Pay Off Mortgage or Invest?

[oldtoyota]

This is an excellent article discussing the above question. Before I read this article, I thought I might want to focus on paying down the mortgage. After reading this article, I see that real estate is a hedge on inflation and so it probably makes sense for me to invest given the low interest rates on mortgages.

http://financialmentor.com/financial-advice/pay-off-mortgage-early-or-invest/7478

For me, I have no debt beyond the house. College tuition savings is good for the kidlet. So, my two choices remain: pay mortgage or invest.

If you have non-house debt, then your priority should likely be different.

To clarify, I decided to do a bit of both. I'm going to put a few hundred dollars more toward the mortgage and then a whole lot toward investments. Putting the $$ toward the mortgage is a bit irrational, methinks, yet it makes me feel better to do that.

[gooki]

Or if you are spendthrift, and incapable of saving/investing, then increasing ones mortgage repayment is a good way to lock some of your money away from your spendy self.

[arebelspy]

Or if you are spendthrift, and incapable of saving/investing, then increasing ones mortgage repayment is a good way to lock some of your money away from your spendy self.

Sure, fine, but a Mustachian looking to FIRE who has a low rate (say, sub 4%) long term fixed loan ought not pay it early under almost any circumstance, but should invest the money.

/see millions of other times this discussion has happened for the math and logical reasons.  the only argument mortgage paydown has in the above circumstance is emotion. debt free "feels good" for some, and that emotion is worth giving up more money in their pocket.

[oldtoyota]

Or if you are spendthrift, and incapable of saving/investing, then increasing ones mortgage repayment is a good way to lock some of your money away from your spendy self.

Sure, fine, but a Mustachian looking to FIRE who has a low rate (say, sub 4%) long term fixed loan ought not pay it early under almost any circumstance, but should invest the money.

/see millions of other times this discussion has happened for the math and logical reasons.  the only argument mortgage paydown has in the above circumstance is emotion. debt free "feels good" for some, and that emotion is worth giving up more money in their pocket.

Yep. Exactly. =-)

[Joel]

I would pay to the mortgage until pmi is eliminated.

[aj_yooper]

The returns on eliminating PMI are very high and they get higher the closer you get to eliminating them. 

[oldtoyota]

I would pay to the mortgage until pmi is eliminated.

I avoided PMI completely.

[Joel]

I would pay to the mortgage until pmi is eliminated.

I avoided PMI completely.

And once that is done, invest any excess!

[Leisured]

The only way is to prepare two scenarios: pay off mortgage; or rent accommodaton and borrow the same money for a house but put into mutual funds, taking into account in both scenarios the tax position and interest rate. Like Gooki, I live in a country where there are no tax deductions on interest payment on a mortgage for your own house (but interest is tax deductible for an investment property), and where interest rates are higher than in the US. Horses for courses.

Pardon my ignorance, but what is PMI?

[matchewed]

Private Mortgage Insurance - Is the bank or lender unsure if you're able to pay the loan you've taken out for a house? The answer is make them pay more until they have a certain level of equity built. Now that they have skin in the game they'll be more willing to keep paying.

[aj_yooper]

This is an excellent article discussion the above question. Before I read this article, I thought I might want to focus on paying down the mortgage. After reading this article, I see that real estate is a hedge on inflation and so it probably makes sense for me to invest given the low interest rates.

http://financialmentor.com/financial-advice/pay-off-mortgage-early-or-invest/7478

To clarify, I decided to do a bit of both. I'm going to put a few hundred dollars more toward the mortgage and then a whole lot toward investments. Putting the $$ toward the mortgage is a bit irrational, methinks, yet it makes me feel better to do that.

Oldtoyota,

That is an excellent discussion of home mortgage debt.  Thank you. 

Since most people do not stay in their homes for the term of the mortgage, I am with you on prepaying to eliminate interest expense so that when the property is sold, you have more principal paid down and thus more capital.  It's a very easy to do savings plan.  I don't think that is irrational to pay way less interest right away (on the first year over 200% of the prepayment principal).

I am reading William Bernstein's The Investors Manifesto; he states (p 37) that you should "never, ever pay more than 15 years fair rental value for any residence", and he prefers to buy at 150 times rental rate.  He goes on to say that imputed rent (the rental value of the residence on a paid for property) at that price  "is about what you might expect from a mixed portfolio of stocks and bonds.  (Imputed rent does have one real advantage over the return from stocks and bonds, which is that it is tax free)."  I like the tax free part. 

For me, in a high mortgage interest rate time, prepaying is essential; now, in a low interest rate time (I used 4%), each monthly prepayment through year 13 on the amortization schedule saves between a multiple of 200% to 100% of the interest charged for that period (it declines by each year on the amortization schedule).  That is a rich vein to mine!  It is not obvious that investing in the market versus prepaying mortgages is a better bet as we all have to pay taxes and we certainly pay mortgage interest.  If we sell before the mortgage term, it is even sweeter.

[sherr]

For me, in a high mortgage interest rate time, prepaying is essential; now, in a low interest rate time (I used 4%), each monthly prepayment through year 13 on the amortization schedule saves between a multiple of 200% to 100% of the interest charged for that period (it declines by each year on the amortization schedule).  That is a rich vein to mine!  It is not obvious that investing in the market versus prepaying mortgages is a better bet as we all have to pay taxes and we certainly pay mortgage interest.  If we sell before the mortgage term, it is even sweeter.

This is a technically true but for all intents and purposes incorrect way to look at the value of mortgage repayment. Hidden in your 200-100% return-due-to-lower-interest is the fact that that savings is spread out over many years - however many years are left on your mortgage at the time. A 200% return may sound good, but if it's spread out over 30 years that's about a 2.34% /year interest rate. You would probably have been much better off investing in the stock market, even if you have to pay taxes on the money earned.

The only thing that really matters is your mortgage interest rate. Repayment is very valuable if you have a high mortgage interest rate, not very valuable if you have a low mortgage interest rate.

[oldtoyota]

Another thing to consider--and I had not, embarrassingly enough before reading the article above--is that the money saved by pre-paying will be worth less when the mortgage is done. One has to take inflation into account when considering future "savings" by pre-paying.

OTOH, I pay--let's say--$20K per year in mortgage payments. It would be nice NOT to have that to pay when I am retired.

So, that leads me to the question of whether it makes send to pay off a house before retiring? Plenty of people who RE and/or are FI still pay a mortgage, so there must be a reason they are doing so...and maybe that just leads me back full circle to the inflation hedge.

[oldtoyota]

The only way is to prepare two scenarios: pay off mortgage; or rent accommodaton and borrow the same money for a house but put into mutual funds, taking into account in both scenarios the tax position and interest rate. Like Gooki, I live in a country where there are no tax deductions on interest payment on a mortgage for your own house (but interest is tax deductible for an investment property), and where interest rates are higher than in the US. Horses for courses.

Interesting. We have deductions for interest payments. However, interest is so low right now that it's not much of a savings to those who refinanced at lower interest rates.

[sherr]

OTOH, I pay--let's say--$20K per year in mortgage payments. It would be nice NOT to have that to pay when I am retired.

So, that leads me to the question of whether it makes send to pay off a house before retiring? Plenty of people who RE and/or are FI still pay a mortgage, so there must be a reason they are doing so...and maybe that just leads me back full circle to the inflation hedge.

Those people took the money they would have spent on paying the mortgage off early and instead invested it. Their investment (assuming current mortgage rates and average stock market rates) generates enough money every year to pay the mortgage, and some extra. Mortgages are an inflation hedge, yes, but that is not the only reason one would avoid repaying the mortgage early. It all comes down to the interest rates - if the stock market grows at a rate faster than your mortgage interest rate then it's mathematically better to put all your extra money in the stock market, even if inflation is 0%. And considering mortgage rates are so ridiculously low right now, it is very likely that will be the case.

[oldtoyota]

That's what I was thinking too....and that leads me to think it's time to stop pre-paying. Off to call the mortgage co to change it.

[Emerald]

Any yet, I spend a ridicuous amount of time daydreaming about a paid off mortgage, no debt, and living cheap.  The mortgage, while not high, is still my biggest monthly expense and a major stumbling block to possible career changes/reductions in pay. 

[eil]

It all comes down to the interest rates - if the stock market grows at a rate faster than your mortgage interest rate then it's mathematically better to put all your extra money in the stock market, even if inflation is 0%.

Only if you can predict the future.

Say you plan to "retire" in 10 years. You have a mortgage interest rate of 3.75% and decide to pay the minimum on it and stash all of your extra savings into a stock market index fund. If there's another market crash in the next few years (e.g, dot-com bubble or housing collapse), you could end up with a zero (or negative) return on those savings. Whereas paying down extra principal on your mortgage is a guaranteed 3.75% return no matter what the market does. So it's more a question of level of acceptable risk rather than straight up "which one is better?"

And I also think there's something to be said for eliminating a huge monthly expense as quickly as possible, from a cash-flow point of view.

I understand that putting your 'stash into an index fund is still a statistically good bet in the very long term (i.e. multiple decades).

[matchewed]

It all comes down to the interest rates - if the stock market grows at a rate faster than your mortgage interest rate then it's mathematically better to put all your extra money in the stock market, even if inflation is 0%.

Only if you can predict the future.

Say you plan to "retire" in 10 years. You have a mortgage interest rate of 3.75% and decide to pay the minimum on it and stash all of your extra savings into a stock market index fund. If there's another market crash in the next few years (e.g, dot-com bubble or housing collapse), you could end up with a zero (or negative) return on those savings. Whereas paying down extra principal on your mortgage is a guaranteed 3.75% return no matter what the market does. So it's more a question of level of acceptable risk rather than straight up "which one is better?"

And I also think there's something to be said for eliminating a huge monthly expense as quickly as possible, from a cash-flow point of view.

I understand that putting your 'stash into an index fund is still a statistically good bet in the very long term (i.e. multiple decades).

Only if you plan on withdrawing all your money when you're at a zero (or negative). Time will still go on, the market will eventually recover and while you feel secure in your 3.75% return of paying off your mortgage you miss out on the return the market just gave you as it recovers.

If the market crashes and you can't afford to FIRE in 10 years I'm pretty sure that the 3.75% return won't let you retire in 10 years either.

[Leisured]

You can pay off a house and borrow to invest at almost the same time. Borrow, say, $250K to buy a house, pay down to, say, $90K, and then redraw $10K on the loan to buy shares or a mutual fund, pay down to $90K, borrow another $10K to invest, and so on. Interest is tax deductible.  Maintain a loan of, say, $100K until you approach retirement, and then pay off the loan.

[arebelspy]

You can pay off a house and borrow to invest at almost the same time. Borrow, say, $250K to buy a house, pay down to, say, $90K, and then redraw $10K on the loan to buy shares or a mutual fund, pay down to $90K, borrow another $10K to invest, and so on. Interest is tax deductible.  Maintain a loan of, say, $100K until you approach retirement, and then pay off the loan.

We can come up with lots of subpar ways to do things, but the fact of the matter is: if your return (and/or or SWR) is expected to be above your mortgage rate, you should pay the minimum, always, and invest everything else you have left into your AA.

That is, if you are planning for an SWR above 1% or so, you shouldnt prepay your mortgage (assuming inflation of 3%).

[tomsang]

The article was also written when mortgage rates were 6%.  At 6% the risk reward is closer to neutral in paying off the mortgage early. For those in the US getting a 3.5% or sub 4% mortgage locked in for 30 years it is hard to come up with any good arguments to pay it down unless that eliminates PMI.

[Rural]

That is, if you are planning for an SWR above 1% or so, you shouldnt prepay your mortgage (assuming inflation of 3%).

And assuming an interst rate of 3 or 4 percent. I still maintain we did the right thing to pay off ours at 7.5%.

[arebelspy]

That is, if you are planning for an SWR above 1% or so, you shouldnt prepay your mortgage (assuming inflation of 3%).

And assuming an interst rate of 3 or 4 percent. I still maintain we did the right thing to pay off ours at 7.5%.

Possibly, if you are outside the U.S. and that was the best rate you could get.  If you are in the U.S. and could have refi'd, I would disagree, and say you did something very suboptimal, and can rectify that right now, if you can qualify for a loan.

[Rural]

That is, if you are planning for an SWR above 1% or so, you shouldnt prepay your mortgage (assuming inflation of 3%).

And assuming an interst rate of 3 or 4 percent. I still maintain we did the right thing to pay off ours at 7.5%.

Possibly, if you are outside the U.S. and that was the best rate you could get.  If you are in the U.S. and could have refi'd, I would disagree, and say you did something very suboptimal, and can rectify that right now, if you can qualify for a loan.

We're in the US, but couldn't refi / now can't get a mortgage on an unfinished house and aren't willing to borrow at a high rate to finish it quickly just to pull out money to invest. Everything that's left is cosmetic, not structural, but it'll likely be three or four years before it will be done enough to qualify for a traditional loan.

Without a mortgage, our expenses are so low we'll likely be at FI by then. Add a mortgage to pay on our residence and FI gets further away.

However, buying  a rental with a mortgage seems like it would make a lot more sense for us.

[arebelspy]

Without a mortgage, our expenses are so low we'll likely be at FI by then. Add a mortgage to pay on our residence and FI gets further away.

No, the whole point is you can invest the whole amount you get from the mortgage and earn a high enough return on average to pay the mortgage payment and put extra money in your pocket.

This sentence is the exact thing people say when they don't understand the math, no offense.  :)

The investment pays for the mortgage payment, you don't.

[Rural]

I understand the math on a mortgage at 3.5 to 4%, but we can't get a mortgage at that rate because the house is unfinished in the bank's opinion. Adding a construction loan at closer to 10% (haven't checked the rates lately) would be counterproductive, especially considering that those loans are over one or two years, not thirty. That's the sort of loan that would set us back rather than help. I shouldn't have called it a mortgage in the lat post; it isn't really the same thing at all.

The mortgage that we paid off was actually a mortgage, not a construction loan, but it was a farm mortgage on empty land at 7.5%. I'm interested to hear your take on an early payoff at that rate.

[SnackDog]

If the remaining work is just cosmetic, why not get the construction loan, finish the work in three months, and move on?

[Rural]

We don't have the time to finish in three months, and it would exhaust my husband (and me, to a lesser extent). We could borrow money, but we would pay twice as much or more to hire someone else to do it, and that seems pretty antimustachian.

* Edited for tone because I was getting snarky, and neither sloanbj nor anyone else here said anything deserving of snark.

[arebelspy]

That may be one of the exceptions.  But, like you said, that's not really a mortgage at all, it's a construction loan (and before that a farm loan on empty land).

It's not low rate, it's not fixed for a long time period, etc.  Naturally it's quite different than what we're discussing (people with sub 5 or sub 4% loans locked in for 30 years paying it down instead of investing).

I'd still, in your shoes, get a cash out refi at today's rates once the place is all finished and qualifies.

I can understand why you wouldn't, going from owning it free and clear to suddenly having a monthly payment doesn't sound fun, but that's the emotional part, not math.  The math supports having that big chunk of money invested rather than locked up in the property (and thus the emotions for me are also wanting to have that invested so I have more money in my pocket).

[Rural]

That may be one of the exceptions.  But, like you said, that's not really a mortgage at all, it's a construction loan (and before that a farm loan on empty land).

It's not low rate, it's not fixed for a long time period, etc.  Naturally it's quite different than what we're discussing (people with sub 5 or sub 4% loans locked in for 30 years paying it down instead of investing).

I'd still, in your shoes, get a cash out refi at today's rates once the place is all finished and qualifies.

I can understand why you wouldn't, going from owning it free and clear to suddenly having a monthly payment doesn't sound fun, but that's the emotional part, not math.  The math supports having that big chunk of money invested rather than locked up in the property (and thus the emotions for me are also wanting to have that invested so I have more money in my pocket).

Which all makes sense, and we will have a look at it once the house is truly finished. But I think I know what our decision will be, especially if, as I think will happen, we're FI by then. If we don't need the money, we definitely won't do it. And we may not regardless. The emotional investment on a place you built with your own hands is higher. I think it also makes a difference if the primary residence is a place you plan to sell eventually, too, and we don't.

But I freely admit we both have some lingering Depression-era influence, too. "Don't bet the farm," you know. But the math shows me that we can have both FI and the homeplace owned free and clear. Others should do different things to match their particular circumstances, values, and goals.

[dudemize]

Good debate, one I ponder often.  There is obviously no right or wrong answer.

A key point is that pre-paying your mortgage is a GUARANTEED rate of return.  If you make the decision to invest in the stock market instead, then you must be compensated by an appropriate equity risk premium over and above your mortgage interest rate.  The equity risk premium is usually in the neighborhood of 4-5% over short term treasuries which means that you need to expect to earn a rate of return of this amount over and above your mortgage rate.  So if your mortgage rate is 4% you need to have an expected rate of return in the stock market of 8-9% in order for you to be appropriately compensated for the risk you are taking by investing in the stock market.  If you itemize on your taxes you could use your expected after-tax mortgage rate for the analysis.

Here is a good piece on expected stock market returns from current levels.  It's a few months old, but still applicable.

http://cornicecapital.com/AlpineAdvisor/2013/04/25/how-it-ends/

BTW, Jeffrey has good insights every week, well worth a read.  It's free.

From his analysis, stocks can be expected to return approx 4%/yr over the next 10 years.  Now these are just models and certainly not an exact science but you need to have some sort of baseline expectation for this analysis.  The model returns change constantly so if the corporate economy starts to decline or if the stock market tanks then that will change expectations going forward.

So, I would suggest that most would benefit more by pre-paying their mortgage.  However, if you have proven over a lengthy period of time that you can beat 8-9%/year with your investing prowess, then by all means invest instead of pre-paying the mortgage.  If this applies to you, then you should be renting (buying the house you live in is a terrible investment) and investing even more in the stock market.  However, the vast majority of individuals are TERRIBLE investors.  Studies have shown time and again that they underperform the market significantly, always buying at the highs and puking up their stocks at the lows.  I'm sure most here are above average investors, but for the vast majority of folks they would do better paying off their mortgage.

Personally, I take the middle road by paying extra on the mortgage and investing.  I'm paying enough to cut my mortgage term in half and investing the remainder.   It does not have to be an all or none proposition.  I can also tweak this over time.  For example if the stock market drops significantly I would probably allocate more to the market.

Cheers!

Jason

[fiskeb]

I think if you asked all those people out there that had the unexpected happen and lost their homes, they would tell you to put your calculators away.  All of those people had a mortgage.

Hahaa except the one in Fort Myers, FL where BofA foreclosed on their house... after they paid it off.  So they foreclosed on BofA... Chained the front door of their local branch shut.  LOL