This is an age-old question. Does it make more financial sense to pay off your mortgage quicker by increasing or adding payments, or to use that extra money and invest in an index fund in the stock market. The simple answer is to choose the option that leaves you with the most monery down the road, and with low mortgage rates, the better choice is investing for the long term.
But that’s a simple answer to a complex question. There is a psychological aspect of money that differs for each person. Money isn’t all about math for most individuals. Some are good at separating emotion from money and treating their finances as a business with little emotional attachment, but that’s not common in my experience. For some people, eliminating debt is preferred over maximizing money. For one, less or no debt can reduce stress, which improves your health.
Nevertheless, Ben Stein agrees with my opinion on the matter:
Generally speaking, if you have a very low mortgage rate, it is better to invest the money than to pay off your mortgage. It’s an interesting fact — the rate of return on your mortgage is the interest you’re paying on it. If you have a 6 percent mortgage and you’re paying it off, you’re earning 6 percent. If you can earn more than 6 percent in the stock market, you should probably put it in the stock market. But, on the other hand, pay it off in an expeditious way. It’s good to have it paid off, or at least mostly paid off, by retirement time.
This simplified answer doesn’t take into account the emotional side of money. Perhaps it shouldn’t, because facts are facts (unless they’re statistics). But it also doesn’t mention tax benefits of a mortgage for those who itemize their deductions and it doesn’t take into account variations in stock market returns depending on your chosen investments and on market cycles.
His last point is the important one, I think. Once you retire and income presumably drops, you don’t want to have that much of a mortgage payment preventing you from using your money for other living or enjoyment expenses.
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Emma: Emotions and character certainlay play a role, which is why people *feel* better about making certain decisions, despite the level of mathematical validity of those decisions for a particular individual.
I wouldn’t expect most people to want to separate their emotions from their handling of money, but I would expect that people try to understand the full consequences of their decisions. If they’re willing to forgo a low-risk future income of (for example) a few thousand dollars a year in order to feel “at ease” earlier by paying off a mortgage sooner, then that’s a perfect, *personal* decision.
This personal aspect is also why one-size-fits-all financial mantras are often bad financial advice.
I completely agree. It would be wonderful to have no mortgage when living off a fixed income. I hope I’ll be in that position. :-)
I’d sooner pay off the mortgage. Investing may pay off more, but only if I choose the right stocks, or the right funds, and the historical returns accurately predict future returns. When I pay more to the mortgage, I guarantee my interest savings. Plus I get to invest my whole mortgage payment plus my prepayment amount after it ends early. Plus I don’t have to worry about that money and how its doing, once I pay it, I’m done.
“This simplified answer doesn’t take into account the emotional side of money. Perhaps it shouldn’t, because facts are facts (unless they’re statistics).”
If this was true, then why is called ‘personal’ finance? People’s emotions and character work hand-in-hand with money, at least how money is handled.
“Once you retire and income presumably drops, you don’t want to have that much of a mortgage payment preventing you from using your money for other living or enjoyment expenses.”
Wouldn’t it be nice to have NO mortgage when you have a fixed income? :)
I think people make this decision a little haphazzardly. If you compound interest of 10% vs. 6% for 30 years, it’s overwhelmingly in favor to stock market. It’s a factor or more than a million dollars in most cases, I believe.
When I think about what’s less stressful, being debt-free or losing a million dollars, the later always comes out on top.
I think the decision has to be taken in context with your oother investments. If you have a 6% mortgage and have all your other savings in stocks, you can count money paid toward that as a lower risk portion of your portfolio. In a sense, it is diversification.
I definately agree with the last statement. You don’t want to be making payments on your home (or car or anything) at retirement.
broknowrchlatr,
I love the way you put that. Paying on a mortgage is a low-risk, low-yield investment, and in that sense it is very much a diversification of your portfolio.
Continuing with that reasoning, think about a 30-year mortgage as a 30-year fixed-rate CD. If you have a long time until retirement, how much $$ do you want to allocate to that CD vs. stocks and stock funds? The answer to that is easy . . . not much. And that’s exactly how you should think about extra payments on a mortgage: low-yield investing. Over the long-term, such investments never (at least not yet) do better than the stock market, and it’s not even close. My minimum monthly mortgage payment is enough exposure to this investment for me, since I’m just 27. I can tolerate short-term volatility to get the long-term payoff.
So am I looking at this the wrong way?
If I have a $160k 30yr fixed at 6% my payments are $989 a month. I pay $500 extra a month to pay it off early instead of investing, I pay it off in 13 years shaving 17 years off the loan and $115,038 in interest. I invest the monthly payment of 989+500 a month for 17 years and I end up with $796,898 minus a few thousand a year for taxes since I lose my mortgage interest deduction, say a good $50k over 17 years leaving me with $746,898 invested after 30 years.
OR I just put in $500 a month and end up with $1,085,600. All assuming 10% return. A difference of $338k.
I haven’t verified your numbers, Chris, but the outcome looks right . . . 338k in favor of NOT paying down the mortgage. The 4% difference between your mortgage and your stock returns gave you a big edge over the time period.
With a low interest rate on the mortgage and a high return on your investments, it’s a no-brainer as far as wealth building. Keep the mortgage and divert your free cash to investing . . . unless your investment horizon is short, like less than 10 years. In that case the low risk of the 6% mortgage may be preferable to the stock market, since in a short period your investment in the market stands a better chance of losing money.
Was anyone arguing that this wasn’t the case? It’s pretty simple math.
The only place where disagreement can arise is the psychological side of it. For most people 90% of personal finance is the psychological side. I mean, really…most of this stuff is very basic math.
For most people being completely debt free is quite the invigorating thing that allows you freedom to do what you want, when you want.
It seems all agree that investing beats accelerating a mortgage. However, I think most, (if not all) these comments presuppose that one has a lifetime to let the numbers play out. I have 10-15 years left before retirement, 29 years left on a 30 year 157,000 mortgage, and $30,000 in 403b. For me, accelerating the mortgage makes the house payment much more efficient (putting more back in my pocket) and has the potential of giving me a $200,000 house (appreciation) paid in full before retirement with a small retirement nest egg. Cash the house out and,coupled with my matured 403b, I have $250,000 for retirement. I can’t achieve that with 403b in the next 15 years. Please show me where I am mistaken. I appreciate the advice.
If I lived in the states, because of the tax deductibility of the mortgage, I would definitely put the savings to work in the stock market.
If you’re capable of earning more than 2% more than your mortgage then you should not pay it off.
If you don’t know anything about investing, you’re probably better off paying it down (after you’ve built up a large emergency fund).
I’ve seen this argued over and over. This is the first time I’ve ever commented, but it’s exasperating to see the same comments presented.
By the numbers, paying off the mortgage early or investing is basically a wash. It becomes an emotional decision.
It comes down to three factors:
1. Estimated alternative return. Long-term future return from the stock market is likely to be about 7% (not the 10% commonly quoted). See this article:
http://www.investorsfriend.com/return_versus_gdp.htm
for details. This article is the best explanation around and justifies the 7% annual return number. Don’t just quote 10%!
At 7% the difference between, for example, $1500 invested monthly for 17 years vs. 500 invested monthly for 30 years is pretty much a wash.
2. Volatility. The 7% stock market return is an average. Look at stock market cycles. If you had to cash out for retirement in 1999, for example, it would have been great. If you had to cash out in 2001, it would have been terrible. If you invest all the money in the stock market (no diversification, which would likely reduce the 7% return) then you better be comfortable with risk.
3. Taxes. The mortgage deduction tax only lasts for the first few years of the mortgage payback, and is further impacted by the AMT. There is a difference, but it’s not a huge difference.
Realistic Numbers show this decision is about emotion. The numbers are a wash. If you less oriented toward risk, then you pay off the house and diversify the investments after that. If you are more oriented toward risk, then you stay on the regular mortgage schedule, don’t diversify, and hope you sell out at a high point in the market cycle.
Your choice.
Scott main thing about retirement and mortgage is if you aren’t maxing out all retirement accounts before paying off the mortgage you are losing out on valuable time to compound money without paying taxes. Or in the Roth IRA no taxes at all.
Livingalmost,
I can agree with your statement. I get 50% employer match for me 403b contributions, up to 5% of my annual salary. Not great, but $5000 + matching $2500 is the best money available to me right now. I plan on maxing that every year. After that, it seems to me early mortgage retirement is my next best investment, since saving money is not taxable today or ever, but earning money and investing is taxable someday. Make sense? Kind of like diversifying.
I just crunched the numbers between paying off my student loan at 9.10% or saving in an online bank account at 5% the results were suprising. Because of compoundin the total of 1000 saved at 5% for twenty years would be 2,712.64 but paying off my loan early (one payment)would save me 1,174.80 in interst. Of course I still have to caluclate the taxes i would pay on my earned interest but the diffrence is 537.84 greater if I save at the lower rate and i get an interest deduction on the loan so is this emotional or not
Investing might make sense when you look at potential gains. But would you consider taking out a loan (assume reasonable interest) just to put money in the stock market. I don’t think many people would advocate that – even if it was long term. So why do that here.
I also feel better paying off loans. That is why I pay more to my super low interest student loans. Sometimes emotions override pure logic.
I read the other comments very quickly, so forgive me if I’m missing someone’s comment. But so far as I saw, I’m really amazed no one has made this very obvious point:
following up on the point made by Stein that paying off a 6% mortgage is equivalent to a 6% return on your investment– and it’s guaranteed– we should also take into account that it’s like earning 6% absolutely tax-free. Because if you’re getting rid of a debt that’s at 6% it’s arithmetically the same thing as earning a 6% return– but crucially it doesn’t involve any income as defined by the IRS!
Now I’ll admit that when I had a house I didn’t overpay my mortgage– I put extra money into the stock market instead (buy and hold, baby!). But I did this in full awareness of the fact that if I could earn 6% in stocks (outside my retirement account), I’d have to pay taxes when I sold, but if I made my debt go down and thus avoided a 6% interest rate on the same money, there would be no taxes. (Seriously: where’s the line on your 1040 to list “how much less I owe on my mortgage now”? If you can’t list it even if you wanted to, then you can’t pay taxes on this “earning”).
How ’bout just paying your mortgage bi-monthly, once on the 15th and the other at the end(assuming no prepayment penalty) You’d knock down the principle quicker thereby save tons on interest. A 30 year mortgage can be reduced to 22 years with this method. There’s no extra cost involved so the ‘extra’ you would have paid to the mortgage, you can put towards retirement investments.
Its November 2008. GM stock has been rated as $0.. worthless. Mutual funds and stock markets are down over 50%. With no end in site! I sold 80 % of my mutual funds in March of 2007 and payed my house off in Texas. I’m glad I did! Texas wasn’t in the bubble and the house is worth more today than when I bought it. If I would have left the money in mutual funds, it would have been worth $300,000 less today. Instead I have great house on the lake in Austin worth more today. I also went cash in a 4% saving account and have just now started buying aggressively in the market again. I have paid all debt off. No house or car or anything. The money I’m investing now in a declining market will pay big in the coming years.
Be debt free. You have many more options in the future. Hey, if you lose your job, you probably won’t lose your house! As we can see in this market with times of huge government spending and borrowing, times are changing.
It’s funny to read the comments from the know-it-alls above about the mathematics of investing and bla-bla-bla. I dare anyone to find a portfolio that has returned 10% annually for the last 10 years! What bull! The last 5 years s&P 500 rate is a negative -2.5%! and before that we had the 2001-2002 crash.
People win the lottery, too.
I wonder what follow up comments the posters from summer 2007 above would say now that their investments have probably lost 30-50% (or more) in the past 3 months, with no bottom in sight yet. Of course, on the flip side, their home has probably lost a chunk of value as well, but the house provides shelter and has personal practical use beyond its monetary value, which can’t be said for stock. If you’re house is paid off, you can live there for the rest of your life, even if it’s value drops 90% and you get the practical use of it. If you’re retirement investments drop 90% and you still have a mortgage to pay off, say hello to foreclosure.
Is everyone still as sanguine about making a 10% return on the stock market now as they were in June 2007?
Is everyone still as sanguine about making a 10% return on the stock market now as they were in June 2007?
The stock market has always had it’s ups and downs. While I think timing the market is futile for nearly everyone, I haven’t been able to resist myself and have recently doubled my monthly investment into several funds. It’s like money is on sale now!
The most reliable way we have to make decisions about the stock market is it’s past performance, and past performance indicates that we’ll continue to average 10% or greater returns going forward, with intermittent dips. Past performance also shows us that 95% of the 5 year periods and 100% of the 10 year periods, in the history of the stock market have made money, and 100% of the 10 year periods. Which is why if you’re investing for the short term you don’t use the stock market…
Pay off your house . Dont let these financial thieves talk you into anything else. At least you’ll have a place to sleep