Stock Investing Versus Paying Off Your Mortgage: Guess Which One's Been a Better Deal the Past 10 Years?

Here's an email I recently received from a reader regarding a Wall Street Journal article titled "Stocks Tarnished by Lost Decade":

The article goes on to state that, adjusted for dividends and inflation, the S&P 500 returned only a 1.3% ROI from 1998 to 2008.  Interesting to me because, in discussions about whether to pay off a mortgage, the advocates of investing typically use ROI's of 8% or more.

If you assume inflation over the 1998 to 2008 period of 3%, and dividend return of 1% (adjusted for taxes on the dividend), then add on the ROI of 1.3%, you get a return of only 5.3%.  This does make it much more attractive to pay off a 6% or 7% mortgage - or even one as low as 5.5% - as opposed to investing.  Factor in the risk factors of certain years being down instead of up, and paying off a mortgage looks even more attractive.

The above said, I've got sizeable investments in stocks.  If you're looking at the very long term - more than 10 years - they're where you want to be.  The problem is that certain advocates of leverage on houses don't realize the level of risk they are taking.  True diversification involves analysis of all the risks involved.

Just my $.02 worth.

I think this was a thoughtful and well-balanced comment and gives a fairly good perspective on the investing versus paying off your home debate. In the end, there's not one correct answer (there never is, is there?) but depends on your circumstances, goals, willingness for risk, and a gazillion other factors.

i

Comments

[Suze]

I agree: it is thoughtful and well-balanced.

Obviously too thoughtful and well balanced to get us all het up in the comments section.

[rwh]

I guess what I would like to see are specific numbers.

Let's say two people had 100k in the S&P 500 in April 1998 and a 100k mortgage at 7%. The first person continued to invest $100/month in the S&P 500 while the other person paid an additional $100/month against their mortgage instead of investing in the S&P 500. They are in identical tax brackets and pay identical property taxes.

What would the S&P 500 portfolio be worth today in each case? How much lower would the mortgage balance be today for the second person compared to the first person? How much more of a tax deduction did the first person get over the 10 years compared to the second person? Add all those things together and see who did better overall.

And who is better diversified today?

Even if the mortgage prepayer wins, my guess is in most 10 year periods that won't be the case.

[sow]

Equity in your house has no rate of return. Unless it is in your hands, it does nothing for you. If you keep equity out of your house, liquid, and earning a rate of return in a safe investment vehicle, then I would say you are in the safest position.

[OneCheapChick]

I paid off my mortgage at the end of last year...and took some flack for doing it, so I'm glad to see this analysis. Thanks for the post.

My calculations suggested that keeping the money invested would likely lead to better returns, but only by a little bit. The security factor of owning my home outright tipped the scales in favor of payoff.

But one huge benefit that nobody seems to talk about is that paying off the mortgage now lets me sock away money like mad now that I don't have a mortgage payment each month. So while I have taken a huge hunk of money out of the market, I'm adding back to it rapidly in a way I wouldn't have been able to do before. So I may be light on equities now, but that's changing fast.

[William R]

It is unrealistic to assume that an arbitrary recent time window (the last 10 years) accurately reflects future expected returns...especially when that time window is immediately following a very strong run. Remember, "long term" in stock market time is not 10 years, it is more on the order of 30 years. Retirement planning should be the name of the game, so why not instead use the long run S&P500 annualized return of ~11%?

Considering that both a home and stocks are long term assets which you wouldn't expect to need to liquidate suddenly, this decision should be based purely on which strategy will most likely maximize your net worth. If you pay off your mortgage, you are foregoing the opportunity to earn 11% on average in order to avoid paying 5.5% in interest (less if you factor in the tax deduction benefit). That is not a net worth maximizing strategy...and the longer your investment horizon, the more certain that is the case.

My recommendation would be to keep your cheap debt, keep your tax deduction, and put all that money that you were thinking about using to pay off the mortgage into some low expense ratio index funds right now!

[Curt at PennyJobs.com]

Paying off your house is the best investment strategy even if you give up 5% in interest. I have read all the arguments about investing the money somewhere else. The security benefits and emotional up and down market is not worth it and most people spend more than the additional 5% they could have made from another investment when they believe their house is not debt. The devistation of losing your home is not something to forget.

[Zook]

At the very least, if possible, you should pay a few extra bucks a month towards your mortgage AND be saving money into tax-deferred accounts and others. BOTH should be done.

If you can get a 5-6% interest rate on a home right now, I don't quite see the need or rush to pay off the debt. Pay an extra payment or two a year? Fine, but a mad rush to be mortgage free in 10-15 years seems incorrect.

Would I like....no love to not have a mortgage payment right now? You betcha, but not at the expense of pumping every account I can to the max.

Now if you are pumping your Roth with $5k and the 401k with $15K this year and have extra paper to pay down the mortgage, go for it.

[Daguru]

By analyzing internal rates of return and risk-adjusted returns, studies by Dalbar, Moody's and others corroborate the fact that the "average" investor has NOT done well in the stock market for a very long time. Some investors have indeed done better than others, but the average investor would have been better off paying down their debt.

[Traciatim]

"In the end, there's not one correct answer (there never is, is there?) but depends on your circumstances, goals, willingness for risk, and a gazillion other factors."

There is a correct answer . . . flip a coin and stop spending your money on crap you don't need.

I think it alot about were your retirement money is coming from. If you have a good pension plan than no mortgage is maybe a good idea. However, If someone is on their own for retirement savings I would lean towards a larger portfolio. For me I am 25 so pre-paying may not make sense for me.This is because the house is paid off in my forty's anyway.When it all comes down to it if someone is doing one or the other they are moving in the right direction.

[sow]

Our plan is to displace as much equity as we can from our primary residence. Meaning, we don't plan on ever paying off our mortgage. As I stated earlier, the equity in your house does nothing. It earns no rate of return. And as one increases monthly payments to pay off the mortgage, the risk of never seeing that money ever again increases with every payment. A homeowner must understand that the next monthly payment of any mortgage is always due, no matter what. So, even if you have paid 15 yrs of extra payments, your next monthly payment is due. So,if you really wanted to pay off your mortgage, even though I would never, the best way to do it is in one transaction.

In my opinion, keeping that equity separate and liquid is the most responsible thing a homeowner can do. Imagine what you could do with that equity. You could actually earn a rate of return in another investment vehicle instead of it being stuck in your house. People who have foreclosed or are facing foreclosure these days would be in a better position of keeping there home if they had that equity liquid and separate. Don't decrease your control of your wealth by making extra payments on your mortgage. All your doing is increasing your risk and decreasing the bank's risk...not to mention letting the bank earn a rate of return on your money instead of you.

[AdamCO]

regarding the idea of keeping house equity liquid. personally, i'd rather own my own house than have the bank own it. if the sh*% hits the fan, the 'investor' who continually acted as a debtor on his own house will lose his house, while the person who paid it off will have their house.

[sow]

The only way you can lose your house is if you don't make payments. So, the lower the payment and if you keep that equity separate, liquid and earning a rate of return in a safe investment... the safer you are.

No one will ever truly own their house. Want to know who really owns your house? Stop paying your taxes and find out. The state will take it faster than you think. And if the crap hits the fan like unemployment, disability, or another emergency, you could possibly need that equity. How likely is it now that you will be able to take the money out of that house? Not likely. Banks lend on the probability that you can pay the loan back. If your ability to pay is not likely, then sorry.

[Big Cheese]

Sow,

Your argument isn't that strong in my opinion. Paying off your mortgage is a guaranteed avoidance of paying whatever your mortgage interest happens to be. Sure you could try and get a higher return and pocket the difference but why not just take a bank personal loan than? If you want to build up your own savings then live below your means and pay off all debt even the mortgage, I guarantee you will accumulate capital faster than you thought possible. Or if things go South your cash flow will look very good as your cost of living would be limited to food and property taxes... not a bad place to be in todays market.

-BC

[Ryan S.]

The reason I don't pay off my house early is not because of the rate of return versus the stock market, it is because of the insurance companies. I am in a hurricane prone area and last time we had a hurricane that damaged lots of houses, the insurance companies balked due to the sheer number of homes that were damaged. So in my area, it is better to own as little of your house as possible, so that you can walk away when the insurance company betrays you.

[steve]

Not anywhere near an expert. But, with a mortgage, you get tax deduction on the interest paid. Should people take that in account as well?

[sow]

BC,
You're right, paying off your mortgage is a guarantee that you're avoiding paying mortgage interest. You're also forgoing earning interest on those dollars and losing liquidity. Let me put it this way. Let's say my home is $100,000. What's the difference between having that money in my house free and clear (no mortgage) and having it mortgaged to the tilt and that $100,000 buried in my yard? They're pretty much the same because they're not earning interest. But, I would say that having it buried in my yard is safer because it's more liquid to me. But I hear someone out there saying, "But yeah, now you have a mortgage." Well, if my mortgage interest is 6%, but really 4% because of the tax deduction, then if I make 4% on that money, I'm already in the black on my mortgage. And it's liquid to me all along the way.

[jim]

I disagree.

Remember this from April 26th on your own blog? "1. Think portfolio, not funds. Before you start picking individual funds, get a plan. Basically, you want to build a portfolio that includes a variety of different types of stock funds - ones that invest in large stocks, small stocks, growth and value, international shares - and bond funds"

Comparing to the S&P500 is too convenient for your argument here. US Stocks account for just 50% of the worlds equity (according to Buffet interview the other night) and the S&P represents much less than 50%. I've had tremendous returns over the last 10 years (can't give you an exact return % number but have a significant growth over what I put in... certainly much more than is explained by a 1.3% S&P return)... and to be honest haven't thought much about it other than to stay diversified accross US equity, International Equities, REIT funds, and some bonds funds.

Here's a good article on "Lazy Portfolios" that show significant gains over S&P for the past 5 years... very interesting

http://www.marketwatch.com/news/story/lazy-portfolio-investors-ride-out/story.aspx?guid=%7B92870014%2D3D83%2D4DC1%2DB3FF%2DB7EE22AB2A9B%7D

I'm still waiting (and hoping) for Mtg rates to get to 5.5% range... then pulling everything out and plowing into the market. I used to overpay my mortgage but switched those payments to Roth IRA instead. Wish me luck.

[Alexandria]

I think there is a major phallacy at only looking at the last 10 years of the stock market.

The reason I currently invest instead of paydown my mortgage is because of my ROTHs. The lucrativeness of my ROTHs is not the return in 10 years. It's the return in 40 years, which I should be able to withdraw tax-free. IT's an insane amount of money I can generate for the long haul by putting little in now. My mortgage can't do that for me. It will be paid off by 55 if I never prepay a dime. So I don't see the big rush.

But does remind me, that I always felt the investing option was highly tilted towards younger people. If you are retiring in 10 years, well yeah, it makes little sense to invest for 10 years. Just pay off your mortgage. If you are in your 20s though, bulk up your tax-deferred investments. Don't pay off your mortgage. (Of course depends on your situation, but the answer differs widely with your age and retirement goals).

Or do both. It's probably what I lean towards. I am not going to waste my 20s and 30s prepaying my mortgage. I am far better off juicing up our retirement, 529s and HSAs. But I doubt I will still have my mortgage when I hit 50 either.

In the meantime, insanely low mortgage rates are much in my thinking as well. Current rate 5.25%. 4% after our measly tax rate. That isn't exactly hard to beat. Cash can beat that.

[Sarah]

If I'm reading your summary right (am I?), the study ended in '08, after a short-term but quite ugly dip. I think the numbers would have been significantly different if it had ended in '06. What this really shows, then, is that you took losses over the one-year span from '07-'08. If you can't afford that kind of loss--if you're that close to retirement, or if you're saving on a short time-horizon of another kind--you should not be that heavily in stocks.

[JACK]

sow,

That game you are playing only works if you have continued cash-flow to cover the mortgage. It get's a lot more complicated if you are having to realize capital gains to create the cash-flow to cover the mortgage. Similarly, the benefit of your mortgage interest deduction will go away over time. So, many of the evaluations of this question depend heavily on how much cash-flow one needs to cover the mortgage and the perceived risk of losing that cash flow, along with whether one is planning to live in the home during the retirement days.

I'm not saying there's not good reasons and a way to make what you are doing work, but it is hardly a slam dunk. And you are certainly right that people shouldn't treat home equity as the same thing as investment wealth. But your money is not "free" and "separate". It is only "free" and "separate" for you to use in hard times to the extent those hard times are not so hard as to cause you problems with your cash-flow covering your mortgage. Debt is debt. There's good and bad ways to manage it. You are betting your cashflow is stable enough for you to take advantage of the longer term better returns in investment classes than in home appreciation. I get that. But let's not pass that off as some mathematically-proven better way to go. Particularly if you happen to be in a market where home value may have dipped below your mortgage balance.

[sow]

JACK,
Here's a simple example of "hard times". Let's say that person A has a $100,000 house and $90,000 in equity in that house. Person B has the same kind of house and instead has separated that $90,000 from that house into a liquid fund, and earning a small rate of return(i.e. using an interest only loan). Both person A and person B lose their jobs. Who's in better position to keep their house (keep making the payments), as well as keep paying other bills? Person B. Home equity does nothing.

[Mike B.]

sow-

Quit claiming that paying down your mortgage is somehow investing in your house. It is not. A mortgage is a loan that just happens to be secured by your home. Making extra mortgage payments is investing in that mortgage (sort of like investing in a bond), it has little to do with your house except that's what you would lose if you didn't pay it.

The question I ask myself when deciding to pay down my mortgage is this: if I had the liquidity that I currently enjoy (and fortunately it is considerable), AND I did own my home with no mortgage--would I take out a mortgage and invest that money in the stock market? Risk my home to bet money on the market? Hell no. So, why wouldn't I get rid of the mortgage as quickly as possible when I can instead of risking money in the market?

I know that technically the ROI for the last century is like 8%--but that is just no guarantee, which is what this 1% over the last 10 is kind of pointing out. Getting whatever your mortgage % is is GUARANTEED money. Better than any stock or bond fund TO ME.

To figure it out is really simple:

Pay down the mortgage:
Return is: (mortgage %) - (loss of deduction for taxes)

Invest straight in market:
Return is: (market return %) - (capital gains taxes)

Those values are all fairly predictable except the market return %. That is wildly unpredictable.

(Note: I like the ROTH IRA idea, but I am not eligible).

[sow]

Making extra mortgage payments in investing in that mortgage? You don't get a return on that money going into your house. So, I don't see how it's investing in the mortgage.

And you're right, the stock market would be too risky. I say put it somewhere liquid, safe, secure, and earning a rate of return. Those equity dollars are ear marked for your house and shouldn't be put into a risky investment.

[Todd]

I tend to be on the "pay your mortgage off first" side of the debate, if only because the rate of return in the market is speculative. And I think that's particularly true in this market, where it is hard to find any investment that can guarantee a rate of return higher than 5 or 6 per cent.

Moreover, I believe that true financial independence comes first from having no debt. I don't buy the leveraged debt for investment theory. And I suspect that those whose net worths are over $1,000,000 have very little debt on average. In fact, I seem to recall that the typical "millionnaire next door" made a priority of paying off all debt, but someone who has read the book more recently can chime in if I'm wrong.

[Mike B.]

Again, sow, extra mortgage payments are not 'GOING INTO YOUR HOUSE'. You are paying down a debt. What secures that debt is fairly insignificant in this discussion. I don't understand how you can't see when you pay off debt, you essentially get a rate of return that is the mortgage rate. Less of your payment the next month goes to paying interest, so therefore you have saved money. And when you have paid it off, you can put that money you would have had to use to pay that bill every month and do whatever you want with it. If you pay off 10 years early, that's 10 years of monthly mortgage payments you can put whereever you want.

People say things like, "you can get always find a conservative investment with a rate of 5-6% easy." Where? Point me somewhere where I can get 5.5% right now. This is an honest question. I really don't know...

[sow]

Mike B. -
Ok, let's use a car as an example. If you buy a car and instead of financing it at 2.99%, I pay cash, you are saying I earn a rate of return of 2.99%. Doesn't sound right does it. I avoid the interest cost, but I don't get a return of 2.99%.

Let's use your example of paying off a mortgage 10 yrs early. If you are at year 11 and can't make that next month's payment, do you think the bank will forgive you because you've paid almost 10 years in advance? No. In fact, when they foreclose, they go after the houses that have the most equity first. How do I know? I have little to no equity in my house. A couple of months ago, I was contacted by my lender to refinance. How many stories have we heard that people have been contacting their lenders to refinance or work something out but to no avail? They contacted me!

[Mike B.]

Sow, Go back to the post with my formula. That's just the way it is. You are right with your car example--you aren't 'earning' interest. But you are also NOT PAYING interest. Therefore you have saved yourself 2.99%. Just put these numbers into an excel spreadsheet: on the one half put 'if I pre-pay my mortgage' and on the other 'if I don't' Extrapolate it out ten years and see how much money you have at the end of both. It's not magic, it's math. At some point, if you assumed enough return, you will definitely make more NOT pre-paying. But then it comes back to the fact that the mortgage pre-paying is guaranteed and the market returns are not.

I understand that you don't want to lose your house--certainly building up an emergency fund you are comfortable with comes first. But FMFs original post was about investing vs. pre-paying mortgage. Not about building an emergency emergency fund vs. pre-paying mortgage. Make sure you have enough in your emergency fund to pay your mortgage for long enough as it would take to sell your home without putting it on a fire sale, and you will never lose the equity in your home to a bank.

[Obafgkm]

I sent the original email to FMF about the WSJ report because I thought, from past discussions on the board, that it was something that would interest him. From the number of comments, it has indeed been a lively discussion.

Some further comments from me:

1. Stock Market returns are definitely related to the time period selected. The WSJ article simply took the latest data. A different time period - even by just a month or two - would give a different result. However, people must understand that the market can be stagnant for long periods. The longest period I can document is 17 years (Dow, late 60's to early 80's) where the gained value was exactly 0. The rate of return was positive due to dividend payouts, but negatively impacted by inflation. I haven't done the calculations, but overall I suspect the return on that index was close to 0 - for that time period. 1928 to the 40's is another long period of no growth.

2. Which stock market you select is a major factor also. Commodity markets, non-U.S. markets, NASDAQ, all have different rates of return over different time periods. All I can speak to is the largest markets. This is the reason that most financial advisors suggest reducing equity exposure and moving more into bonds as a person nears retirement age, to reduce the risk inherent to equity investments.

3. Mike B., I advise you to give up. sow has made up his mind and is not doing the numbers. Money put into a house is indeed the same as investment in a comparable bond. It has the added risk/reward of capital gains if the property value goes up/down. The investment capital is illiquid, but the value is not stagnant. The risk of foreclosure doesn't impact this calculation.

4. The tax deduction for mortgage interest is typically strongly over-emphasized by people. It is large in the first 15 years of a 30 year mortgage, then rapidly becomes very unimportant. People in the later years of a mortgage are usually surprised when they realize that almost all of their payment is going to principal, not interest, and that they get almost nothing as a mortgage deduction.

Last, if anyone can guarantee me an 11% stock market return over 30 years, I'll thank them very much. And, yes, I'll do the same for a 5.5% bond return these days.

My $.02 worth

[Laura]

I don't understand why everyone automatically assumes it's either maxing out retirement and emergency fund savings OR paying down your mortgage. If you truly subscribe to the "living below your means" mantra, you can and should have both.

We could afford a $1200 mortgage. So we bought a condo with a 15-year note of $500/month (and still pay $1200/month to the mortgage). We each save 20% of our salaries (gross) for retirement. With the rest of our salary, bonuses, extra paychecks, selling stuff, second jobs and overtime, we're paying down the $3000 of debt (that was almost $30k early last year). I make in the high $30s and he makes in the low $40s (he's a 4th-year teacher). We have $5000 in emergency funds, to which we add a few hundred dollars to each month.

On the surface it may seem like we're splitting our funds between paying off the mortgage (which will be paid off in 24 months -- we got the loan in Jan '08) and savings; but to me, we've "maxed out the savings." We may not be contributing the max that the government allows for retirement, but we're contributing what the max is for our family. (Contributing 20% each for retirement when we have pension plans that will pay out 90% and 60% of our respective salaries will give us, in our opinion, what we need during our retirement.) Also, the $5k in emergency funds is more than 3-months' worth of living expenses. 3 months' living expenses is my comfort level (but not his-that's why we're adding to it). But since our emergency fund is higher than what I think we need, to me, we're maxing out our savings in this respect as well.

By sharing one car (in Houston), living in a 1BR 760 square foot space that feels much too small for us, etc., we're able to "max out" our savings and pay off our mortgage in 2 1/2 years total. So pardon me if I say both of you camps are wrong! :) Max out your investments AND pay down your mortgage quickly. To me, you should be shortchanging your standard of living for a few years (living in a smaller space/working extra), not shortchanging your debt repayment or investments.

PS. We plan on having 2 kids while we're here. (We got married in Jan '08). We'll move out and rent this place when we have around 50% to put down on a house (we'll be here a total of 4-5 years). We want to pay our first house off in 3 to 5 years as well. (We don't plan on working extra when we have our first child). We are both exceptional organizers and are already building ourselves inexpensive storage solutions to make this place work space-wise when we have a toddler and an infant. And for all the people who say we won't last here with 2 small children, HAH! Watch us. My grandmother did it. So can we. Good luck to you all.

[Geoff]

I would like to see what all the "pro investing" people have to say after the market dropping 20% the past week. It makes me feel pretty good about the decision to prepay mortgage rather than investing