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November 06, 2007

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I think 3,4 and 5 (always important) say it all. You can do all the calculations and projections you want of whether to invest or payoff the mortgage, but for a lot of people, the psychological aspects of the equation are most important and usually get left out of the discussion.

He, of course, brings out the old tax benefits of the mortgage, which just doesn't hold much water with me. This is our first house (we've had 3 in the last 4 years) where there is enough interest and taxes to claim more than our standard deduction as married filing jointly. So, I'm only going to really see tax benefits for anything over the standard deduction.

Great points. As a compromise approach, I recommend people at least try to make one extra payment a year on their mortgage. There's no reason why it has to be all or nothing. I save for retirement and for emergency needs and I am trying to capture some savings in interest avoidance by paying my mortgage off faster than my plan calls for. I've made it as automatic as my investing. Each month my payment is a bit higher than required.

The house note is all my wife and I owe, and #3 is why we are in pursuit of paying it off early. I like to say it this way: There is a lot less risk involved if you have a paid for home.

It's tricky because it can take a long time before those extra payments actually get you free. So point 3 won't come into play for a goodly time, and in the meantime you're a little *more* vulnerable because you've reduced your liquidity. I've struggled with this issue with respect to a student loan, not a mortgage, and although I've elected to accelerate repayment as much as I can (especially because the loan payments are large enough that I am effectively required to remain in a very demanding job, which I would at least like the option to leave when I feel ready), it does make me a little anxious. I also recognize that I'm giving up some long-term return (the loans I'm focused on are at seven percent, which given my time horizon to retirement I expect I could beat if I invested the difference).

It's easy to get money out from stocks. It's hard to get money out from home equity.

Paying extra to mortgage is good for those who:
1) don't know how/bother to invest.
2) don't have disciplines/motivations to invest.

To aa above:
3) People that are allergic to debt like myself.

aa - I believe that's why FMF suggested (#1) that money used to pay down a mortgage not come at the expense of emergency savings. One could always have a home equity LOC ready as well.

It's not "easy" to get money out of stocks if the market is in the tank or if the stocks are in a IRA or 401(k).

I'm with Ben Stein on this one. Sitting on a huge pile of cash is better than sitting on a huge pile of equity.

Regarding reason 2, it's funny that on the one hand everyone advocates investing regularly and following a long-term savings plan for retirement, yet when the "mortgage prepayment versus investing" argument comes, almost invariably the main argument against investing is that people don't have the "discipline" to follow through. Doesn't it take discipline to save for retirement? Why question whether people have the discipline for one type of automated investing while assuming they can handle another?

Reason 3, as your already pointed out, is mitigated if you have a huge pile of cash. Did I mention I prefer huge piles of cash?

Reason 4 is just one way of looking at it. If my goal is "effective asset allocation", I may look at a paid off mortgage and little in the way of other assets as a serious risk and imbalance in my portfolio. Like it or not, your property represents real-estate holdings in your investment portfolio. If a person is serious about diversifying their investments, they need to account for this.

What happens if your home is struck by an uninsured disaster, how will you recover? If your net worth is almost entirely contained in your house and it's wiped out by uninsured damages, what recourse do you have? You can't argue it could never happen. Look at New Orleans. How many people lost everything? Wouldn't it be nice if they had an investment portfolio to fall back on?

If you have a diversified portfolio, on the other hand, you may take a hit on the house, but so will the bank. Your other investments will still be there for you.

Toby, I agree with you on Reason #2, however, what am missing on uninsured disasters?

If you don't buy/own a home that is below sea level like NO(hence a probably flood zone), what disasters are not typically covered by insurance? I guess I always assumed that pretty much anything that happens to my home would be covered, but maybe I am drastically wrong?

If that is the case that a tornado/flood/earthquake/fire that totally destroys your home is not recoverable by insurance, then I guess you need to do risk analysis on what would most likely occur, the natural disasters mentioned above or a stk market crash......

Insure your house against flood and all oher perils. Make sure you know what is covered and what is not covered. People in New Orleans had criminally irresponsible insurance agents. I agree though, diversify your investments, and don't count on real estate as a stable investment. There are many people in my area (SW Florida) who spent WAY too much money when housing was booming;$400-500k on property that wouldn't sell for half of that now.

FMF,

From a purely financial standpoint, it is always better to invest "surplus" in the market or a business. This holds true for both "hot" or "cold" real estate markets. In a "hot" real estate market, your leveraged dollar (assuming 20% downpayment, 80% mortgage) is earning a better return than if you owned the property outright. And in a "cold" market, you don't want to be sitting on a whole bunch of home equity that is losing value.

But there are possibly some deeper moral and ethical questions regarding debt and being "enslaved" by the lender. Obviously Dave Ramsey would take issue with "choosing" to have a mortgage if one had the option of paying with cash up front. I would take out a mortgage even if I could muster 100% cash.

Paying off a mortgage early, at the expense of a healthy stock market portfolio, tends to throw the idea of a "diversified portfolio" to the birds. I'll bet most home owners have way too much (>50%?) of their total assets sunk into their home and not enough elsewhere. I myself am in this category and am trying to work on it!

Jonathan

Acts of war, Nuclear holocaust, Floods, earthquakes, landslides, sinkholes, volcanoes, etc. are perils that may not be covered automatically by Homeowners insurance. Talk to an experienced agent to find out where there may be coverage gaps.

Insure your house against flood and all oher perils. Make sure you know what is covered and what is not covered. People in New Orleans had criminally irresponsible insurance agents. I agree though, diversify your investments, and don't count on real estate as a stable investment. There are many people in my area (SW Florida) who spent WAY too much money when housing was booming;$400-500k on property that wouldn't sell for half of that now.

To individuals that disagree with paying off mortgages early, please answer this question for me!

Situation: Very bad economy, stock market is way down, housing market is way down, and many jobs are being lost.

Who is in a better situation?
Person A: No mortgage, lost his job, has 30k of liquidity, stock portfolio 1/2 of what it was 1 year ago.

or

Person B: Mortgage $1.5k/month, lost his job, has 30k of liquidity, stock portfolio 1/2 of what it was 1 year ago.

Thanks for the insurance comments Fred!

Jonathan --

"Paying off a mortgage early, at the expense of a healthy stock market portfolio..."

I didn't pay off my mortgage at the expense of a healthy stock market portfolio. Yeah, it could have been higher, but I was still socking away some serious money in my 401k.

@ Beastlike: Well, assuming Person A was systematically paying down their mortgage while Person B was not, Person B might, very well, be in the better position. You never define the size of each portfolio and please don't make me laugh by claiming they are the same size...

Person A's portfolio halved might be worth 10k? 20k?

Person B's, on the other hand, even halved, might be worth 100k or 150k+.

Potato - Potah-toe

Personally, I'd rather have the pile of cash.

----------

How about you change that scenario around. What happens if the downturn occurs *during* the accelerated paydown of the mortgage.

Person A: 75% equity in their house, 1.5k mortgage. No job. 30k liquidity. Portfolio of 10k.

Person B: 25% equity in their house, 1.5k mortgage. No job. 30k liquidity. Portfolio of 150k.

In this case, Person A feels the pinch a lot sooner than person B. Wouldn't you agree?

My point is that for every scenario one person can devise that champions paying off the mortgage, another can come up with an equally likely scenario where that can be a poor if not tragic move.

Toby - You got me there in the last scenario...

However, back to my scenario, if Person A had 100k in their portfolio before it dropped 50% and Person B had 300k before the crash, now person A has 50k and B has 150k with a mortgage. I rather be Person A.
- I guess the point that I am getting at is the more you have in stock and the market crashes, you will lose more. Whereas if you live in a house that loses half it's value, who really cares if you have it paid off and plan on living there for a while. On the other hand, it would be horrible if you are paying back a 250k loan when your house value fell to 200k and you lose your job....

I think this is one of those things where there is no right answer, but I still believe paying off the mortgage is the less risky route.

So, did all you "pile of cash" people finance 100% of your homes? If not, why did you decide to part with the cash?

People put money down for a reasonable rate; 100% money is quite expensive.

Insuring against all disasters is uneconomic. Some are too high risk for insurers to want to deal with.

A good case for someone who might want to keep a mortgage is someone on a fixed pension. A mortgage allows them to reduce their inflation risk. It really requires locking in a low rate though. I realize subprime allowed people to buy that otherwise couldn't, but at the rates they pay it wasn't a good idea anyway.

Just to throw another log on the fire...

What about people like myself who don't plan on living in the same home for more than 3-5 years? Personally, in that situation I'd rather have the money since paying off the mortgage doesn't gain me much of anything no matter what type of market it might be.

I owe 84,000 on my mortgage, at 4.875% fixed rate. I have a little more than 84,000 in cash, mostly in my retirement accounts earning 5.07%, mostly tax free (in addition to index funds and a couple of stocks). Even though I could pay off the mortgage, I don't see the point. It would cost me money, and cost me flexibility. If I really needed the cash in an emergency, its cheaper and faster to use the funds that I have, rather than start a home equity loan. If interest rates drop a lot, I may pay the mortgage down, but not while I can still earn over 5%.

There is no universally correct answer to this question because individual circumstances need to be taken into account (such as job security, risk tolerance, propensity to save and so on). Not all of these factors lend themselves to objective analysis.

That said, the major asset classes (shares and real estate) have historically produced returns which are materially higher than the cost of debt secured against an owner occupied residential property. So long as your time horizon is long enough and you have confidence that you will not panic if the market moves against you in the short term, investing is much better than paying down debt. I agree with Jonathan on this one.

Hello. The main problem is that Stein, bloggers, and people in general tend to underestimate the risks, underestimate the debt costs, and overestimate the gains, both in past stock performance and in the arbitrage game.

It really comes down to what makes you comfortable. There is little dispute that investing the extra mortgage payments provides a better long term return (so long as you can live through a market downturn and diversify to mitigate the downside risk). However, some folks just feel better not owing anything on their mortgage.

Either way, you are doing great if you are paying down a mortgage quicker or adding to your investment portfolio. So pick what makes you feel better and go with it. If you are married and your spouse has the opposite view than you, then split the difference - take half the extra cash flow and invest with the other half paying down the mortgage.

Of course, those favoring the "pile of cash" aren't factoring in the interest savings that they are not getting.

Look, it's insurance. Same as anything else. How much are you willing to insure against risk. Paying off a mortgage is a form of insurance against depending on cash flow for shelter. You have to reach a judgment on what you are comfortable taking on in risk and what you can afford to insure against.

I agree with the sentiment that it's not good to view yourself as wealthy if all your value is tied up in a house. That's stupid. But it is also stupid to pretend that a house is more iliquid than it is. Unless you are in Michigan, it's actually still quite possible to sell a house in a reasonable time and free up that equity if you need to.

I had to make a decision on this very question two years ago. I was living in L.A. in a house that had appreciated from $125,000 to $525,000, of which I owed $90,000. I wanted to move away from that city and the city I was moving to had very nice homes for under $400,000. But I had a choice there. I could put down $80,000 (20%) and invest the rest, or just consider the whole thing a windfall trade of my house for this house plus zero debt. For me, it wasn't close. I bought my house in cash, and now I take the mortgage payment and invest it. My portfolio is already up to $120,000 (it was around $75,000 before) but the best part is this:

I have zero debt. No car payments. No credit cards. No mortgage. I pay utilities, insurance, and taxes. My monthly housing costs in an area with very high taxes is still under $400 a month. Think I can survive a downturn at those costs?

Yeah, me too.

I've paid off my house...in part due to this column by Scott Burns. Yes, it is a bit dated (written in 1999) but it opened my eyes to the term "imputed income." Here's the link:
http://www.dallasnews.com/sharedcontent/dws/bus/scottburns/columns/archives/1999/990525TU.htm
Close your eyes and imagine what you could do with the money you sused to send in to pay the mortgage. Invest? Travel? Give to your favorite charities? That is the beauty of "imputed income."

There is a huge 6th point, a factual/math debate (not just a "whatever you feel like" debate), about questioning the expected returns, as covered in "Payoff Mortgage v. Invest Stocks: Housing Myths Part 12."

Many people make the simple compromise to just round up their mortgage payment each month. If you owe $1240, pay $1300 and make sure the extra $60 is applied to the principal. It won't make you debt free overnight but it chips away at it in a way that has little impact on most people and probably makes good sense.

Bottom line, when comparing housing debt to long term equity market returns, it is better to carry a large fixed rate prime mortgage and pay minimum or even zero principle:

A prime 30 year mortgage is currently <6% or <5% after tax (overcoming the standard deduction) while conservative LT market returns exceed 10%. This +5% difference will make you much richer over the long term. Invest in a total market etf and you will postpone 99% of taxes.

An additional advantage is the liquidity of being able to sell shares, say if you lost your job, as you would not be able to get a home loan.

You have done a good job; the comparison is very nice and manages to hit the basics of mortgages and investments. It is much affordable to be an investor instead of putting all savings for mortgage; it’s a truly wonderful blog.

I'm 38 with a just-paid-off house. For those of you talking about liquidity of funds (or the lack thereof), my husband and I obtained a HELOC 1 1/2 years into our 4-year payoff plan free of charge from our bank, giving us a $100K line of credit for emergency purposes...all for a mere $50 yearly fee. There is nothing freer than saying "I don't owe the world a thing!!!" No stock would ever give us that kind of freedom and security.

Unfortunately, we all have house payments...property taxes.

Given the current market turmoil I feel more confident about working towards paying my mortgage off early. One of My long standing believes is that owning my home out right is a wise long term plan (inflationary insurance, peace of mind). My 401K is at a 33% loss, not sure how long it will take to recuperate, but I do know that by paying my mortgage off (approx. $159,000) in the next 5 years will save me approx. $170,000 in interest as opposed to making minimum payments over 30 years. I still get to stash some cash away and have no other debt beside utilities...can't wait to be debt free.

And of course I continue to invest/save towards retirement.

what about all the interest paid for a large longterm mortgage? it bothers me to see how much interest i will be paying on my mortgage. i'd rather pay off early, be debt free, avoid all that interest, and start saving and investing aggressively again afterwards.

Seems to me it might make sense to pay more down on the mortgage at the beginning of the load while the interest is still high. Once it's paid down lower you will not be sparing yourself as much interest and maybe time switch to other investments.

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