whatever your increase in property value is. So, putting $1000 extra toward the mortgage when prop values are only going to go up 1% means a 4.5% return... But if property values are going to go up 4%+, you get 7.5%, which is 0.5% better than market average, so...

Simply: (loan rate %) + (% increase in prop value) = Total ROI on extra mortgage payments

No.  The loan rate % part is ok but, due to leverage, not the prop value part.  For example,
- House purchase price $100K.  $20K down payment.
- Principal starts being paid off.  Meanwhile the house value rises to $150K, and the house is sold for that amount.
- If $5K more principal has been paid, ROI = $50K/$25K = 200%
- If all remaining $80K has been paid, ROI = $50K/$100K = 50%

Of course, leverage works against you if the house price falls.

So I typed a whole bunch of stuff about how I didn't understand what you meant but then after I was done I realized you're totally right, so thank you MDM for covering my mathematical butt yet again. ;)

Is leverage important to OP? More or less important that peace of mind in paying something off/soothing the DW?

[MDM]

Is leverage important to OP? More or less important that peace of mind in paying something off/soothing the DW?

That's the real question, isn't it?  Only the OP knows for sure....

[rpr]

Do you and your wife have access to 401K's at work? Does your employer offer matching contributions? Are you contributing enough to those to at least get the match?

What is your marginal tax bracket (federal+state)? You can reduce your tax bill significantly by maxing out your 401Ks and IRAs. This can be a hefty chunk of change.

[rpr]

It's not the potential gains, but the huge tax bill you are going to incur. I assume that you are in a taxable bracket of 33%+ with federal and state taxes. I would first max all tax deferred space before prepaying the mortgage.

[rmendpara]

I wouldn't sacrifice all savings to pay it off early, but no harm in putting a bit extra toward the mortgage.

Good advice I've heard is to work backwards. If you want to pay off the mortgage more quickly but also want to build investments, then choose a ratio for extra cash each month to do that. 50/50 seems reasonable, so you are equally contributing to additional mortgage and more investments. I won't argue the "math" of paying down 3.5% vs investing, since the math will almost always (not always) suggest you keep a 3.5% mortgage as long as possible, but that ignores the flexibility/risk reduction/freedom/happiness/whatever from having lower monthly cash outflows.