Paying Down Your Mortgage Makes a Comeback

As an add on to our discussion yesterday on how to pay off a mortgage -- check out these thoughts from the NY Times:

Homeowners with an aversion to debt are sometimes tempted to pay down their mortgages before they come due. That can be a misguided approach, some financial counselors say, if borrowers can instead put that money into relatively safe investments that produce a higher rate of return than the interest rate they are paying on their mortgages.

In the current financial environment, however, prepaying on a mortgage might make sense.

With the securities markets plunging early this month, there have been few well-paying safe harbors for investors, making early mortgage payments more enticing than might otherwise be the case.

As has always been true, paying off a debt is a guaranteed return on your money. With the market the way it's been lately, nothing's guaranteed in the short run (though in the long run odds are it will be a good performer.)

As you all probably know, I paid off my mortgage using a specific formula for buying a house. The move to pay off our mortgage, something that once looked ridiculous to many when evaluated on a financial basis alone, now looks like it was a pretty good move, doesn't it? ;-)

For those of you interested, I've written about the tradeoffs of investing versus prepaying your mortgage (a couple times.)

I'm interested in hearing from you. Anyone out there who used to be in favor of investing over mortgage/debt prepayment now shifted their position (at least in the short term)?

Comments

[Mike B.]

I haven't shifted my position, but I will say I'm looking fairly brilliant right now for having chosen to pre-pay my mortgage over the last 4 years as opposed to investing in the market. 2 years left to pay off!!!

[Mark]

Nope, I still think it's misguided to prepay your mortgage under most circumstances, with the exception of maintaining 25% equity at present market value at all times. The recent meltdown in home prices is proof that no investment is certain, but history is on the side of stocks and mutual funds beating home appreciation by a wide margin. I've seen many older folks being forced out of their homes paid for decades ago because they can no longer afford the property taxes--some of which are higher than a full year's worth of mortgage payments.

Now if it just helps you sleep at night knowing the home is paid for, then so be it. Good for you! I would sleep just as well knowing that I could get out of my house if I needed to, without damaging my credit.

If I could get away with it, right now I would consider taking out all the equity in my home, burning it to the ground, taking the insurance money and buying as many stocks and mutual funds as I could afford in this down market. This too shall pass....

[MonkeyMonk]

I've never been a paying down advocate probably because I tend to look at money and investing in the long-term. With interest rates as low as they have been in the recent past I would think most experienced investors would take their chances of beating their mortgage percentage in the markets.

I'm not in the house market right now but if i was I would probably only put 20% down even if I could put much more sizable chunk down. There's just too many bargain investments out there right now and in order to add to my portfolio I need liquid assets -- once they're in the house they're tied up for as long as I own the home.

On a related note: What likely impact will today's interest rate reduction have on current mortgage and refi rates?

[Jim]

I think that this is one of the areas that isn't so much about the right answer versus the wrong answer but its more a matter of personal priorities and choices.

WE're paying down our mortgage for the security and because it is a guaranteed return.

Security is probably the bigger reason. If the home is paid off then your expenses are lower and you don't have to worry about making a big mortgage payment if you run into financial problems.

I certainly do agree that long term its likely that the stock market will give you better returns than paying down a mortgage. But the returns from the stock market are not guaranteed. Paying down a mortgage is a guaranteed return. THe stock market will also not give consistent year to year returns and will be volatile.

I also think that paying down a mortgage is a lower priority than a lot of things. You should first have a sizable emergency fund, pay off other debts, and fund your retirement savings.

For a long time I waffled over paying down the mortgage or making more investments. I eventually decided to go ahead and start paying off the mortgage. I can tell you first hand that owning a home free of debt made a HUGE difference for my parents financially.

Another reason I'm paying down my mortgage is that I also have rental real estate with mortgages. The more leveraged you are the more exposed you are to risks. I would like to lower that risk exposure by paying down the mortgages one at a time and paying off our primary residence first secures our own home.

Jim

[Rod Ferguson]

I have always been an advocate for debt reduction, which includes mortgages. As with any real asset, a house only has counterparty risk when a mortgage is attached to it - otherwise, you simply have to maintain it. To quote Mark Twain: "I am more concerned about the return OF my money than the return ON my money."

With that being said, we are about to receive an estate check (my wife's mother recently passed) that will go directly into our home. It won't pay it off, but will reduce the time to pay it off down to 4 years (and save me about $60k in interest payments).

[Matt @ Steadfast Finances]

This may sound wishy-washy, but I think you should do whatever makes you comfortable. Some people aren't comfortable investing, so they put their money in places where they know it's a safe investment.

Number one investment people make is their home, so it's not surprising to see an uptick considering the stock market turmoil.

Mathematically speaking, investing the extra money and getting the 8% historical returns is a better way to go, but seeing that the S&P 500 is lower than it was 10 years ago... it's a tough sell to make.

[Troy]

I am in the camp that you either like debt or you don't

It keeps things simple when you look at it in concrete terms.

Good debt, bad debt, deductible debt, risky debt, rewards debt, short term/long term debt. Whatever. It is all debt - just a matter of degree and excuse as to what you label it.

I don't like any debt. Not credit card debt, not car debt or student loan debt or home loan debt.

I thououghly understand triangular arbitrage and advanced finanical theory. Part of my MBA and now my employment. I too thought I was smarter than the situation, but then we realize we are not in charge, the situation is.

I then realized that debt is bad. It is a form of risk. Some slight, some heavy. It also complicates finances.

I see and hear those that speak of debt as a tool. I used to think that as well. Then the light I saw. Money is the tool, not debt. Debt is a form of aquisition of the tool. Debt isn't the tool, it is renting the tool.

After the episode of brightness, I saw everything differently.

Credit cards. I see right throught them and their marketing propaganda. Absolute worst financial instrument ever concieved for its average user.

Car loans. Likely the 2nd most foolish way of aquisition ever. Nothing like financing a depreciating, initially and annually taxable liability to "drive" the point home.

Home loans. I understand their need, and due to generalized appreciation, not a bad move for aquisition, but I think it should be your major priority to pay off as soon as possible.

So yeah, I shifted my position, and it has nothing to do with the current financial situation. It has everything to do with a simplified financial life. Not owing anyone anything is pretty simple. No risk is simple. I like simple

[Kevin @ The Money Hawk]

I've always been a fan of paying off mortgages. I don't use other types of debt and a big hefty mortgage doesn't sound like fun to me either. I'd rather have ZERO payments and a boat load of cash flow.

That directly translates to FREEDOM.

[hal]

I've been making extra payments to pay down my mortgage early. However, lately I am seriously thinking about stopping my payments all together. Then I can call the bank and tell them I won't pay, and have them renegotiate my loan. Seems like that's the right thing to do these days.

Being responsible in this country is a losers game. And that's before Obama gets in...

[Stephen]

I bought my first house 11 years ago. I refinanced a couple times for lower interest rates and reduced the loan period each time to my current 10 year period. Looking on how I would have done if I had invested the extra money instead I'm very happy with what I did. I'm not paying extra now as the interest amount is so low at this point it doesn't make sense. Any extra money now goes into index funds. I'll have my house paid for in 4 years and am looking forward to the additional money I'll be able to invest when that happens. Oh, not to mention the security of having it paid off !!

[Sarah]

It would be unfortunate if you had sunk so much into mortgage repayment (which gives you a relatively illiquid asset) that you were not able to deal with, say, losing your job in the present environment.

For various reasons, this year I decided that rather than prepay my student loans monthly, I would put the money in an online savings account and pay one off entirely at a time (yes, this cost me the percentage point spread between the account and the student-loan interest rate, but over the course of less than a year, that's a pretty small amount). Then I had a significant personal crisis (out of my control and unanticipatable), and I was so glad to have that money there as a cushion (even though spending it on something other than loan repayment would have crushed my soul, having to run up credit card debt to deal with the situation would have crushed my soul *and* mangled it). It gave me options I wouldn't have had otherwise, and it let me be a little easier on myself during a very stressful time period.

This is not to say that mortgage prepayment is a terrible idea, but I'd tend to want to split that money and put at least some of it towards plumping up the emergency fund a little bit more. (Speaking in general; I seem to recall yours is quite large, FMF.)

[Sarah]

(I should add for clarity that I do have an independent and not tiny emergency fund; it's just that the loan prepayment savings were about 1.5 times more money.)

[JimmyDaGeek]

Paying off a mortgage must be looked at from a long-term perspective. You can't eat the house. You can't use the money locked up in the house without borrowing it again. So how smart is that? So comparing to the current market situation is stupid. Market investing is long-term perspective, too.

[Joe B]

What if you are currently underwater (owe more than your house is worth) is it still advisable to accelerate the pay down when you are one job loss away from losing the house?

[Miss M]

Joe B, don't know your whole situation but I can relate to the underwater part. I bought in LA in 2005 and am definitely swimming at this point. You imply a job loss would equal losing the house, do you have an emergency fund to cover your mortgage for a few months? If not put any extra money in savings first, the only way prepaying would help is if it gets you into positive equity territory where you could sell rather than lose the house. In my case there's no way to pay off enough, it's better to wait out the market.

I think prepaying a mortgage is important if early retirement is your goal, otherwise I don't like the liquidity problem and I'd rather have my extra cash available to me.

[Mark]

I think I'm starting to go the other way - STOP pre-paying. IF you believe the stock market is near a low, this is a buying opportunity. If you need cash to buy stock, get it by NOT prepaying your mortgage.

It is emotionally tempting to separate our money into different pockets, but I like to think of using home equity (WITHIN REASON) as a margin loan with the following advantages:
- it cannot be called if the market drops
- lower interest rate than a typical margin loan
- deductible interest.

On the other hand, if you DON'T believe in buying stock on margin, then you should put every spare dollar into your mortgage, and have NO taxable savings or investment account except for short term or tageted needs (emergency funds, college)

[Mark]

Just to be clear, I believe that any savings (including retirement savings) in taxable accounts (i.e., after you have maxed out 401-k, IRA, etc.) while you still have a mortgage means that you have borrowed against your house to invest for retirement.

[Mark]

And one slightly off-topic point: If you want to feel good about your progress on the prepayment, get an amortization schedule for your mortgage. Notice the tiny fraction of the first few payments that goes to principal. All you need to do to pay off in less than half the time is the following:
In year 1: Total up the principal that should be paid in year two. Divide by 12. Add this amount to each monthly payment in year 1.
In year 2: Total up the principal that should be paid in year four. Divide by 12. Add this amount to each monthly payment in year 2.
In year 3: Total up the principal that should be paid in year six. Divide by 12. Add this amount to each monthly payment in year 3.
etc.

This becomes more difficult as you get further out (take a look at the total principal in year 30). But, if your income grows as the years go by, it all takes care of itself and pretty soon it's paid off.

[Tim]

Great topic.

One thing I never see mentioned in these pay off mortgage early discussions is in relation to the "guaranteed savings". These savings are only guaranteed if you own the house until the mortgage is paid off. THEN you start saving. If you just pay for a while, then move and sell, you have NOT SAVED anything. IE when you pay extra principle, unless it is a HELOC, your payment doesn't go down. You still pay the same amount every month.

[cff]

I am from the mindset that paying down your mortgage the "conventional" way is a risky situation. The money isn't liquid and not earning a rate of return. Strategies such as using 15 year mortgages and accelerating payments make it even riskier. You could pay all you want for 10 years and if you miss 1 payment, the bank doesn't care. You are required to keep making payments even if you've paid extra of the years.

They'll even take the houses that have more equity in them first. This is to recapture their losses. But, if you really want to pay off your home, you do it in one payment. Make your payments as low as you can (i.e. interest only loan). Do not use an amortized schedule. Once you can make one huge payment for the remaining balance, then stroke the check.

That's if you want to pay off your mortgage. However, the equity inside a house can be used in much more productive ways.

[Mark]

Tim said:
"If you just pay for a while, then move and sell, you have NOT SAVED anything. IE when you pay extra principle, unless it is a HELOC, your payment doesn't go down. You still pay the same amount every month."

There are two errors in this statement. Firstly, regardless of when you sell, you have saved the interest on the prepaid principal - which may not seem like much at the time. Secondly, when I had an ARM, the monthly payment reset every year. The new payment was calculated using the new interest rate AND the current outstanding principal. If I prepaid enough, and interest rates rose, the payment still went down.

It is true, however, that if you sell before it's fully paid off, you have not reduced the amount of time you hold a mortgage - because you'll go right back out and pick up another 30 year mortgage!

[Tim]

Mark,

As to your second point about the ARM re-setting each year - I haven't seen it, but if that happens, that is a good point. But even so, that is only for ARM's, most people have fixed, and if they do have an ARM, it is usually only 1,3,5, or 7 years then fixed. And if you pay extra principle in the first month, you don't get the savings till up to 11 months later, ie 11 months with zero percent return on your money.

As to the first point re "regardless of when you sell, you have saved the interest on the prepaid principal - which may not seem like much at the time." I am not clear what you mean by this. On a fixed rate amortized mortgage, if I pay $1000 month normally and $100 goes towards principle and $900 towards interest. I pay off an extra principle amount, my payment the next month is still $1000 with $100 towards principle, is it not? And that payment would go on till the total principle was paid off. At that point, I would start saving, but that is ONLY after it is all paid off, so zero percent return if you sell before all principle is paid off? What did I miss? Are you saying that the $100 towards principle would go up because the principle balance is lower? I know it does adjust up slightly each month as part of the amortization process, but is that pre-programmed, or does it adjust on the fly as you pay off extra principle?

Thanks,
Tim

[nooney]

You should read this article called "10 Reasons to Carry a Big Long Mortgage":

http://www.rosswealthadvisors.com/PDFs/10_Great_Reasons_to_Carry_a_Big_Long_Mortgage.pdf

[Mark]

Tim,

Most ARMS are fixed, then adjustable, not adjustable then fixed. (3/1 means fixed for 3 then adjustable each year)

"And if you pay extra principle in the first month, you don't get the savings till up to 11 months later, ie 11 months with zero percent return on your money."

That is not how mortgages work at all. Every month, your payment goes to three sources: Escrow (property tax and insurance), interest and principal. Everything left over after the first two goes to the third. And every month, the amount of interest is recalculated based on the current outstanding principal - i.e., after the previous month's payment. You receive the benefit of your prepayment of principal the very next month.

"Are you saying that the $100 towards principle would go up because the principle balance is lower? I know it does adjust up slightly each month as part of the amortization process, but is that pre-programmed, or does it adjust on the fly as you pay off extra principle?"

That's exactly what I'm saying. See my explanation above. The amount of interest depends on the current principal balance, and adjusts on the fly as you guessed. The only case in which you would pay the same amount of interest every month would be if the principal was unchanged - i.e., an interest-only loan.

The key point in all this is very simple: You only pay interest on the outstanding principal.

[Strick]

A lot of things get mixed up in the whole pay off home versus not debate. The only difference between pre-paying on a 5% mortgage and putting the money into a 5% taxable cd/money market is availability of the funds.

Everything else discussed is really a different issue:

1)tax deduction of interest just requires you to calculate the true after-tax deduction rate of interest. The tax savings on deducting 5% interest equals the tax liability on making 5% in a taxable account. If your talking a tax advantaged account, the math gets more complex but still exact.

2)the "no risk" of pre-paying reasons (like the one that Dave Ramsey uses to encourage paying on your house) is really a question of balancing your investments. The savings of paying down your mortgage is just like if its put into a FDIC insured savings account at the same interest rate (both guaranteed at a certain rate). I think its important to factor in your home equity when doing this balancing. A 35-year old with 90% stocks/5% bonds/5% cash is taking on completely different amounts of risk with 50% of his home paid off than one who has zero equity. I look at my home equity as part of the cash of the equation. Of course doing it like this means the normal risk models don't really apply.

If I put the savings in its own taxable account (I can even name it the "HOUSE PAYOFF ACCOUNT" on quicken) that pays interest at the same rate as my mortgage, the amount of money in that account will always equal the amount I would have knocked off my mortgage balance, and I can always pay the mortgage out of that account to get to the same point I would have been pre-paying. If the bank account pays more, pre-paying only makes sense if I get value out of not being able to easily touch the money (forced savings). If the bank account pays less, saving the cash only makes sense if that has a value (needed cash flow to pay the bills).

The difference is which path someone takes is tiny compared to real keys -- don't buy too much home in the first place and spend less than you earn.

[headknocker]

I think the big difference in paying off a mortgage early and investing the "pre-payment" amount is the results of earning interest on the investment. If you take the extra and invest at 10% instead of paying off a 6% loan, the 'benefit' would be around 4%. Once you pay taxes on that growth, it isn't 4% anymore. But for me the biggest reason to pay the extra on the mortgage is the risk involved in the market. I don't know of any guaranteed 10% investments, but paying down the mortgage is a guaranteed no-risk opportunity.

[Mark]

Rick Edelman is correct about NOT paying off your mortgage, and Dave Ramsay is wrong (about many things financial)

[Penny girl]

I investing in other things while paying the minimum on my mortgage. All the finance books I rread convinced me of that. Then I heard from suze Orman to pay off your mortgage early because it is safer and more secure to live in a house that's paid off when you lose your income versus having a mortgage and losing your income. I wish I listened earlier.

[Savers]

What happens to the total mortgage interest in the following situation? Mortgage payment due on 3/1, but instead it is paid on 2/20. Then each subsequent month the mortgage is also paid about 10 days before it is due. Does this speed up the pay off?