Wondering About Pre-Paying a Mortgage Versus Investing

My formula for buying a house allows users to "become debt free in 7-10 years." Personally, we haven't had a mortgage payment in over 10 years and I've detailed why we advocate paying off your mortgage. That said, I'm starting to have second thoughts on the issue.

As many of you know, we've been looking for a new house for almost a year. We'd like to move to a different area of town and have a bit of land as well. I have a fairly good down payment saved up and my plan had to always pay off the new house in 5-7 years max -- maybe as few as two or three years. But with mortgage rates as low as they are, it seems like paying off the mortgage early may not be the best way to grow our money. Instead, we could put the extra into index funds and likely make several percentage points more in return.

I know many people have advocated this method here before, but I've always rebutted it because that's not what we did (and that's what this blog is about -- how I've grown my net worth and how you can do the same doing what I did/am doing) and because the trade off was so close to being a wash (when we paid off our house, rates were 8%, so faster mortgage payments were a pretty decent return.) But things have changed in the rate world and maybe we'll take a different direction with our next house. Maybe.

I know that we're disciplined enough to keep saving/investing rather than spending our "extra payments" -- something that's a downfall for many who decide not to pre-pay a mortgage (they simply spend the extra they have left over, make no financial progress towards investing and don't pay down their mortgage either.) But I'm sure my wife will resist the idea. She's a "get rid of all debt" sort of person.

What's really got me thinking is this Consumer Reports piece on pre-paying your mortgage. The highlights:

While paying your mortgage is definitely a good idea (the alternative being possible foreclosure), whether to take cash you might otherwise invest and pay the loan off ahead of time is a trickier calculation. The decision has become even more complex lately given the ups and downs of the stock market and the downs and more downs of the housing market.

Our statisticians created a computer model to compare prepaying a mortgage with investing in a Standard & Poor's 500 Index mutual fund during a variety of market conditions.

It turns out that while home may be where the heart is, it's usually not where the heartiest returns are. True, in recent years and for short periods since 1969, home prices have climbed as much as 16 to 27 percent a year in some regions. But on average, they rose only about 6.5 percent a year during that period.

The longer you own your home, the less likely it is that mortgage prepayment will be the better choice.

Aside from the cold, hard numbers, there are other reasons you might choose one option over the other. If you need access to your money in an emergency, for example, it will be almost instantly obtainable if it's in a mutual fund and much harder to get to if it's tied up in your house.

On the other hand, many people find peace of mind in paying off their mortgages and owning their homes outright, especially as they approach retirement. That can make an investment in your mortgage a worthy choice, psychologically if not financially.

Still, the bottom line, according to our Money Lab, is this: Although there are exceptions, chances are you'll be better off putting extra money into a good mutual fund, not into prepaying your mortgage.

What's your take on the issue? Assuming someone actually follows through on the strategy, which is better -- investing or pre-paying -- in your opinion?

Comments

[Daniel]

I have been thinking alot about this same issue lately. My fiance and I are just starting to look for our first home to purchase. We have decided on a maximum price we want to pay which we figured out with a mortgage will give us a few extra hundred dollars a month to either save or pay extra on the mortgage. I believe financially it makes more sense to invest and try to earn a higher return then the 6 or 7% we will be paying on the mortgage. However, I think my strategy will be a combination of the two. Why not take a certain percentage of the money we have each month leftover after expenses to pay down the principal on the mortage and then put the rest in an index or mutual fund? This way we can practice the ever popular personal finance idea of diversification. I will feel good that we are paying off our mortgage faster then the 30 year loan (even though not as fast as we could), and I will feel good about seeing our savings grow in the mutual funds. I think for us this will be the route we take and hopefully everything will work out.

[Gary]

I do not believe in paying off the mortage, as long as you have equity in your home, of course if you do not, then you need to pay it down until you have adequate equity to use in case of a emergency. I have always put any extra money into mutual funds. My funds have far exceeded the 5.5% interest on my mortage, last year my funds increased by 35%, early years have averaged well above 10-25%. I have been investing in mutual funds for over 50 years, always contributed to 401k and invested the maximum in an IRA every year also. The key is to have equity in your home for an emergency, you do not want to tap your 401k or your IRA's. Take it from your equity. I have a ELOC at 8.5%, well below what I can and have made in mutual funds if I need money.

I have survived many recessions without taping either of these two. I have never stopped putting money in either during a recession, not a wise decision. It is very tempting in a downmarket to follow the crowd, I never waivered during the 1987 dropped of 600 points in 1 day and the following 3 3 months, it was very tempting believe me. The market will turn around and you do not want to miss the upside of the market, you can not time the market. I am down about 7-8% for the year, and it is not going to be a great year, I understand that, but it will be an up year by years end, maybe only 5-8%, but my portfilo as up 35% last year, I can live with that.

Hope this helps.

[Michael Goode]

It's a vicious lie! Prepaying a mortgage does not mean you won't have access to the cash. Just get a HELOC. Many banks and credit unions will give you a HELOC without charging you many fees (I paid only $200 for an appraisal of my house). If an emergency comes up and you need cash, just take it out of the HELOC. Of course, you should still have some cash.

Also, if your income tax rate is high and your mortgage and other costs are small enough that you cannot consistently itemize deductions, you will benefit by prepaying a mortgage rather than investing. Also, prepaying will tend to be better the more 'active' your investing is, because your investing will then incur tax hits (keep in mind that prepaying is tax free return).

[beastlike]

I am stuck on this one too... I have been prepaying not because it may be the better decision but because I hate debt. Moreover, my plan once my house is paid off is to continue buying homes to rent out, which will further diversify me and I think put me in a better position in 20 years..... I let you know in 20 :)

[Dave]

There is no "right" answer. Statistically, your odds of coming out ahead are better with investing in index funds. The S&P 500 has a historic rate of return of 11% which, after taxes, is still better than the 6% you'd be paying in mortgage. But it's all about peace of mind vs. risk, and that is something that only you can decide. Are you willing to take on the risk in order to get the better return? Or would you rather purchase peace of mind? Given these odds, I would take the risk. However, it sounds like your wife is more a PoM person.

[Independent George]

The key variables are (1) interest rates, and (2) inflation.

Back when mortgage rates were over 10%, you were almost certainly better off paying off the mortgage; given that conforming loans have been below 6% in recent months, the expected returns over the life of the loan favor saving & investing the difference.

Inflation kills also has the side effect of killing debt (which is part of the rationale behind the Phillips Curve). If there's any bright side to high inflation rates, it's that it effectively acts as a hidden payment of your debts (it's also effectively a tax on savings, but that's another story entirely).

[db]

Well -- if you've paid off the mortgage aren't you 100% in equity?

I'd still pay off the mortgage early. If you're feeling torn about it, split the difference and invest half of what you would have otherwise paid extra toward the mortgage.

[Ummmm]

All I see is responses dealing with the current or possible return. Isn't anyone considering the diversification that comes with investing your money in several different areas?

If pouring extra money into your mortgage doesn't throw off the percentages that you have set to meet your goals it makes sense. But if you have way too much of your money tied up in just your house, you are missing the mark I would guess.....

[Lord]

If your income is steady, investing it usually does best. The less steady your income the sooner you can pay the mortgage off the better.

[thomas]

If you can get a higher return in the market, then investing is the better choice. Why go through the hassle of getting a HELOC when you can just sell a few shares? The interest on the home is deductable so that's another semi-positive to keeping it.

[juanny]

Maybe I don't completely understand how prepaying mortgages work, but I don't see the advantage to doing it on a monthly basis if the concern is getting the guaranteed return of the mortgage rate vs risking it in the stock market. Wouldn't it be better to buy CDs instead of prepaying. That way you are getting a guaranteed return (even though it may be a small one) but earmarking that money for prepayment when it will pay off the mortgage.

For example, let's say I have an extra $100 a month to either prepay or invest, but I'm afraid of losing money investing in the market. If I ladder CDs every month to have them mature in 5 years, after 5 years I will have $6,000 plus a couple hundred dollars in interest on the CDs to put toward prepayment, whereas if I prepay the $100 each month, I would only have the $6,000 in prepayment.

I've never seen this as a suggestion for prepayment (maybe it's out there, but I haven't come across it yet), but it seems logical to me. What am I missing here?

[Ryan]

Michael,

You point about the taxes has a downside also. If you prepay the mortgage, they may be tax free returns, but it also reduces your tax deduction (mortgage interest), effectively "taxing" you tax free return by prepaying the mortgage.

[Brandon]

Something to chalk up to pro-prepaying a mortgage that I don't see mentioned as often on PF blogs as it should is that if you have kids in college, the equity in your primary residence does not count toward your FAFSA basis for need-based scholarships and grants. Nonetheless, it does matter for many private schools. So, I could see primarily investing in a mortgage pre-payment if you had a kid going to school and you thought it might make the difference in their getting some grants and such.

Juanny

Your suggestion doesn't work because the time your money was sitting in Cd's at 3% you would be paying interest on your mortgage.

For Example,
Cd's over five years at $6000 initial deposit plus 3% would be $6955 after 5 years ,a $955 gain. Mortgage interest at 6% over that time would be around $2000.You would have paid an extra $1000 on the mortgage than gained on the CD's because the interest on the mortgage is higher than the interest on the CD's. So you would be losing money in the long term.

[Mike S]

FMF,

Great post. I've been thinking about this same thing for a few weeks.

I've always been a pre-payer. I'm currently paying $500 extra each month on a 15-year fixed rate @ 5.75%. This note is less than one year old.

We just refinanced (haven't closed yet), a 15-year fixed rate @ 4.85%. I'm not sure it makes sense to pay $500 extra on a rate this low.

I'm planning to allocate the extra principal payment of $500 + an additional $170 each month (representing the difference from old payment amount vs. new payment amount), and transfer $670 per month to an equity index fund.

Maybe we'll let the index fund $$ accumulate until it's enough to pay off the mortgage, or maybe let the index fund $$ sit and pay the mortgage according to the 15-year schedule.

[Kevin]

Mike S - I hope you didn't pay too many closing costs on those 2 mortgages in the past year. That alone could wipe out any savings you earn by prepaying or investing the money.

[rwh]

I was a pre-payer back in the early 90s with our first house. Rates were about 8% then. Our current mortgage is at 5.5%. We itemize and we're in a combined 32% tax bracket (fed and state). Subtract that and an annual inflation rate that is now about 2.7% and the current "real" cost of borrowing is about 1%. That's historically very cheap.

In addition, we fund 6k/yr combined in two Roth IRAs and an additional 5k/yr combined in two college 529 plans. We also save another 5k/yr or so in bank cds and a money market mutual fund for emergencies, and when you have kids, cars, a house and middle age health you will have emergencies.

We have no other debt and paid cash for a new car in 2007. We are very comfortable with our current $600/month mortgage payment.

As I've stated before on this blog, don't pay extra on your mortgage unless you can first diversify as described above. Notice we are NOT maxing our Roth or our 529 contributions. This is because we cannot afford to, which means we cannot afford to pay our mortgage early either.

One final comment: It seems odd to me that someone would pay their mortgage early in order to "get out of debt" then use a home equity loan as their emergency plan if they need cash. Getting out of debt doesn't really make sense if the only way out of an emergency is to go right back into debt. And remember, those home equity loans usually require payment in full in 5 years.

[Julia]

The strategy that works best depends upon the specifics of each individual's situation. What's best for me may not be best for you. I worked to pay off my mortgage completely after reading a few articles on the Get Rich Slowly blog on this very topic. I realized my mortgage was my only debt. I had fully funded retirement, emergency funds, etc. I started cutting way back on expenses so that I could put even more money towards my mortgage. To me, I was willing to give up cable and other fluff in order to own my house outright. If I instead decided to maximize my investments, I wouldn't have been nearly as motivated to be so frugal. I think I had already lost the ability to deduct my mortgage interest, so that wasn't a benefit for me. I did sell some securities to pay off the mortgage, but they were all in one company and I really needed to diversify. The shares in that company have gone down quite a bit since then, so I feel even more like I made the right decision. The goal of having my mortgage paid off also motivated me to stop dreaming about a nicer house. What's better, living in a paid off house, or living in a bigger/nicer house that you still have to pay on every month? I decided the paid off house was well worth it. In addition, the smaller house means less furniture to buy, less energy to heat/cool it, and lower property taxes. Win win win.

Now the next step is saving up money for retirement. My 401(k) is already maxed. With such low living expenses it's even easier to consider retiring early. But that's a goal where my 401k and Roth won't help. I need to keep building on my investments.

[Mike S]

Kevin- Great point! I did the math and it still makes sense to do the REFI, but the savings is NOT a substantial amount.

[Mark]

Paying off your mortgage is usually not the best use of your extra cash flow, but paying it down to a certain point is a smart move. The recent slowdown in the real estate market was a healthy wakeup call to those who expect their homes to appreciate more than 5% per year. That's barely higher than inflation, and far less than the 8-10% average returns on most stock index funds. While 30-year mortgages offer lower payments and more cash to invest, the amount of annual interest is only partly deductible based on your tax bracket. A better option is the 20-year fixed rate, 80% LTV, which offers a balance between principle and interest payments.

If you can't sleep at night with the thought of losing your home, then my suggestion would be to set a goal of always keeping at least 25% equity available based your home's PRESENT MARKET VALUE. You can check comps on several websites like Zillow for your home's market value, based on recent sales. If you have a mortgage and other home equity lines, pay those down to maintain 25% equity. That way, if you lose your job, or are forced to move unexpectedly, you can put your home on the market for up to a 25% discount for a quick sale. After that goal is reached, go back to making the scheduled payments and divert the remainder to other investments. If your home value sees a plunge like most did these last few months, keeping this equity buffer gives you the freedom to set your sale price without having to worry about foreclosure. Get over the fact hat your home lost value, and be satisfied that your credit and your freedom to move on are spared.

The bottom line is that a house is your home first, a tax shelter second, and an investment third.

[aaktx]

I paid my mortgage off last year. It took 19 months and was well worth it. My cash-flow is so much better, and I have been investing the previous mortgage payments into index funds. I still think I am young enough to see appreciation in my index funds(36years old). The market and my index funds/etfs are down but I think in twenty years they will seem like a bargain. I made sure I had a year of emergency expenses in a money market fund and that I took advantage of pretax contributions before I paid the mortgage off. My location and job are pretty stable. You can view the mortgage as a conservative bond-type allocation with a 5-6% yield.

[juanny]

someone replied to my question with: "You would have paid an extra $1000 on the mortgage than gained on the CD's because the interest on the mortgage is higher than the interest on the CD's. So you would be losing money in the long term."

Wouldn't you be paying that mortgage interest regardless? Prepaying your mortgate doesn't eliminate the interest on your monthly payments. You would continue to pay interest until you have paid off the principle, right?

With your example, if I prepaid on the mortgage I would have $6 more in equity, and still have paid $2k in mortgage interest. Where as the CD example, I would now have $6900 that I could now put toward the principle, so I would be $900 ahead.

I know I must be missing something, because this seems so obvious to be the right solution. Sorry if I'm an idiot.

[Kenny]

I am a pre-payer back in the early 90s with our first house and then buying a bigger house in 2000's. With the first house paid off in Chicago, I took advantage of the LOW Greenspan rates and borrowed against my long term stock portfolio at 3.75%. I made some moves in the market, and paid that huge loan off.

Now I am debt free with no home mortgage rates, no credit card debt and no HELOC either. I have the choice to go HELOC if needed, but have not opened it, since I like holding my own paper to the home. We also itemize and we're in a combined 35% marginal tax bracket (fed and state). Even though borrowing is getting cheaper, getting returns from stocks, stock-dividends, and mutual funds is ALSO going down.

The theory of borrowing, making more money than the loan rate is NOT that easy, even by holding the dividend paying stocks, or Dividend paying ETFs (many of them), or a garden variety of CEFs. Hence, the ADDITIONAL cash flow from the income minus taxes minus expenses, is what I now use to buy 5 different ETFs every week (weekly averaging, which sounds a bit crazy!).

I can guarantee you that if you ARE able to pay it off, please do that, since you ONLY realize the net-net-net-net-benefit after you pay it off. All the fancy-dancy calculations I did in my 30's, borrowing more and more, did NOT always work out, due to uncertainty of returns. My Asian ETFs did as high as 40%+ last year to a low of -10% for REIT CEF.

I max out the 401(k) for myself, as well as pull out a chunk of money to max out my wife's 401(k). We prepaid Two College 529 plans (for tuition) and then funded another 529 plan for the College Expenses (don't forget this one). We save another sum and have $25K CDs rolling over for 5%-6% in a bank that gives me the highest rates in my metro area. This allows me to stay put at my bank without constantly moving my money around. Just have to take the proof of the highest 6month to 1 year CD rate to my bank, and they MATCH IT!!!!! Have you heard of this before? It works guys. You just have to ASK.

We have no car debt either, and started buying cars in auction. The last one was undervalued by $5500, but I am talking about a dealer auction here (where we pay the dealer $700 for taking us there!!!!!).

So, all in all, if you can do it, please SAVE the most, Pay off Debts, Save for College, Save for Retirement, Save extra funds and dump into CDs, and don't borrow on margin (I paid mine off in 1 1/2 years), and for God's sake do not borrow on 401(k).

Please ping me with questions, although I come to the blog 2-4 times a month. Spending late nights watching CNBC-World to check on the China and Indian markets (Chindia!). It is the place to invest the money and get 20%+ returns for another 2-3 years. After that the Super-Bull over there is OVER.

Kenny

ps: Look into Asian market ETFs, Dividend paying stocks, and create the buffer zone to increase wealth over years. Safety net gets built by living BELOW our means (I am living proof of not buying Coke when I eat at restaurants.....Now people agree with me after 25 years of drinking water cause it is good for you, and it saves $1.25 per coke!!!!!!!!!!!!). Imagine where all that savings from coke money from age 23 to current age 49 is sitting (ETFs).

[mel]

Thanks for all the great comments. This is something my husband and I have been contemplating. For the sake of our marriage I think we will split it 50/50. Half of the amount we would pay monthly to pay down our mortgage and half to be invested in mutual funds etc. I'm the one who wants to pay off our mortgage because I love the idea of no debt and security in knowing that all we need to pay is our property taxes. My husband is worried about missing out on compounding interest while we were paying off our mortgage. I think it would benefit us to do both.

There are also other kinds of gifts you can make to reduce taxes for long- term estate planning. First, you can give up to 12,000 per donor per recipient to family members and others each year without triggering gift taxes. You can also give to your children’ s or grandchildren’ s education through 529 savings plans. You can gift 12,000 a year to a 529 plan tax- free— or better yet, take advantage of a law that allows you to give a single contribution, covering five years, to a 529 plan. That means you can...