Coffee heat rising

Should you pay off your mortgage?

Preparing to write the next installment in a series on achieving financial freedom, I ran some figures to compare the result of paying down a mortgage with extra monthly payments toward principal with investing the same amount monthly in a mutual fund. What I discovered runs against my theory that you’re well served to pay off a mortgage as fast as you can.

I still think that’s true if you’re getting close to retirement. In retirement, every debt should be wiped off your books, because you will need all your cash flow to live on. However, if you’re younger—say, anywhere between 20 and 45—and your mortgage rate is low compared to returns on equity investments, it would be to your advantage to invest extra dollars in a mutual fund earning around 8 percent. At today’s rates, this strategy allow you to accrue enough to pay off the principal faster than will throwing a monthly amount at the loan principal. Here’s how this shakes down:

M’hijito and I have a 30/15 mortgage at 4.3 percent. This means that for the first 15 years, we make payments at the 30-year amortization rate, but after the 15 years have passed, we either have to pay off the loan or we have to refinance it. The loan’s principal is $211,000.

We chose this mortgage because, at the time we bought the house, we believed the real estate market was nearing the bottom. We believed the house would drop in value another $4,000 or $5,000 and then begin to rise, probably at around 3 percent p/a. We figured that in five to ten years we could sell or rent the house and either break even or make a small profit. As everyone now knows, this was dead wrong: in fact, real estate was in free-fall, and the house is now worth at best $170,000, but more realistically around $150,000. This turns the loan into a real albatross. One strategy we are considering is to try to pay down principal with whatever extra monthly payment we can make (which ain’t much!), so that in 15 years, the amount to refinance might at least be no more than the house is actually worth, possibly allowing us to sell the house at that time.

In 15 years, with no extra payment toward principal, the loan balance will be $138,338. Monthly principal and interest payments are $1044; PITI comes to something over $1200.

Note that the projected loan balance is less than the most pessimistic present-day valuation. If the market finally has bottomed out and housing increases in value at 3% a year (a figure that is now being bandied about), in 15 years the house will be worth $233,695. That is less than we paid for it, but at least if we sold the house at that time we would walk away with a little cash in our pockets.

With me out of work, about the most we can afford to pay extra toward loan principal is about $100 a month.

Using Excel’s full value (=FV…) formula, I calculated the the return on a $100/month investment in a mutual fund earning 8% per annum. (Over at Vanguard, a number of stock funds and even a few bond funds are returning at this rate; one of them is Windsor II, in which I happen to already have a little cash.) I then used Quicken to run an amortization schedule, and compared the amount a $100/month investment would be worth in 15 years with the amount an extra $100/month principal payment would reduce the loan balance.

Assuming that our mutual fund investment averaged an 8 percent return, if we sent Vanguard $100 a month, in 15 years we would accrue $34,604 (full value =(.08/12,15*12,-100). If we paid an extra $100 a month toward the loan principal, in 15 years we would have paid the balance down by an extra $18,000 ($100 x 180 pay periods). According to Quicken, we would still owe $113,116.

With no extra payments, remember, we would still owe $138,338.

$138,338 – 113,116 = $25,220

Compare that with the $34,604 we would have earned in the mutual fund. Clearly, we would be ahead—by over $9,000!—by investing the money in a mutual fund with low overhead, such as Vanguard and Fidelity offer.

Well, now. Suppose you were not out of work, and so had plenty of cash to throw at the principal. Let’s suppose you really have plenty of cash and you decide to pay the equivalent of an entire P&I payment toward principal. Then what?

If you put $1,044 into a mutual fund every month, in 15 years you would have $361,264. If you paid $1044/month toward principal (in addition to your regular payment) on a $211,000 loan, you would pay off the loan in 10 years.

But by putting the cash into a mutual fund returning 8 percent, in 10 years you’d earn $190,995. Since in 10 years, with no extra payments, your loan balance would have dropped to $167,901, you’d still come out ahead:

$190,995 – $167,901 = $23,094

In other words, if you put the amount of an extra loan payment in an 8% investment, in ten years you would have enough to pay off the mortgage and still leave $23,000 in your pocket. If you used the same amount to pay toward the loan once a month, you would pay off the debt but would have no cash left over.

The conclusion is obvious: If your goal is to pay off your mortgage, you’re better off investing a regular payment in a decent mutual fund than paying the same amount toward principal.

This assumes your mortgage interest rate is lower than the rate of return from an equity fund. Note also that my figures do not take into consideration the small tax advantage gained by paying mortgage interest; this factor also would tend to improve the picture if you invested in the market.

Risky? Sure. But we now know that investing in real estate is wildly risky, too: more so, it develops, than the stock  market. My stock investments are rapidly regaining their pre-crash value, but there’s no credible sign of any recovery in the real estate market here. Even if the value of the house starts to increase at 3% p.a. today, in 15 years it won’t be worth anything like what we paid for it. If property values remain flat for any length of time (as it appears they will), we will lose not only our shirt but our pants, socks, and underwear.

I used to think my father was crazy because he refused to buy a  house until after he had saved enough to pay for it in cash. All the time I was growing up, we lived either in company housing or in rentals. His reasoning indeed was crazy—he bought into The Protocols of Zion, an irrational tract that led him to believe all mortgage lenders were part of a hallucinatory international Jewish conspiracy. However, the effect was that when he retired at the age of 53, he had enough cash to buy a house and a car and to support himself and my mother in a middle-class lifestyle without having to work.

Crazy like a fox, that old boy was.

A rabid fox, but still…

13 thoughts on “Should you pay off your mortgage?”

  1. You make valid points, but it’s definitely a crapshoot — you have to hope your investment return is more than the mortgage interest/tax savings. As I tend to be very conservative with my investing, I use a bit of both theories. We make a small extra principal payment on our mortgage and invest the rest. Definitely playing both sides, but I prefer it to the all-investment strategy.

  2. You are comparing an 8% assumed return to a 4% guaranteed return. i figured my mortgage prepayments were akin to a bond investment. The 10 year return on most equity investments is close to 0.

    I think your house may appreciate more than you think–it’s a good size for downsizers and has other good qualities.

  3. @ frugalscholar: I hope you’re right!

    Experimenting as we scribble with the 0-detergent laundry. Already made an interesting discovery. More later!

  4. Interesting post – when my husband learned to use a computer the first thing he did was run our house payment and discover how much interest we would be paying over the course of the loan. We were horrified, and promptly set about putting all extra money there. We did pay it off – it helped that we were both working, but also had 3 children in college so it was difficult. The biggest plus, tho, is that we will NEVER have a house mortgage again. Nothing feels as good as no house payment! I think you just have to do what feels rigfht to yourself.

  5. It is indeed true that my calculation works only when mortgage rates are low and investment rates of return are normal to high. Obviously, if mortgage rates are around 8 or 9 percent, which is pretty typical, and the return on your mutual fund is about the same, none of the above applies. In that scenario, you may very well do better to pay off the mortgage, since 30 years of interest payments can more than double the actual number of dollars you pay for the house.

    At the time I paid my house off, a “good” mortgage rate was around 8.4 percent. I don’t recall what I was earning in the stock market — in fact, at the time probably hadn’t yet learned how to figure it out. All I knew was that between prepaying principal and then later cashing out a mutual fund, I could free myself from a house payment that equaled more than half my piddling net salary, and that once SDXB moved out and I lost his “rent” payments, I could not could not live on what would remain after I paid the entire bill.

    HOWEVER, right now mortgage rates are extremely low and return on securities investments is about average. Real estate values remain depressed and probably will not begin to appreciate again for some years. As long as those conditions hold, we’re in an entirely different scenario…one in which it may be to your advantage to invest extra money in higher-returning investments rather than throwing it at your mortgage.

  6. Does this assume that you’re not paying any tax on your 8% earnings? Will you have to pay tax when you pull the money out of the investment to pay off the mortgage?

  7. I’m debating on whether or not I want to tackle our mortgage after we pay off our car loan. I’m still deciding. :/ I’m making small extra principal payments when I can!

    • @ Mrs. Money: FrugalScholar’s point that it depends on the spread between your mortgage interest and the rate you can earn in investments is well taken. And don’t forget to take into consideration Marianne O’s point on the tax ramifications of drawing funds out of an investment sometime in the future to pay off a mortage with a saved-up sum.

      My sense is that, as delicious as it is to be rid of the dratted mortgage payments, the smartest move is probably to get rid of revolving debt first, then pay off the car loan as fast as you can. That leaves you in the enviable position of being able to decide whether to budget to pay down the mortgage or to contribute to savings. Or some of each.

  8. A good post!

    I agree that if your mortgage rates are low then alternative investments might be the way to go. Mine is currently 2.85% (variable), I’m socking my extra cash into investments that are paying me 9% after taxes. This income is not only servicing my mortgage but the extra income will eventually be used to payoff some of the principle on the mortgage.

    As “funny” points out in their comment – why put extra money in an “asset” that is depreciating (which mine has since 2006 and I believe will continue to do so until 2012).

    The cap my mortgage is 10%. Once the rate increases to above 9% (hopefully not for awhile), then I’ll have to reconsider this strategy.

  9. Assuming 8% return over 15 years is way too optimistic considering what has just happened in recent years.

    We have a 5.375% mortgage rate on a 15 year fixed loan. Our original loan was a 6.75% 30 year fixed. After refinancing, we save about $200K in interest payments. For me, this is a much safer diciplined saving method over dollar averaging mutual fund investment. i will always find execuse to blow the investment I accumulated like replacing a car, or redo our backyard since I know “I have money in my accounts”. But money paid to the mortgage is something I can’t touch… In the long run, it works out better for us to pay off the mortgage.

    We are in our mid 30″s right now, By 2022, we will be done with our mortgage.

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