Should You Prepay Your Mortgage or Invest Instead?

One of the on-going debates in personal finances is whether to pay off your mortgage or keep your mortgage and invest extra money in stocks (or some other investment.) The two sides of the story were recently highlighted in a couple different pieces -- both suggesting a different outcome. First, here's David Bach making a case for paying off your mortgage early:

Like some of my fellow Yahoo! Finance columnists, I'm often asked if it makes more sense to prepay a mortgage or invest the money in stocks and bonds. Rather than ponder which asset will get you a higher return, I think the better question is which investment decision will free you financially and allow you to retire earlier.

In my 9 years of experience as a financial advisor for Morgan Stanley, the clients who paid their debts off early -- specifically their mortgages -- retired 5 to 10 years before those who didn't.

He goes on to tell how to pay off your mortgage early -- make bi-weekly payments (don't pay for the service), automating your extra payments, etc.

This is what I've done and have now been without a mortgage for about 10 years. We did it by keeping our expenses very low, well below my income, then using as much possible to pay off our mortgage. We also applied gifts, bonus money and extra income from a side business to the mortgage. And we did this while fully funding my 401k.

But if you do prepay, be sure to fund your retirement first or else it could cost you:

A recent study suggests these households blow more than $1.5 billion a year, or $400 per household, by accelerating their mortgage payments instead of contributing more to their retirement accounts.

The research found that at least 38% of those who were making extra payments on their mortgage were "making the wrong choice." Instead, these households would get back 11 to 17 cents more on the dollar by putting the money into a workplace retirement plan like a 401(k).

Then there's the other side of the argument -- the one that says to keep the mortgage and invest instead (FYI -- there's a more recent piece than this one, but I just can't find it. But this one will do):

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.

I've said before that there's a big difference between planning to do something and actually doing. And one thing I've seen over and over again is people who plan to keep their mortgage and invest what they would have put as extra against the debt. But what most end up actually doing is keeping the mortgage and SPENDING the extra amount. So they end up with a long-term mortgage and no additional investments (or at least not much.)

What's your take on the issue?

Comments

[Jeff R.]

I say pay off the mortgage. Even though the interest rate may be low, its a guaranteed return. I know that over time, the market will return more. But how can you predict that over the long term? Most people will panic (like me) and not stay invested when the market is slow (like last week).

Pay off that mortgage, and enjoy the peace that comes with it. Then you can invest without worry.

[bettis]

pay off the house but save for retirement. the reason being - 401K matches & Roth IRA contribution caps. those are not things you can catch up on later in life, after the house is paid for.

[Blaine Moore]

Save for retirement, prepay the mortgage, then invest.

[Kevin]

My wife and I have decided to aggressively pay off debt now, while still contributing enough to my 401(k) to get the full employer match. We are first paying off her car (mine is already paid off), then will put that $250 a month towards our second mortgage along with the extra $325 we already pay. We computed that next July her car will be paid off (2 years early) and the year after that, our 2nd mortgage will be gone.

So after 4 years in our home we will have $25,000 in equity from paying off the 2nd, plus market appreciation. Since we want to buy a bigger home in a couple years, we thought this was our best strategy. Our goal is to have around $50k to put down. And, if we decide to stay longer, it will be a great relief only having that first mortgage.

[Toby]

I am keeping my mortgage and investing the money. The power of compounding is amazing and the longer you are in the market the better. A guaranteed 4-5% return is not my cup of tea. I'd rather take a slightly riskier position and reap the rewards.

In addition, if you invest your extra money in a taxable account, you can always liquidate all or part of your position to smooth over rough financial spots in your life. Cash is king! You can't pay medical bills, buy groceries, or make mortgage payments with your home equity. **Okay, with a HEL/HELOC you can, but it's a lose-lose, low returns on home equity (the roaring RE market is over people!) plus you have no guarantee that the bank will give you the loan when you need it. Just try getting a HEL/HELOC from the bank while unemployed.** Houses can pay off as investments because they are so heavily leveraged when purchased(try buying stock 80% on margin, ain't gonna happen). So why do people insist on lowering their returns by handing over extra principal to the bank?

As far as the extra money getting into the investment instead of being spent? That is a matter of discipline. I've adopted a combination of "pay yourself first" and the "60% solution". Most of my paycheck is distributed to various investments and savings accounts automatically. I don't have a rigid budget, but my wife and I have spending limits. The "pay yourself first" ideal makes sure that my investment dollars make it to their respective accounts automatically before any bills are paid. The "60% solution" includes a "slush fund" which smooths out spending patterns over the year for our family. So far the plan is working well. I haven't had to dip into my investment accounts and during especially frugal times even some slush funds end up in the investment accounts.

[cory]

A major issue that is always overlooked when this question is asked: How much sooner will you finish paying off your mortgage?"

The mortgage has a term, an end-date. At some point the question should become irrelevant because your mortgage will be gone and the loss of liquidity will no longer matter.

So if you have the option of putting your extra cash towards your mortgage and getting rid of your 30 year mortgage in 24 years, don't bother. Invest the money and you'll do just fine. If you put all that money toward your mortgage for those 24 years, you're now a short-term investor.

However, if you have the option of paying off your 30 year mortgage in 5 years, absolutely do it. You're skipping out on 25 years of interest and 25 years of housing payments which is, of course, huge. You can do whatever the hell you want with 100% of that money after 5 years and invest your heart out and still be a long-term investor.

[Brad]

Keep the mortgage, save/invest the money. Liquidity is a big, big factor in this decision too, almost as important as the rate of return. If you save every penny and throw it in the house, it's now trapped and you can't get to it without paying. Paying to borrow your own money! You have the option to avoid that situation, or at least avoid getting into it prematurely. Unless your mortgage has a high rate, pay the minimums and put the extra cash away.

[plonkee]

I'm on the with cory. It depends on how quickly you can pay it off. I think that if I put my extra money towards my mortgage it'll still take me over 20 years to pay it off. I honestly don't think that I can stick at it for more than 20 years, especially as I know its not the most lucrative way of using the money.

Instead I'm investing the extra in the stock market. When I get to the point where the amount I have invested is greater than the balance of the mortgage, I may pay off my mortgage. And I may not.

[Lord]

How many that don't have the discipline to invest, have the discipline to pay off the mortgage? One thing the wealthy have is mortgages. It is one of the few tax write-offs available to them. But the lower your tax bracket, the valuable it is.

[Lord]

less valuable

[aaktx]

I paid off my mortgage in 1 1/2 years and it has freed up my cash-flow significantly. I don't feel like I have missed that much in the market. I think that paying off the mortgage is a good idea if you know that you are going to stay in that location for a while.(and can do it quickly) I agree that theoretically it makes sense to invest versus pay off, but practically you noted no one does this consistently(there are iPhones and pet rocks to be bought).

[EMF]

"In my 9 years of experience as a financial advisor for Morgan Stanley, the clients who paid their debts off early -- specifically their mortgages -- retired 5 to 10 years before those who didn't."

I wonder if he's implying a cause-and-effect relationship that really doesn't exist. I think the cause is that people who manage their money can produce the both the effect that their mortgage is paid off sooner and that they can retire earlier. Paying off your mortgage early will not in and of itself lead to being able to retire earlier, particularly if you had to do it "automatically" as Bach suggests. Unless you also automate other retirement savings.

Not preaching against paying off the mortgage early -- I did it myself.

[Tim]

I'm with EMF on this.

FMF said "I've said before that there's a big difference between planning to do something and actually doing. And one thing I've seen over and over again is people who plan to keep their mortgage and invest what they would have put as extra against the debt. But what most end up actually doing is keeping the mortgage and SPENDING the extra amount. So they end up with a long-term mortgage and no additional investments (or at least not much.)."
This is a flawed rational for arguing against, because the argument holds true for those in the pay off early camp. One can plan to pay off mortgage early, but never do. not a a good argument at all.

i'm of the camp to maintain mortgage simply because you can invest the extra money. If you pay off the mortgage early and need equity from the house, you will need to either sell the house or to get a HELOC. Why would you take a HELOC and pay more interest on the money vice investing the money to make money? i just do not see the logic, but it is more a risk tolerance level than anything else, why you would sit on equity in a house that doesn't do anything necessarily and will cost you money to tap into. do houses appreciate, yes, but they also depreciate or remain flat. at least with investments you can definitively gain an appreciating security. there is also the case that you cannot afford to sell your house in order to take out the equity, if you cannot afford to move or buy a house afterwards. liquidity gives you much more flexibility in the case of a mortgage.

[FMF]

Tim --

I'm not arguing based on logic or what should be done, I'm telling you what I've seen actually done.

For some reason (maybe it's the fact that people have to pay a mortgage every month anyway and it's easy to add a few extra payments), the people who decide to pre-pay their mortgage usually carry out the plan while those who go the investing route fall off the wagon a couple months into it and end up spending their money instead. Again, not sure why that occurs, but it's what I've seen based on working with people on their finances over 15 years.

So you can have the greatest, logical argument ever for a plan, but if people can't or won't pull it off, then it's worthless. That's what I'm saying here.

[Ryan]

It's all about diversification. Should a kid coming out of college with his first house pay off his mortgage early instead of investing in the stock market? Probably not since he would be overly invested in real estate. Should he put off buying a house and put every available dollar in the stock market? Also probably not. For most people, paying the required payments on a fixed rate, fixed term mortgage is pretty much the right amount of money that they should be putting in real estate, without needing to make extra payments. If your assets are stock-heavy, it may be a good idea to throw more at your mortgage. A good mix for someone in thier 30's is 1/2 in stocks, 1/4 in real estate, 1/4 in other investments. If you exceed in one category, it's time to make a shift.

[MONEY BLUE BOOK]

I like the idea of paying off the mortgage ASAP...automated payments will definitely help. 401K's and ROTHs are also a must in the long term.

The only loans that I am allowing to run its course are my graduate student loans...$30k now at 2.25%. I managed to consolidate at the lowest in 2003/2004.

~Raymond