Should You Prepay Your Mortgage?

Here's one of those money questions where I always answer on the side opposite of "conventional wisdom." But, then again, I'm not conventional and I've certainly never been accused of having wisdom. ;-)

This piece is a question from a Money reader who's wondering if he should pre-pay his 5.25% mortgage or invest the $500 extra he has left over ever month. Here's what Money has to say:

My take is that as a purely financial matter, you're probably better off investing the extra $500 a month given your low mortgage rate. If you repay your home loan ahead of schedule, you're basically earning a 5.25% return, which represents the amount of interest you avoided paying by making the extra payments. I think you should be able to do better than that over the long term by investing in a diversified portfolio of stocks and bonds.

See, I told you I'd disagree. If it was me, I'd pre-pay the mortgage.

My problem with Money's answer is that:

1. You SHOULD be able to beat the cost of the loan. But paying off the loan is guaranteed, the return is not.

2. What if the interest rate increases? This guy has a fixed rate, so he's ok, but for holders of variable-rate loans, the answer could be different. After all, seems to me that rates are headed one way lately, and it's not down.

3. There is a HUGE difference between a philosophical answer and the practical execution of that answer. What I've seen most people do is to get this answer to justify why they shouldn't pre-pay their mortgage, then end up blowing (not investing) the $500 each month. It's a rare person who actually invests the amount as planned.

4. There's a great feeling to being totally debt free. I've been without debt for several years now, so I'm speaking from experience.

Money does recognize this last point -- as well as discusses how retirement savings should play into this decision -- and makes the following comments:

My advice is to first make sure you're maxing out your retirement savings plans and make sure you're on track toward a comfortable retirement. Once you've got that front covered, you can start paying off that mortgage more quickly to reap those psychological benefits you find so appealing.

And one final note: If you do pay off that home loan, use the monthly cash flow that's freed up as a way to ramp up your retirement savings, not as an invitation to spend more.

This is a good, valid point and I agree with it. I'd put maxing out your retirement savings (at least enough to get the full company match) ahead of paying off the mortgage. But once my retirement saving was funded, I'd pay off the mortgage next. This is what we did and it's worked out very well for us financially.

Comments

[rob]

Wouldn't 5.25% return on your money be the minimum return?

If the price of your house doubles in value wouldn't that influence your return on that investment?

[Bronco]

Not only is the 5.25% return guaranteed, but it is tax free! That would be the same as about 6.6% on a typical investment--even more for a savings account.

[javasoy]

I dispute your points, and I'll explain them point by point.

1) You really have to look at it from the right perspective. The money you put into mortgage should be considered a 30-year investment. If your horizon is 30 years, pull up the equity market chart, no 30-year S&P500 period under perform the meager 5.5% percent. Statisically, it's ALMOST guaranteed it would outperform the 5.5% return.

2) Under normal circumstances, the usual mortgage terms people go for are fixed 30-year loan

3) You gotta give credit for people having more discipline than you expect. In other words, if people are already reading your blog, they at least have the motivations and the will to succeed financially. Perhaps you should re-read freakonomics.

4) That's subjective, not objective. Leverage, is often a tool to maximize return. I often think of my mortgage as a fix-asset-backed margin for my equity account. that 5.7% APR sure beats the 9% the brokerage house charges on margin rate. That why I am long only.

5) Finally, I think you should know this since you have a very strong finance background. Investment risk DECREASES for equity as the investment horizon extends, and INCREASES for fix-income when investment horizon extends. The risk of having your money tied-up at 5.5% over 30 years is so huge, I can't even begin to describe the horror. What if inflation increases? a 5% inflation rate will render your real return to almost zero. Worse, when inflation goes up, the fed will fight inflation with interest rate. I still remember the late 80's when your daily saving account can enjoy a 6% return, not to mention the CDs gave you over 10%. Your 5.5% will terribly under-perform even the safest investment instruments. There are not guarantee of success, only chances.

I also like to comment on Rob's opinion. Tax-free is a poor reason for investment. After all, there are many Muni's out there being totally tax-free and have a higher interest rate. They make this tax-free mortgage pre-pay look inadequate. And yet, they are not a investment of choice for many. The reasons for that is beyond our topic here.

[FMF]

Javasoy --

1. I don't view my house as an investment like I do my stocks, funds, etc. Does anyone??? (Really??? I don't think so.) As such, I don't imply investment-related principles to making this sort of decision.

2. "Under normal circumstances, the usual mortgage terms people go for are fixed 30-year loan." I'm not sure what this has to do with anything. It doesn't change my opinion one way or the other.

3. I don't give the American consumer much credit when it comes to handling money. If you'd have counseled, written about and corresponded with the hundreds of people I have throughout the past decade, you wouldn't either.

A related point -- there's a BIG difference between the theoretical and the actual. The theoretical says: "I can borrow at 5.5%, keep the debt, and invest any leftovers for a better than 5.5% return." Practically, one out of a hundred people will actually execut this strategy. The other 99 will find ways to spend much, if not all, of the difference.

4. The fact that being debt free feels great is subjective doesn't make it any less real for me. I recommend what I recommend here for one reason: I do it myself and it's worked to give me a net worth well above that of the average American. Anyway, have you ever been debt free? How do you know if it feels great or not?

5. See point one.

[javasoy]

FMF,

I think you are missing my point. Whether your primary residence should be considered as a investment is debatable, which is NOT the subject.

The subject is the extra liquidity one finds available, and how to apply it. I don't mean to be a jerk, just want to clarify. Now with that context, should you be fortunate enough to find a few extra thousand, or tens of thousand suddenly fall in your laps, what you should do with that money has nothing to do with whether your house is an investment or not, because the financial instruments we are talking about here, and comparing to are the large sum of money you owe the bank, which generates a negative cashflow at 5.5% annually for the next 30 years; or another form of investment that generate x% positive (hopefully) cashflow, at variable length, at your discretion. The way I see it, as long as I can be sure, that my extra cash can generate a return more than offset the 5.5% negative cashflow w/ minimum risk over the next 30 years, it's a better choice.

I also think we have very different philosophies. Nothing wrong with it. Each person looks at things differently. I am financial control freak who checks his bank accounts and credit card accounts on-line everyday, making sure I know the allocation of all my assets. My goal is to maximize and use my assets in the most efficient way with minimum risk. (I made a mistake in my previous comment, I should have said "Cash account only" instead of "long only" for my equity account) I manage my risks diligently, and have emergency cash (or equivalent) to last my family's expenses for a year.

I have been debt free (I will explain later). I also speak from my experience what worked for me. The best way to become debt-free is never get into debt the first place. My family came to the US with just clothes on our backs. Thank God for capitalism that I am at where I am today. I also somewhat agree with your "related point." While it's extremely rare in the Chinese community to have debt problems or bad spending habits, I found out that's not true with average American.

One final note, I have debts. I said I was debt free because I don't feel like I have debts. I bought my cars from GM when they had the 0% financing. Why pass off the free money? I have the cash pay for them, but didn't make sense to me if I can invest that money for 5 years, which I did. I also can pay for my current house with cash, but the 5.75% rate is such cheap money.... anywayz, you get my drift. You and I have very different philosophies. I am not going to argue who's right or better. I just want to explain to you, there are more than one way to handle the same situation, either way could be the right way, just depend who the person is.

[FMF]

So, all that to say either one of us could be right? ;-)

[dl73]

>Not only is the 5.25% return guaranteed, but it is tax free!

Although it isn't tax free if you itemize / deduct mortgage interest on your tax return. By deducting less mortgage interest you are in essence "paying tax" on the 5.25%.

[Deborah]

I love this post and I agree with your position.

I fought with this conventional wisdom and lost. I set up spreadsheet and did long term financial calculations. I actually did not even want to put money into retirement savings. I'm Canadian so we do not get to deduct mortgage interest.

My conclusion from my analysis was actually that it would make little difference regardless of where we put the money as long as investments made around 5%. Well, we lost 1/3rd of the investments in our retirement in the tech crash.

The market is showing all the indicators and signs that it isn't the safest place right now, so in this market, go for the sure thing every time.