More on Mortgages

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By JLP | May 8, 2007

ISPF over at GradMoneyMatters sent me an email yesterday asking me to check out his justification for paying off their mortgage early. Here’s the facts regarding their situation:

1. They have money left over each month after funding their 401(k) and paying their bills.

2. Their mortgage has a 5.125% interest rate (FYI - My GMACBank savings account is currently earning 5.16% per year).

3. They don’t like debt.

Readers of this blog probably already know where I stand on this issue. I mean we have blogged this issue to death, with each post garnering lots of attention and lots of comments. My basic line of thought on this issue can be summarized as follows:

If your mortgage rate is substantially lower than the long-term rate of return in the market, then you are better off investing your extra cash in the market and taking your time paying off the mortgage.

That said, he and his wife have still decided to pay off their mortgage early. That’s fine as long as they understand that they are making an emotional decision.

If you are new to this blog, you can check out these posts about mortgages. Be sure and read the comments, which are really quite good:

A Follow-up to the Dave Ramsey Post - This is Interesting

More on Mortgages: 10 Reasons to Carry a Big, Long Mortgage

Check Out the Latest Dave Ramsey Poll

There’s lots more in the Mortgages Category.

Topics: Mortgages |

Comments to “More on Mortgages”

Patrick Says:
May 8th, 2007 at 2:39 pm

I read ISPF’s post, and I understand his reasonings. It seems they want the guaranteed return vs. the possibility of losing in the marketplace (even though they know they will likely be better of in the long run).

There are other factors you have to consider - their long term plans. If they are newlyweds, but plan on having children soon and dropping to one income, then paying down a mortgage gives them the flexibility to do that.

Long term, the stock market is going to return more, but not having a monthly mortgage payment gives them a lot of financial freedom they otherwise would not have.

You can make the arguement they should invest in the market and use the proceeds to pay off their mortgage if that is the way they want to go, and that is something they may consider.

They may also want to pay extra on their mortgage as a means of diversifying their investments, much like having a certain percentage in bonds.

In the end the stock market will likely give them better returns, but it may not give them the piece of mind they desire.

dimes Says:
May 8th, 2007 at 2:47 pm

Of course it’s a justification, not necessarily the best financial sense. A rational person would play out these kinds of loans (or student loans…) since they do become cheaper over time. But still, the psychological hurdle can be a hard one to clear. And sometimes, in a financial family unit, one partner gets it while the other doesn’t. Which is always fun!

Don Says:
May 8th, 2007 at 2:58 pm

I don’t know what the price of your house is, but mine is just inexpensive enough that I don’t itemize to use interest as a deduction.

I have chosen to maximize my investments in tax-advantaged accounts like IRAs (Roth and Traditional) and 401(k)/403(b)s. But after that, if my choice was between a “regular investment” or an investment I’d have to pay taxes on like T-bills or Bonds or (to a somewhat lesser extent) stocks I would want to remember that removing an expense goes further than adding income.

Consider if I remove $600 per month of expenses, and I am in the 15% federal tax bracket. To get the same benefit by earning more, I would have to earn $705 just to cover my federal income tax. I’d have to make even more to cover my state income tax and my FICA tax.

So while a mortgage might be at a rate of 6%, it seems to me that as an investment you need to account for the effective yield as higher, perhaps 7% or 8% or more depending on your situation. When I look at it that way, I think paying a house down early is very tempting.

Dave Says:
May 8th, 2007 at 3:00 pm

One key factor is ISPF’s age. While investing instead of paying down the mortgage might make the most business sense for someone in their 30s, say, the opposite might be true for someone in their upper 50s. Having to take larger distributions from your retirement plans to make mortgage payments may endanger the survival of your portfolio.

Chris Says:
May 8th, 2007 at 3:42 pm

I have crunched the numbers on this a few times and I always end up ahead by paying the mortgage early.

My reasoning is this (I’m rounding these numbers here): Option 1, I invest $100 a month for 30 years at say 6%, in the end I have $101k and no mortgage.

Option 2, I have a $130,000 mortgage and I’m paying $700 a month at 5% interest. I pay an extra $100 and I cut 7 years from the loan and save $33k in interest. I now have $800 a month laying around for 7 years so I can invest it, same 6%, and I get $89k, so with what I saved in interest I’m 122k ahead. Figure I pay a couple thousand extra in taxes each year without a mortgage deduction and I’m ahead $108k, $7k more than if I were to just invest.

It would seem to me that paying it early puts you ahead, plus you end up owning your home much sooner. I’d like to see some more number crunching to verify/dispute my opinion!

JLP Says:
May 8th, 2007 at 3:49 pm

Chris,

6%? I’m pretty sure that over 30 years you could do much better than 6%.

Rob Says:
May 8th, 2007 at 4:31 pm

They can put their money into FDIC guaranteed CDs and do at least as well as paying down the mortgage. Even taking on some minimal additional risk would give them a better return. They can do 80% in a CD and invest the rest (conservatively in income producing investments, even), for example. And this doesn’t even factor in the tax savings on the mortgage interest. Paying down the mortgage makes no sense whatsoever. Sometimes peace of mind can be very expensive.

Don Says:
May 8th, 2007 at 6:32 pm

Rob: They can’t put their money in FDIC guaranteed CDs and do as well because their CDs will be fed and state taxable.

ispf Says:
May 8th, 2007 at 9:14 pm

JLP: Thanks for the post.

Everyone: Thanks for the comments.

We *do* understand that it is an irrational choice and it will cost us some money in the long run… and yet, we find that we would rather pay the mortgage first. It is this illogical behavior that I was trying to find an explanation for. Like Dimes pointed out it is a psychological hurdle we need to get past. Hopefully some day (sooner rahter than later), we will.

db Says:
May 9th, 2007 at 5:20 am

@ispf:

*I* think its a wise choice, and wisdom trumps logic. I wish you much success in paying off your mortgage early!

Brad Says:
May 9th, 2007 at 8:02 am

The psychology cannot be ignored. Some people are swayed by it and others aren’t, but if the mortgage debt bothers you, then you are without a doubt better off paying it down. The most logical/financially optimal solution is NOT RIGHT FOR EVERYONE (though I prefer it myself).

Good luck!

Miguel Says:
May 9th, 2007 at 8:53 am

I really like the ISPF framed the issue: “…some times what is right rationally, may not be really *right* if you are not psychologically prepared for it.”

I’m in the keep the mortgage, maximize investment camp, because my experience with investing has largely been positive. Actually not just positive, but fantastically positive. And by investing, I don’t just mean mutual funds in 401K’s, I also mean real estate and business ventures - which require significant capital on tap in order to participate. I am fond of saying that like Lotto, “you have to play to win”. If you don’t have money to put to work, you can’t reap the rewards.

But, you do have to be prepared for the risks. And I have certainly lost money in the past as well. So, maybe it really does come down to a psychological tolerance for risk.

Rob Says:
May 9th, 2007 at 11:41 am

Don - I understand about the taxes but unless you live in a really cheap area a good percentage of the mortgage interest you pay will be tax deductible and evens out the taxable gain. Looked at another way, when you pay down the mortgage you are really paying down a 4% loan rather than a 5% loan (rough estimate figures) because you are also removing the tax advantage. And with keeping the money in a CD you will still have relatively liquid cash as opposed to having your funds tied up in your highly illiquid house.

Tony Says:
May 10th, 2007 at 12:09 pm

Yes, I think the emotional component is important and not at all a silly thing to pay attention to.

Once the numbers have been crunched, both for and against paying it off early, it comes down to: which option would make you happier?

One can not always assume that pinching pennies, or benjamins, will necessarily be a good emotional investment.

fin_indie Says:
May 12th, 2007 at 10:45 am

Lots of good comments here. Clearly, trying to optimize for returns can make some sense, but I am squarely in the “pay it off early” camp.

The question is: Honestly, how much are you going to come out ahead by investing in the market? I haven’t seen anyone come up with a reasonable expectation of the *magnitude* of the difference in returns, given interest rate changes, inflation, etc. If we’re talking about a mild out-performance in the market vs. paying off the mortgage, is it really worth the risk? That’s the question.

Also, realize that timeframe is everything. The question is: what kind of returns will someone realize in the market in these *NEXT* 10-30 years. ie. If I only have 10 years left to pay on my mortgage, and we have an oil crisis over the next 10 years, where inflation is 12%, don’t come talking to me about 8-10% market returns.

So, again, I ask: is a mild out-performance worth the risk?

LDS Personal & Family Finances » Blog Archive » Freedom vs. Wealth Says:
May 12th, 2007 at 12:54 pm

[...] In a recent discussion on the AllFinancialMatters blog regarding whether or not to pay off your mortgage early, the blog’s author JLP summed up his position with the following: If your mortgage rate is substantially lower than the long-term rate of return in the market, then you are better off investing your extra cash in the market and taking your time paying off the mortgage. [...]

Kitty Says:
May 13th, 2007 at 11:59 am

For me the decision to pay off my mortgage was mostly emotional: even though my rate was higher than the CD rate at the time, I suppose I could’ve refinanced it.

I paid off my mortgage a couple of years ago using gains from the sale of the one bedroom condo I was renting out (I rented it out instead of selling when I moved into a townhouse in 1997, still can’t believe my luck). Sometimes I think I should’ve refinanced it at a lower rate and put the money in a bank, but the feeling of owning my property outright is just great. There is also feeling of security that even if I loose my job, I’ll still have my home. Currently my taxes and common charges add up to about $600 a month, and this is in the area where one bedrooms go for $1300-1600. Now we also have an assessment for re-siding, and because I don’t have the mortgage, I can easily afford it - it does reduces the amount I save every month, but it doesn’t make a dent in my budget.

By the way, if my rate had been lower than CD/treasuries rates without having to refinance, maybe I would’ve kept my mortgage. My friend is doing that even though she has the money to pay it off, but she bought her house where the rates were at the lowest point.

I would never again base the decision to pay off mortgage on market returns. I tried it once, and got burned. At the height of the internet boom, a friend suggested to me that I should sell my company’s stock and pay off my mortgage. I told him that I was earning more on the stock market. Then came the crash. My company stock lost over half of its value. Now it went up a bit but it still is worth about 2/3 of what it was at its height; my total portfolio value excepting my company’s stock is only now approaching where it was in early 2000. Had I listened to his advice, I would’ve kept the gains from my condo. Index might be better long-term, but if you loose your job while the market is down, you still need to come up with mortgage payments. It took several decades to recover completely from the crash of 29, and you may just happen to need the money during the downturn.

AllFinancialMatters » Blog Archive » The Top 5 Reasons to Pay Off Your Mortgage? Says:
May 14th, 2007 at 10:28 am

[...] More on Mortgages (from May 8, 2007) [...]

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More on Mortgages