Ready to rumble?
There’s a fight brewing. Two contenders have climbed into the ring.
Both are clawing for victory. Only one will survive.
In one corner: Crush Your Mortgage, and his team of anti-debt advocates.
In the other corner: Keep Your Mortgage, and his cheering crowd of leveraged investors.
Who will take home the title?
Pay Off Your Mortgage or Invest the Cash?
In all seriousness: “Should I pay down the mortgage? Or should I invest?” is a hot question.
There are SOLID arguments on both sides.
It’s been consuming my thoughts recently.
At the risk of sounding obsessive, I’ll admit: I think about this everyday.
I ponder this while I’m cooking. While I’m showering. While I’m running gnawing chocolate-chip ice cream straight from the pint.
Why deliberate so much?
- It’s complex.
- It demands a decision (and it needs one now).
- It influences hundreds of thousands of dollars. (And I thought being an adult would be easy.)
And since I have three mortgages, that’s three times the fun. ☺
Let’s take a look at some of the factors at play.
NOTE: This article is written for owner-occupants who would otherwise invest in the market.
The discussion and big-picture lessons apply to real estate investors, as well. But the “target audience” for this article is owner-occupants.
The Reigning Champ: The “Keep the Mortgage” Fighter
The reigning champion in the ring, returning to keep his heavyweight title, is the “Keep the Mortgage” fighter.
He’s the champ because most of America supports him. Most people spend 30 years paying off a 30-year mortgage. (Not that most people are investing that money, but …)
Keeping the mortgage is the norm.
But Afford Anything rebels don’t blindly side with the majority. We’re radical free-thinkers. So let’s think.
Here are the benefits to Keeping the Mortgage:
1) Investment Gains > APR on Loan
The top reason why rebels keep the mortgage? They believe their investment gains could outpace their loan APR.
This is a simple concept: You borrow money at a low interest rate. You invest it for a higher return. You pocket the spread.
- Banks borrow from the Fed at a low rate; lend to the general public at a higher rate.
- Travelers earn in dollars or euros; spend in Thai bhat or Colombian pesos.
And whether or not you’re consciously aware of it, every person who holds a mortgage and invests also plays this game.
So – Could your investments really outpace your mortgage APR? Probably. From 1990 to 2010, the S&P 500 returned 9.14 percent as a long-term annualized average.
“WTF does that mean?”
If you dumped a bunch of cash into an S&P 500 index fund in 1990 and didn’t touch it for 20 years, you would have earned 9 percent annual returns over the long-haul.
“But those were unusually great years. Right?”
Nope. Those two decades include the dot-com burst of 2001, plus the Great Recession of 2008. (Notice that the timespan ends mid-recession, before the recovery.)
“Oh, so I could earn 9 percent. Then why are we having this conversation? Isn’t keeping your mortgage a no-brainer?”
Nope. In finance, there’s a concept called “risk-adjusted return.” It’s a fancy way of saying that you can’t just stare at your returns in a vacuum – you have to look at returns within the context of risk.
- Earning 10 percent on Facebook stock is different than earning 10 percent in a savings account.
- Earning 12 percent on a dingy rental property in a high-crime area isn’t the same as earning 12 percent on a sparkling rental property in a high-end, luxury resort.
- Borrowing money to invest in the stock market isn’t the same as paying off a loan.
“But I’m not borrowing to invest!”
Yes, you are – in the form of opportunity cost.
But we’re getting off-track. In this section, we focus on arguments in favor of Keeping the Mortgage. So let’s look at the second reason:
2) Compound Interest > Simple Interest
Alright, this one gets a little more complex. Hang with me:
When you invest, you earn compounding interest.
- Year 1: $100 * 10 percent = $110
- Year 2: $110 * 10 percent = $121
- Year 3: $121 * 10 percent = $133
By the end of Year 3, your original $100 has grown by 33% of its value. Wowza.
Mortgage interest … well, if Facebook had a relationship category for mortgage interest, it would be “It’s Complicated.”
Mortgage interest is calculated as simple interest, meaning that it’s a straight-line rather than a compounding figure.
- Year 1: $100,000 * 5 percent = $5,000
- Year 2: $100,000 * 5 percent = $5,000
- Year 3: $100,000 * 5 percent = $5,000
Seems “simple” by definition, right?
But there’s a curveball: Mortgage interest is “amortized,” which means that during Year 1 of a 30-year mortgage, the vast majority of your payments are applied to the interest, rather than the principal. In other words, you barely make any equity gains as a result of mortgage pay-down.
In Year 29, the tables are turned: You’ve repaid almost all the interest, and the bulk of your payments are now used for equity paydown.
This gets complicated quickly, so let’s use charts and a calculator to illustrate it:
Here’s the situation illustrated in the chart:
- Loan: $200,000
- Term: 30 Years
- Interest: 5.375%
- Tax and Insurance: $250/mo
This tracks the first 8 months of the mortgage. Notice how the bulk of the payments are applied to interest, with only a tiny sliver going to the principal?
Okay, now climb into our Time Machine, speed ahead to the year 2044, and look at our payments.
Notice how the majority of payments are applied towards principal, with only $5 on interest at the end?
(Yeah, this is how I spend my Saturdays. #NerdAlert)
Let’s recap:
- If you invest, you earn compound interest, which is sexy.
- If you pay mortgage interest, you’ll only pay simple interest (yay!!), but you’ll pay on an amortized schedule (boo!!).
If your head hasn’t exploded yet, check out the next “Keep the Mortgage” argument:
“‘Cuz We Are Living in an Inflationary World”
(Sung to the tune of Madonna’s Material Girl)
If you have a fixed-rate loan, inflation is your best friend.
Thanks to inflation, you’ll repay your loan in cheaper-and-cheaper dollars over time. Today, your monthly mortgage payment is $1,400. That same $1,400 could buy you roundtrip airfare from New York City to Christchurch, New Zealand.
In 2044, your mortgage payment will still be $1,400, but thanks to inflation, that money will only cover a quick hop from New York to Chicago.
Major point in favor of keeping the mortgage intact, and investing instead.
(P.S. Actually, your future mortgage payment will be a little higher due to taxes and insurance. But since those expenses will burden you regardless of whether you carry a mortgage or not, we’ll leave them out of the equation. Death and taxes, right?)
Speaking of taxes …
Mortgage Interest Deduction on Taxes
First, an important Public Service Announcement:
Never spend money for the sole purpose of a tax deduction. You’d spend $1 for the sake of saving 33 cents.
That said, I’d be remiss if I didn’t at least mention that your mortgage interest is tax-deductible, which lowers the “effective” interest rate on your loan.
For the sake of a simple example, let’s say you paid $10,000 in mortgage interest this year, and your overall tax rate is 25 percent. (Not your top marginal bracket, but your overall rate.) You’d save $2,500 in taxes.
(This is a rough number — there are more complex factors that come into play.)
You’ll get the biggest tax-deduction impact when your mortgage is fresh and new. Your tax deduction will shrink as you progress along the amortization clock.
The Contender in the Ring: Crush Your Mortgage ASAP
The dark-horse contender fighting in the ring, eager to claim championship victory for himself, is the “Crush Your Mortgage” contender.
This fighter has fervent supporters among a minority niche.
If you fight for the Anti-Debt Army, mortgage freedom is the ultimate victory.
Mortgage freedom is rare. When most people say “I’m debt-free,” they mean: “I’m debt-free except for my mortgage.”
In America, it’s assumed that every homeowner carries a mortgage until age 55-65+. Breaking free is a defiant act of rebellion.
But should you crush your mortgage?
Let’s look at the arguments in favor:
#1: Lower Debt-to-Income Ratio
Let’s assume you’re a rental property investor. You have a mortgage at 5 percent. New 15-year mortgages are being offered at 3 percent, and you’re hungry for a slice.
You have two choices:
a) Refinance your current mortgage.
b) Decimate your mortgage so that you can qualify for a new mortgage (on a new house) at 3 percent.
Both are solid options. If you can wipe out your current mortgage in a short timespan (before rates will rise), you might be better off clearing the slate so that you can qualify for another mortgage.
“Um, Paula, WTF?”
I know, I know. It sounds ridiculous to crush debt in order to take out more debt. So let’s move to Reason #2 —
#2: Better Cash Flow
Crush your mortgage, and your cash flow will skyrocket. (Wheeee!)
- If you’re an owner-occupant, you’ll keep a huge chunk of your paycheck.
- If you’re a real estate investor, you’ll keep a massive chunk of your rental income.
You win, either way.
You can then invest every dime of the money that would have gone to mortgage payments. In an index fund, you may make long-term 7-9 percent returns without the added risk. (Or you can buy your next rental property in cash.)
This is one of the most compelling arguments I’ve ever heard for crushing your mortgage. And so is the next one —
#3: Humans are Imperfect.
It’s grand to ask, in theory, “Should you pay off your mortgage or invest?”
In reality, though, how many people will actually invest that money? How many will spend the cash on steak dinners, pedicures, brand-new cars, handbags, and trips to Aruba?
Furthermore — (and this is the argument that really gets me) — will you then feel guilty while you’re enjoying those activities? Will you surf the waves in Costa Rica while thinking, “I’m borrowing for this trip, via opportunity cost?”
BTW: You can’t think this way. You’ll drive yourself nuts. #AskMeHowIKnow.
Ironically, the only way to stay sane is by embracing a little economic irrationality.
Speaking of economic irrationality …
#4: Would You Invest a HELOC?
Ready for some cognitive dissonance? (Am I ever!!)
Would you borrow a home-equity line of credit (HELOC) or a cash-out refinance, and put that money in the stock market?
“Heck no!”
Really? Why not?
What’s the difference between borrowing against your home equity and putting your money in the market, rather than using that cash to build more home equity?
“Um … those loans have closing costs.”
Fine. Imagine that I’ll give you the $2,000 to cover closing costs, if you take a massive loan against your house and shove all that money into the stock market.
“Uh, I still don’t want to.”
Why not?
“It’s uncomfortable.”
Again, what’s the difference? Aren’t you borrowing against your house, either way?
“Uh …”
Boo-yah!
This is one of the most compelling “Crush Your Mortgage” arguments I’ve heard.
Actually, it’s a great litmus test. Would I be willing to borrow against home equity and use that money to buy more rental properties? You betcha. Absolutely. In fact, that’s how we bought House #4.
But would I be willing to borrow against home equity and give it to Wall Street? Hahahaha … No.
No-no-no-no-no.
****
Championship Victor
Which fighter wins the round? “Crush Your Mortgage” vs. “Keep Your Mortgage”?
There’s no clear victor.
There are rock-solid arguments for both.
You’ve gotta call the winner in your own game.
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Hmm…
A huge solid argument that I believe you neglected to mention is…”crushing your mortgage IS investing.”
In your example, you are investing at the same rate of your existing mortgage, 5.375% FIXED, if you use your money to pay it down. There is no need to guess..I mean predict…I mean assume..I mean…you get the point…that your money will return 9% annualized in the stock markets.
The problem, though, is if you pour all of your extra money in your home to crush your debt you can be setting yourself up for future disappointment. Image, $100,000 into your debt demolition and a nicely new 5 unit apartment complex comes on the market. Your savings are crushed and you’d be forced to get a HELOC. Now your effective return on investment is affected by the additional interest rate charged on the HELOC.
You’re right. It’s complicated.
A hybrid choice would be to put your cash flows into a “wealth number” account. This is what I suggest in my book, The Wealth Number: The Financial Solution to Pursuing the Job You’d Love.
The same concept applies.
Agressively save your cash flows until you have enough to pay off your mortgage balances in full…if you want. In the meantime, if another property comes on the market you’ll have the ability to pay it instead. Who knows, you may be able to pay cash for the next investment property if you save aggressively enough.
If you use this method you wouldn’t have to worry about the S&P dipping again or crappy tenants that destroy your properties because you’ll always have a shit ton of reserve funds…waiting for you to make a solid choice as you need it.
Bottom line. Don’t lock up your cash flow in a house until you’re ready to pay the entire balance at once and take advantage of the tax advantages as long as you can.
@Romeo — I’m not joking: Your remark about a “nicely new 5 unit apartment complex” totally got me to open a new browser tab, and start crawling listings of multifamily units in Atlanta. And that sent me on a 20-minute Internet Distraction spiral. Hehehe. (It’s after 2 pm and my brain has turned to applesauce.)
In all seriousness, though, another advantage of the “save your cash and make a HUGE payoff” model is that it’s psychologically motivating. It’s fun to watch your savings account grow … and grow … and grow … and then make a massive payoff. I do a modified version of this: I’ll accumulate $5,500 or $17,500 in my savings account, and then make a big, one-time chunk payment into my Roth IRA and my Solo 401k (respectively). Yes, I’m losing a teeny-tiny extra amount in theoretical gains (probably $200 or less) during that hold time, but that’s the price of maintaining the mental motivation.
One other factor that weighs on the side of prepaying a mortgage rather than investing in taxable accounts that often is not mentioned in analyses of the issue is financial aid for college. This would only matter for a subset of the population, but the federal need analysis methodology does not consider the equity in a family’s primary residence. So, if someone will be filling out a FAFSA in a couple years and has a mortgage balance and money sitting in a taxable investment account, he or she might be better off throwing the money at the mortgage and thereby maximizing aid. Of course, many private schools do their own analyses (using the CSS Profile, etc.) and do factor in equity in a primary residence.
@M — That’s an excellent point. Yes, federal college aid models look at the balances in your taxable investment accounts, but don’t look at your home equity. (They interpret the former as reflective of your ability to pay, but not the latter). If you have a child that’s applying for college soon, you have a stronger reason to put your money towards mortgage pay-off.
Nice job on this! You made a fairly dry topic pretty easy to follow.
I bought my house just over a year ago, and with the first (awesome!) tax return this year I started my investment plan. My PITI runs just over 1200/month, 1012 of which is PI, the other 200 is TI.
I’ve decided to invest 4k/year into the stock market (Vanguard VSTAX), which is pretty close to a mortgage payment per quarter. I calculated that if I prepaid my 3.55% APY mortgage by 250/month, I’d shave 9 years off, but if I invest and get only a 6% return, I’ll shave more like 12 or 13 years off the total repayment (my numbers may be slightly off, but investing at a conservative rate will save me about 3-4 years).
That also lets me have the cash available in case of disaster (though obviously it’s vulnerable to market fluctuation), and since I’m a single-income household that feels good. A main risk, of course, is when stuff happens – will I hit that account to replace my car, do home maintenance, etc.? That is not my intent but I can’t swear I won’t.
We’ll see if I change my mind after your next post!
@Bethh — Thanks! I’m happy to hear that I can talk about a dry topic in an entertaining manner.
If I ever taught a writing class, I’d probably have a lesson in there about “The Benefits of MisQuoting Madonna’s Material Girl.” 🙂
Coming from the pay off the mortgage early camp, it’s nice to hear an unbiased review. Dave Ramsey always pulls the would you borrow on your house to invest in the stock market and 99% of people would say of course not, the other 1% prefer sky diving to work as a form of transportation.
My wife and I chose pay off the mortgage(rental) early for a couple of reasons, that’s what my wife wants! Paying off the rental will increase our cash flow and give us more of a peace of mind, paying off a house early with someone elses money really isn’t that bad.
@Steven –
On a totally unrelated note, you have the most entertaining profile picture … 🙂
I’m guessing more David Beckham than Warren Buffett or are all things equal?
Always invest and don’t lend!
In the category of “if I knew then what I knew now…” I’d CRUSH. THAT. MORTGAGE!
Why? Back in 2004, things were going swimmingly. I’d just used a good chunk savings to invest in a small business with a friend. Things were going along great. Until…mystery illness.
Starting in May, 2005, my life was turned upside down by a terrible illness. I had to take disability – it took me three years to get. I live alone – no second income. Needless to say, I racked up some HUGE medical bills during that time. I used all my savings and retirement paying those and my daily living expenses. I was financially bled dry by this. I damn near lost my home – I fought to save it from my hospital bed between episodes of unconsciousness. I just barely managed to save my home.
Even though I managed to save my home, I still had to figure out how to pay the mortgage. If I had been smarter and chosen to pay the mortgage off first, that one ENORMOUS worry would have been off my mind and I would have more money now.
You just never know. And I’d been super healthy all my life up to that point….
With all due respect, it was the business decision that almost caused you to lose your home, not the fact that you didn’t pay off the mortgage. Had you had the cash available when you had your unfortunate episode (instead of putting it in a business or a home) you probably would have been in a better financial position. In any case, I’m glad to know that you are doing well.
Agreed. But the business was a plan I’d had for a long time and I’d saved carefully for it, had money in the bank to survive for 18 months without income, and was still working my “cubicle job” for the first 6 months of the business. The illness hit fast and hard. I was lucky to have the funding I needed to keep me going until SSDI kicked in.
It’s worth noting that this is not an uncommon story. I’ve heard variations on the theme from many who are now disabled. I envy and applaud those who can say – “thank goodness I paid off my mortgage, otherwise I would have lost my home.” No one is immune to the vagaries of life, even when we plan, save, invest, etc. I was very smug about my various financial safety nets. The situation above wiped that smug smile of my face.
But hey, I still have no regrets because I am both a risk taker and an adventurer. I’m learning a different kind of freedom now.
…..good words from your ‘cutting edge of real-life’…Freedom does come in many forms for sure. ‘Sometimes we lose …but always we learn….’
Ideally you would be paying into an investment account that is not used for starting businesses, its your “mortgage payment alternative” account that grows alongside and is not part of your business-starting venture. Essentially you risked your mortgage payment power on a business and that risk did not pay out. That is not a reason to pay your mortgage instead of investing..it is however a reason to pay your mortgage instead of risking $ on a new business.
You should choose a risklevel. Not using your house as collateral would send mortgagerates skyrocketing. Repaying is a sure way to get a good cash-flow-impact. But ! Rather than repaying in full, repay it to a level where it would be possible to live with, for a long time during rainy periods. You will get sick, as people do, would you cope then?
Not using some of the money for risky, but profitable, investments also carries a risk – the risk of not receiving dividends and value increase. Every thing in life is a risk. Repaying is a risk – not doing it is too.
In a perfect and predictable world, you should get the largest possible loan and then invest the money somewhere where the interest received is greater than payed. No such world exist.
One advantage of paying off properties sooner is that traditional lenders will only let you have 4 mortgages at a time, so having too many mortgages (aka too much debt) will limit your investing potential. What I’ve done is put the 4 mortgages I have in my name only, then I will put the next 4 in my wife’s name to mildly circumvent the rules. By the time we get to that point, it will be relatively easy (due to amortization of existing 15 year mortgages) to pay off a small balance loan to add on the next one. At some point, I will have to turn to non-traditional lenders, but that’s ok. With today’s low interest rates, I want to take as long as possible to pay off that debt.
With 3 of the mortgages in the 3% range, by the time I tax deduct the interest and factor in inflation (both today’s rate of inflation and the expected rise in inflation… not if, but when rates rise), my mortgages are close to 0%. My cash is then focused on saving for the next down payment (investor properties require 25-%-30% down), funding retirement accounts, and making a contribution to my son’s 529 account.
Great article contrasting the two sides of the argument.
Great comments. This is exactly the situation I am in, and the information provided here is very useful. Thx.
both succeed.
but you have to go on this journey together, I haven’t had all the conversations that I need to with my partner who (no shame on their part) started the journey later.
> we know the principles of FIRE
> but the voices from the past, and maybe the now, screech in our ears
Wells Fargo only requires 20% down for investment properties. 😉
I think a lot of it depends on the individual involved. I’ve done it both ways. I paid down my first mortgage in only 7.5 years and used the extra money to invest. Then I took out a mortgage on this house when I had it paid off to buy a package deal of 4 houses which I’m slowly paying down. I was able to buy another place for cash which has been paying off the other 2 properties I have seller financed mortgages with. It’s all working out so far, but I do feel better being totally debt free (no mortgages) and I’m working towards that goal again now. I would NOT take a mortgage to invest in the stock market (even tho I have done fairly well on choosing stocks), it is just too risky, nothing in the market is a sure thing, no matter what anyone says. There are just too many risk factors we don’t have any control over.
Have you considered the risk arising out of your rental properties – tenant suing you, fire destroying it, etc. When that happens, your mortgage company is a co-defendant and you can use their power/help to combat the problem. If you have paid off the mortgage, you are on your own.
Paula, I just love your blog. Your posts are always well researched and thought provoking, AND they have personality! Love it!
Anyway, the “keep your mortgage vs. crush your mortgage” issue is one I’ve been struggling with myself… I’m leaning toward paying down the mortgage early. Why? Mainly because it will feel good. I didn’t come to frugality and investing naturally. It’s been a process over several years to develop the focus and discipline I need to keep making smart financial decisions. Finding a new goal to throw myself into keeps me from backsliding into over-spending. I think crushing my mortgage is a new goal that will keep me on track.
@Angela — Thank you! That’s exactly what I’m striving for (well-researched, informative and motivating posts that are also funny and entertaining), so I’m thrilled to hear you say that. 🙂
Paula, we struggle with this debate even well after we paid off our mortgage. There are huge opportunity costs associated with our mortgage pay-down period (2010-2013). But they’re done and gone. Now all that matters is what we’d do going forward. We may, like you, tap our equity to buy more rental properties, once our cash reserves are gone. But, for whatever reason, I’m also more comfortable doing that than borrowing money to put in the market. Who knows why.
I’ll say that I’m more relaxed and happier now that we have no mortgage debt (though we’re in the process of getting some more, with our first rental). Who ever said we’d be rational with our financial decisions. 😉
@Done by Forty — There are two reasons I’m more comfortable tapping home-equity to buy a rental property (as opposed to invest in the market):
1) Knowledge. The best investments are the ones you understand. And rental properties are much easier to understand than complicated corporate earnings statements.
2) Control. In rental-property investing, I have the ability to manage the costs more tightly and make the operation more efficient. I can test different pricing models. I can call a dozen contractors for the cheapest quotes. By contrast, I have zero personal control over the stock market.
It’s interesting to hear that you continue to struggle with this question even after you’ve paid off your mortgage. I suspect that I’ll have the same experience. No matter which option I choose, I’ll always wonder how my life might have changed if I had picked the other one. That’s just the nature of making big decisions, I guess. 🙂
I enjoy reading PF blogger’s viewpoints on this.
My mortgage is still new – so as you pointed out, each month’s worth of payment is heavily weighted toward interest.
The *benefit* of this is that right now, every additional principal dollar I can come up with, has a bigger effect on reducing the length of my loan period, than it will in the future, *because* my principal payment each month is so low.
Someone on a PF blog pointed this out a few months ago – if my payment each month is $1000 and $300 of that is principal, then every additional $300 I can come up with each month, takes a month off of my loan period. In 5 years, when my $1000 payment has $500 going toward principal, it will take an extra $500 each month to reduce my loan period by that same month.
And, I like updating my spreadsheet every month, and watching that payoff date move further up the page each time 🙂
I prefer a hybrid method. Rather than adding to my monthly payment, I prefer to invest with the intention of being able to write a check in a couple years to payoff the mortgage. I have always appreciated the options that come with liquidity.
You write so well and so often about freedom on your blog. After paying off my mortgage in 2 years, I have freedom that those with a mortgage do not have. I have the freedom to invest a large sum of money ever month however I want — or some months — travel and make lifelong memories. I saw my mortgage standing in the way of my freedom, so I got rid of it!
Love this!!!
Think it is very true freedom is what we all aspire to in the end I think and progress/gain in financial situations. I have always felt the $ that I could invest wouldn’t be able to earn me more than what The current interest I’m paying on my mortgage.
So at the moment i was 100% focused on paying off my mortgage then inveating after that.
So this has made me more curious to explore the hybrid method. Instead of focusing on solely paying off my mortgage
We are in a very similar situation. We decided on the following method. We will take our income from our property in excess of our reserve and put that towards principle.
Our W-2 saving will be put towards new properties.
We will decrease our debt coverage but not limit our investment. High risk vs guaranteed yield. We will have a heloc on those free and clear properties to invest should the right deal come along. We can also use those helocs for quicker principle reduction by shifting the amortization table in large chunks rather than small monthly increments.
Also I don’t consider the interest rate on a mortgage when I look at payments. I calculate the mortgage constant.
Take a $20,000 car loan at 3% interest over 60 months. Payments are 359.57. While the interest may only be 3% the loan costs 21.5% each year. 359.57*12/20000. I think this is useful for folks looking for cash return on cash and net spending/income. $20,000 paid down buys $359.57 per month.
We paid off our mortgage and there is no feeling like not having a house payment. Unless the government takes it through eminent domain, or you neglect to pay your RE taxes, this piece of property is yours forever. The psychological impact is priceless. However, we both look at the numbers and totally recognize that there may be a benefit to having the cash available to invest. Obviously you have to run the numbers comparing mortgage rate vs. investment rate, plus figuring in your interest deduction you can take on your tax return. While the house is definitely an asset on your balance sheet, it is harder for the equity to help in an emergency situation unless you have a HELOC in place, which then costs you interest. With stocks or bonds they can easily be sold and the cash available in just a few days. Of course then if you sold at a profit, the government wants their share of that which has to be factored in as well. It is quite the conundrum, but we think if we ever buy/build another house, we will go the mortgage route assuming the numbers make sense. You put forth a great discussion covering all the bases.
Where is the hybrid method? Why can’t you pay off your home early and invest some of that money along the way. Sounds like diversification to me vs Putting your eggs in one basket approach.
One of my coworkers just paid off her mortgage and is very happy about it. I’m doing the opposite, as I leverage more to be able to purchase more rental property
Is she wrong? It depends. She wants to focus on more piece of mind and flexibility as she not longer has that mortgage payment over her head and can invest other ways (stock market in her case). I believe that leveraged real estate is generally a far better deal that the markets and that taking on mortgage debt to do so is a much better approach.
Both of us believe in investing, and both of us commit to putting money towards financial independence. I believe that my approach is superior, but it does involve more work (in the short term) and ties me into the investments – my properties – longer.
Either way, at least we are both actively investing, and that makes us better off that 80%+ of the population.
What you’re actually talking about is investment risk. She is sitting clean with no mortgage and no risk.. She’s now free to invest all of her income without any risk.
If her or her spouse lost their job or became disabled, all will not be lost..
The same cannot be said with your approach. Yes, you might come out ahead in the long run, But the alternative is bleak at best..
Interested to know the source for the information for “From 1990 to 2010, the S&P 500 returned 9.14 percent as a long-term annualized average.”
The NYTimes has a nice chart based on the performance of the S&P 500 which shows that the data might be right. But go back one year to 1989 and you’d barely be matching inflation over that period.
http://www.nytimes.com/interactive/2011/01/02/business/20110102-metrics-graphic.html
@Carrie – The source is Dalbar’soriginal source, here’s their press release, and here’s a Motley Fool article following up with analysis.
The stock market collapse from 1989 to 1989 was one of the biggest crashes in our lifetime — that’s why October 19, 1987 is called “Black Monday.” Anytime you face such a tremendous crash, you need to wait for a few years for the recovery. (The timespan 1990-2010 includes the recession in 2008, but doesn’t include the recovery that’s stretching well into 2014).
As the NYTimes piece says, “From the end of 1979 to 1999, $10,000 would have grown to $48,000.” That being said, “$10,000 invested at the end of 1961 would have shrunk to $6,600 by 1981,” indicating that investing always carries an element of risk.
We paid off our mortgage a year ago yesterday. We chose to do it solely based on how it would make us feel. We hated being in debt, even for a house. Not owing anyone money is a great feeling! Very freeing. Now we can focus on investing even more with the extra money.
I have an argument for the “Keep your Mortgage” camp…I bought some furniture a while back on a 0% interest loan. It’s one of those even payment loans where you just pay 1/60th of the loan every month and it closes without paying any interest (I didn’t buy too much furniture because of the financing deal, promise). I’m probably half way through that loan. Is there any logical reason that I should pay that loan off early? I’d say “no.” I don’t necessarily know what the marching orders are of those specific dollars that I kept within my cashflow, but I know that I am generally making good decisions with them. I struggle to max my Roth’s and 401k, blah blah blah.
Applying the same logic to your Mortgage, I think that the answer to crushing it depends on the interest rate and your risk tolerance. If the mortgage was 0%, you’d definitely keep the mortgage, right? …right? If it were 10%, you’d definitely crush it. Somewhere between those numbers is where you change your mind. I’m not sure where that number is, but for me, it’s not at 3.625%.
Thank you!
The detail that never gets discussed in this debate is how you’ll make the monthly mortgage payments if you keep all your money invested. Obviously, you’ll have to pay them out of a checking or MM account – and THAT’S the losing side of the issue. You’ll always be paying out more than you’ll be making in the account you’re paying from, and you’d have to be extremely lucky to make enough through investing to offset that fact over the long term. I think the only reason to keep a mortgage (or credit card debt) is that you don’t have enough money to pay it off.
Thanks for sharing your thoughts on pay off your mortgage.
Regards
Jeez, that was a really good read.
I only came here to see if I could find a solution to my current problem of living at home, paying off a house with tenants in it.. and wanting to move out but not having the financial ability just yet to buy house #2, which is my next goal..
Renting.
Pah.
Very neatly written. I was strongly in “Keep the Mortgage” camp. But my wife didn’t understand why invest outside of 401K. Whenever we were planning any major purchase or vacation, we end up fighting cause she wanted to “invest just a little less just this one month”.
Finally we decided to payoff mortgage ASAP. She can see mortgage amount going down every month, and she feels excited. While our interest is only 3.3%, I would love to use this cheap money for investments but now at least now I don’t have to argue every month to not cut back on investment/savings/payments.
I’m really late to this party, but the economist in me says “It depends on each individual’s level of risk tolerance and debt utility curve.” I’m a total nerd 🙂
That being said, in a recession environment (like, I don’t know…the past year) the choice gets even more tough: stocks are running at a discount, and real estate will likely follow. Having a lot of cash on hand would be your friend. On the other hand, let’s say that your remaining mortgage is $100k at 4% – by paying it off you’ve guaranteed yourself $4,000 of “investment” returns when the rest of the world is going negative.
I don’t mind taking risk. In a recession, I’d keep my mortgage and put every penny I could into the market. As the economy recovers, however, I’d maybe back off on the stock investments and do some extra principle payments. This isn’t a one-time decision: you need to weigh your options every single year.
@Mike — Love this comment.
What would you do right now (Jan/Feb 2016) — given that we’ve been in a bull market, but now there’s a pullback. We don’t know if the current market decline is preceding a cyclical recession, or if it’s just a temporary blip. In today’s market, if you had $100k in cash, and a mortgage balance of the same amount at 5 percent — is it better to repay that mortgage? Or wait for a potential future recession?
It’s a tough choice. There are pro’s and con’s on both sides. Just curious to know your thoughts.
Ok, let’s assume this scenario. If mortgage debt is something that would be left better intact, then all loans that person has would also be better to keep if they had an interest rate comparable to a mortgage. Who would be in favor of that?
Some people in life get off track and careless with debt and find themselves all of a sudden in a tough situation. That being said, what if a person in a debted situation with several debts “wakes up” one day and says ” I want to do something about my future! ” Say in view of all the debt, would she be better off taking her extra 150.00 per month and pay down 1 loan at a time by continuing to roll extra monies into each loan as it is paid off or take the 150.00 per month and put it into the market gradually.
What would be the saner approach? Here, take away the notion that a person needs a certain minimum to make stock investing profitable. But say she has 500.00 or 1,000.00 each month extra.
My argument is if if may not be sensible on a small scale, does it automatically become sensible when we are talking larger numbers?
Feel her empowerment of knocking off one loan at a time each time freeing up additional money to pay down the next loan. Now it comes to her last debt, the mortgage. This system has been encouragingly snowballing for her and finally in time blasts through the mortgage. Through the way she researches how at the end of the mortgage she is going to rent that house out and move into possibly into a similar type home, use the rent from the previous home and now all her extra monies available from debt reduction and now blast down that mortgage, then rinse and repeat if that would be her desire.
I make the point this way because I feel in the beginning even having 1000.00 each month extra it is better spent on a process of altering your life thru a guaranteed course of debt reduction versus every extra penny thrown into the market.
Your thoughts?
Yes, I’d be in favor of holding onto ALL loans that have an ultra-low-interest rate (comparable to a mortgage), like 4 percent. If your interest rate is roughly the same as the level of inflation, there’s a solid argument for holding onto that loan and investing the money instead.
There are strong arguments in both directions, and either choice (repay debt vs. invest) is well-supported and justified.
Another late-commer to the party, had a few comments.
Mortgage interest is still compound. In your example, you have 5% on 100,000 as being $5,000 each year. But that is assuming that you are paying the $5,000 of interest each year. For example, if you took out a mortgage for $100,000 at 6% annual interest, your monthly interest rate would be 0.5%. So that first month, your int payment would be $500. If you failed to make that payment, your mortgage balance would go up to $100,500, and your next month’s int payment would be $502.5. Still compound, but you are reducing the amount each money with your principal portion of the payment.
I have a small issue with point 2 for the pay it off camp. While paying down a mortgage will definitely get you better cash flow, I would argue that not paying it down would as well. In your comment above, you ask what Mike would do with $100,000 (if he had a mortgage at that amount as well). If he has a 30 year mortgage at 5%, paying it off likely gets him $536 in extra cashflow each month, YIPEE!, however if he would invest it in dividend index that earns 7%, he gets $583.33, YIPEEEE! (more Es means more excitement!)
I also just wanted to mention that paying down your mortgage also gets you a liquid asset in the form of home equity (which you can pretty quickly tap into a HELOC with). So it provides a very nice “emergency fund” type cushion in case you need it for an emergency (or maybe just a fantastic investment that needs cash).
One thing to add here if you are looking at FIRE in the short run less than ten years you may lean more towards mortgage pay off because in the short term the market can return a low rate.
That’s why I am paying off mine because in five years I can know my return and be FIre.
I also compare reits vs dividend paying stocks and bounds .
My husband and I recently decided to take a hard-core look at our finances and were paying extra toward our debt (our personal mortgage and student loan – I’m not talking about our rental mortgages here). I ultimately decided to keep them as they are both at 3%. The mortgage hurts a bit because it’s a 15 year so larger payment, but at the same time we only have 12 years left.
Have you ever done any posts on total crap properties LOL? We have one rental that is absolutely awful – and we are just torn on what to do with it. Let’s just say that while you make money when you get into the deal is true, unfortunately that was not the case for us and we’re pretty stuck. We’d likely have to bring so much to the table to unload it that we can’t bring ourselves to do it. But meanwhile we want to invest in a much nicer, closer, stable area near us and are too tied up in this crap one. 🙁
What about the length of the loan and the investments? Suppose your are on the last four year of your mortgage or another type of loan. You have an amount to kill some part of the debt or to invest on dividend stocks. The debt is going to take some part from your cash for some years (let’s say it reduces the length of the loan in one year), but a dividend stock can stick with you for several years (for example, 10).
Would it be valid to do a VNA of the interest of the loan as it is now, minus the VNA of the interest of the loan after amortization and the compare it vs the dividends on year 10 transforming them to present value? In this way we will be comparing present value of both posibilities. And we should stick with the one that mantains more money on our pockets.
I’ve been in both camps and ultimate I decided it’s better to pay off the mortgage. Here’s why. I actually paid it off once, with a nice windfall I got, and my financial advisor at the time told me that was stupid (not an exact quote, but that’s the idea). He gave the same reasons you give in the pro-mortgage camp.
So that always stuck with me. Some years later I decided to re-mortgage and put the proceeds in the market. But now I was stressed out having this monthly payment obligation hanging over my head all the time. And although the market was giving me decent returns (so far), the volatility was stressing me out, especially when I saw that the value of portfolio had shrunk smaller than the loan amount. (It came back fairly quickly but I did not like that feeling.)
So I started really thinking about what made sense to me and what I valued. The notion popped into my head that a mortgage is a negative bond and I googled that. That led to some interesting discussion (of course my idea was not original). If you have a mortgage and a bond portfolio, then have essentially bought bonds and sold a bond (your mortgage).
So the question is not stocks vs mortgage, but bonds vs mortgage. Which interest is higher? I had some bonds paying a higher coupon than my mortgage but rates have come way down since then so the value of the bonds increased. Yet at maturity I would only get par. What to do? Well, long story short, you need to know your YTW (yield to worst) — which was much lower than my mortgage. Fortunately my broker did the calculation. So I started selling bonds and raising cash and paid off the mortgage again. Now I have a smaller bond portfolio, no mortgage, and the same amount of stocks.
So I would say don’t keep your mortgage unless you really are comfortable investing the proceeds into common stocks. If you hold bonds and a mortgage ask yourself why, because I’m sure the rate you’re paying on your mortgage exceeds the rate you’re earning on your bonds. Yes you can reap some nice capital gains if rates continue to plummet but do you really want to bet on the direction of interest rates, especially when they are so low already?
Investor, know thyself. I sleep better at night knowing I have the optionality that comes from not having a mortgage. And knowing that even if the stock market crashes I still have a paid off house. And if I did have a mortgage I would want enough in bonds to pay off the house in case the market crashes, but that doesn’t make sense given that it costs more to borrow than I can make lending.
Sorry for the long comment.
Hello. I just came across this article and I would argue against paying off any mortgage in the current market conditions. I would even go so far as to say it’s not even wise to put 20% down.
1. Assuming your house appreciates at a modest 3% per year, the more equity you have in your house equals the less return on that equity. I.E. a $100,000 house returns $3,000 in appreciation or 3% on $100,000. However, if you only had 20% down, that return is $3,000 on $20,000 for a whopping 15% return! Without getting overly complicated, even if you had to pay PMI because you put less than 20% down, the added costs of the PMI would not exceed the additional return you would gain on the money invested elsewhere. (NOTE: Even if your house does not appreciate, or it even depreciates, you’re better off having the $80,000+ in the bank or in more liquid assets rather than having that loss tied up in your house)
2. If you feel safer by not having the monthly expense of a mortgage payment, you can put 20% down ( or less ) and use the remaining 80% to pay your mortgage payment for you. At 3.5% over 30 years, that’s a $359 monthly payment. Even if you earned no return at all on the $80,000 in the bank, there would be enough in there to make your P&I on your mortgage for over 18.5 years. AND, this doesn’t even take into account any appreciation in your home over those 18.5 years.
You’d only have to make a modest 3.5% return on your $80,000 over time to make this totally break even. With a historical stock market rate of return at 7%, your initial $80,000 investment in the stock market with regular monthly $359 withdraws would actually end up being valued at $208,796!!! Not to mention, given this example, if you still ‘pretended’ you had a $359/mo mortgage and added that money instead into your stock market investments over those 30 years, it would be worth an additional $406,000+ after 30 years.
3. One must also consider that 3.5% over 30 years essentially becomes “Free” after a few years due to inflation. Assuming a 2% rate of inflation, that 3.5% your paying on your mortgage is free after just 2 years and continues to become more of a benefit over the length of your mortgage.
Put another way, if you can invest your money elsewhere and gain a better return on investment than any mortgage interest rate minus approximately 2% inflation rate, you will be MUCH better off investing your funds and taking out the higher mortgage.
Great arguments on both sides, as usual, Paula.
I just went through the same argument with a colleague who was making additional payments of $1500 per month into his mortgage. He and his wife wanted to pay off their 30 year mortgage as quickly as possible. I presented the argument that $1500 x 12 months x 15 years invested in an index fund would potentially get him twice the money or more. And, after 15 years, he could liquidate half of that amount to pay off his mortgage and still have the other half to himself. I think he was very happy to hear I might have saved him hundreds of thousands dollars.
I came to this article after doing a Google search on my particular situation. I have a $430K house and $140K left on the mortgage (and 25 years left to pay it off). I am forced (due to layoff and a change in location — for more money, by the way, and an area with a cheaper cost of living) to move. I am planning on buying a home in the new location, but I wonder what to do with all that equity that I have in the old house. Should I transfer it all to the new house and keep my mortgage payment low, or should I invest it and use the proceeds to help defray the higher mortgage payments on the new house? I was thinking that I could reach a compromise by investing the money in an REIT or preferably an REIT mutual fund. If I do this, then I am still investing in real estate, getting a return (hopefully) on that investment, and getting the tax deduction on the higher mortgage interest payments. The downside is the capital gains. This strategy also increases my ability to “walk away” from my home like everybody else did in 2008 (I will be selling my home at a loss because of what happened that year and feel “burned”. Owning a home is also a risky investment, as far as I am concerned — just like Wall Street). Any comments?
I personally would sell the house and take the 290k in equity and buy your new house where you are moving to in cash. You would have the house and no payments on it at all. You would own it outright. Then invest every month your mortgage payment into your investment portfolio (diversified !). Ideal example would be to buy a 200k house in cash, and have 90k left over for your diversified portfolio. You do that AND add a mortgage payment to your portfolio, man—you would be rolling.
I’d consult with a tax advisor for some guidance in regards to dealing with capital gains on the sale and reinvestment into another property.
Good explanation of the pros and cons of paying down a mortgage. The only thing I would point out is that since deductions work against your highest tax-bracket income first, you should be using your marginal (highest) tax rate rather than your effective (average) tax rate when considering the benefit of a mortgage interest deduction. As an economist would say: “always think at the margin.” 😉
My wife and I only owe about $20k on a original $225k 30 year mortgage (at 3.5%) on our primary residence, that also has a rental dwelling on the property. Our 401Ks are doing fine, but we both retired early a few years ago and can’t touch those funds without incurring stiff penalties for some time to come . We’re not getting much of a write-off on our income taxes from this mortgage either.
However, we also have some liquid funds in a few savings accounts, but with the current interest rates being pretty dismal (less than .5%), we’re thinking about taking some of those funds to pay off the remaining $20k in a lump sum.
We have another property that we still have a fairly new mortgage on, and we made double payments towards the principal for the first year, yielding a savings in future interest payments over the term of the loan.
Paying off that remaining $20K on our primary residence will free up $700. every month and we’ll only have one mortgage left to deal with.
I personally think that, with all the opportunities to make money online, it would be better to test the ground on different fields such as affiliate marketing or stocks and invest whatever money you have in order to make even more money in the future. The market in all sorts of fields is becoming more and more saturated as entry barriers are very low these days. I am a firm believer that you should invest and get the chance to make even more money, rather than going for safety by reducing debt.
Okay so here is where I fall on this. My mortgage interest rate is only 3.75% and I got a 15 year instead of a 30 year. So I keep the mortgage because I NEED these investing years. For things like a Roth IRA and a 401k there are yearly limits and you can’t get those back. So if you pay off the mortgage you are losing opportunity cost to max out your Roth IRA and 401k. Now if the argument you’re making is that you should max those out first THEN pay off your mortgage THEN invest in OTHER investments over and above IRA and 401k I’m with you on that, but Absolutely without a single doubt I think IRA and 401k should be maxed Because you can’t get that back. You can’t just pay off your mortgage in 4 years and then be allowed to invest a bunch more money in your roth and 401k. It doesn’t work that way. Given the huge opportunity cost and also the tax benefits of both accounts, definitely freaking INVEST in those first.
But it gets more murky when we’re talking about taxable investment accounts. I’d lean toward paying off mortgage in that situation. But everybody needs a Roth IRA (if they are eligible) and a 401k. And between the two of those that is a lot of investing for most people. MOST people aren’t going to max those out every year and STILL have enough money leftover to piddle about whether they should pay their mortgage off faster or invest more in other things.
It was a bit concerning that from 1961 invested at that time was worth $6600 in 81. Is that considered to be a couple of lost decades then? I can definitely see both sides of the coin. For me, I think I at least want to insure that my roth is maxed out every year, and throw a little extra towards my mortgage and pay it down at least a little faster. It’s nice to think that the market could return 10% every year but it could also be 1961 again.
My wife and I are building. With my background in all phases of construction, I decided to be my own builder and designer as well. We are paying cash as we go. No mortgage for me ever again if I can at all help it. Anyone can argue the upticks to carrying a mortgage when it comes to monetary gains, but the down side is often ignored. I lost a home in the 2007 bubble burst. I owed 185k and got a offer of 150k. The bank said no! That was not acceptable. I ended up losing the home and it went to auction and guess what it sold for?? 100k! That’s right folks…50 k less than what the bank was offered. The bank wasn’t phased by the loss, as the system allows them a double dip. On the other hand, my credit and family was destroyed. So if someone were to ask me wether mortgage or pay cash, I would not hesitate to give my view. Screw the banks! I am back and better than ever, but now, I don’t need the banks money. And that is a feeling that too many will never learn to appreciate. Slaves to a master is what people are anymore. Except this time, they choose the master. I broke my chains and will do anything and everything to make sure they are never laid upon me again.
Love this subject and the interesting replies.. I don’t know if it was the right thing to do or not – but I started overpaying my mortgage by a small amount with my first house payment at age 28. (Mortgage was $847, I paid $900) This was after I had a $5k emergency fund and was maximizing my 401k match. Each year I split my raises between my 401k and my house payment. Even after buying a summer home 6 years later (and overpaying that mortgage) I was able to pay off both mortgages by age 51.
I really can’t say if it was a good or bad decision, I will say it changed my overall financial life from my 20’s till now to dedicate paying off debt. (It became more natural to avoid debt, purchase cars used with cash etc). After my home was paid for, I put everything from my mortgage I could into a Roth IRA.
I think I am in a much better place as I approach retirement to have zero debt. While I may not have a monster sized retirement balance, I won’t need as much with no debt and $750k in real estate. If I get in trouble, I can sell a property, downsize or both.
I am definitely in the “pay off your mortgage camp” I just happened to do it s-l-o-w-l-y
Thanks, Kirk from Kansas City, Mo
Really a nice article to read. According to muy opiniion if you have a child or some other major responsibility then you have a stronger reason to put your money towards mortgage pay-off. But sometime its also important to take risks to grow in life.