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Money Magazine Takes on Six Financial Dilemmas
By JLP | December 12, 2007
There’s an interesting piece in the January, 2008 issue of Money. The article, Make the Right Call, addresses six financial delimas that most of us face at one point in our lives. The dilema that interested me the most was the one subtitled “Prepay your Mortgage OR Invest.” Long-time readers of this blog already know my thoughts on this topic because I have blogged about it numerous times (the related posts are listed at the bottom of this post). Here’s Money’s take:
Prepay your mortgage OR invest
The feel-good choice isn’t necessarily the smart choice.
When some extra cash comes your way, it’s tempting to put it toward your mortgage. You’ll save on interest and pay off your house earlier. Buying stocks, on the other hand, feels like a risky leap into the unknown, especially now.
Strictly by the numbers
Paying off your mortgage or any loan is an investment, and your return is essentially the interest rate on the loan. If you have 25 years left on a 30-year mortgage with a fixed rate of 6.2 percent and you deduct your interest payments on your taxes, you’ll earn 4.5 percent by prepaying the loan (assuming you’re in the 28 percent tax bracket).
Now let’s say you invest your spare cash in stocks instead. You’ll pay a 15 percent tax rate on your long-term capital gains and dividends. So to beat the 4.5 percent return you’d get from prepaying your mortgage, you’d have to earn just 5.3 percent a year on your stocks before taxes.
The odds of your doing that over the 25-year remaining term of your mortgage are excellent: Historically, a portfolio of 80 percent stocks and 20 percent bonds has returned 7.5 percent a year after taxes.
But wait
Paying down the mortgage earns you a risk-free 4.5 percent. That’s as good as you’ll do with Treasury bonds. True, and if you are investing for a near-term goal and don’t want to take any risk, you can make a stronger case for prepaying your mortgage. But if you are investing for a goal that’s more than a decade away, you can and should take more risk for a chance at a higher return.
You do the math
To run the numbers on how much money you could end up with by investing, use the savings calculator at CNNMoney.com. To see how much interest you’d save by prepaying your mortgage, use the payoff calculator at Dinkytown.net.
Beyond the math
Of course, all that mortgage debt may be keeping you awake at night, especially if you are worried about losing your job or you’re approaching retirement and hope to live on less. You’d be grateful to be rid of that major monthly bill sooner. In that case, prepaying your mortgage starts looking better.
Remember, though, that by prepaying your mortgage, you are reducing your liquid assets. If you suddenly need money, it’s easier to sell a mutual fund than it is to pull cash from your home, and you can always pay off your mortgage later with the money you invest now.
The bottom line
Investing wins.
Interesting. Oh, and in case you’re wondering, I didn’t post this just because it basically agreed with my opinion.
I urge you to go read the rest of the delimmas in the article. It’s an interesting read.
Now here’s some related posts that you might find interesting:
Which is Better: a 15-Year or 30-Year Mortgage?
Ever Wonder What a Mortgage Amortization Looks Like?
How an Interest-Only Mortgage Works
Check Out the Latest Dave Ramsey Poll - The topic was mortgages.
A Follow-up to the Dave Ramsey Mortgage Post - This is Interesting
10 Great Reasons to Carry a Big, Long Mortgage
The Mortgage Deduction and Taxes
Should You Prepay Your Mortgage? - This was a popular question of the day.
How Much House Can You Afford?
Topics: Mortgages |
December 12th, 2007 at 9:08 pm
Interesting. I wonder if another answer could be–both. That depends, of course, on how much money you have. But if I had $300 extra (and no debt) every month, then I could prepay my mortgage for 6 months and invest for 6. Either alternating or in chunks of 2, 3, or 4. Or 8 months of investing and 4 of prepaying.
Just a thought that it doesn’t have to be an either-or proposition. Investing probably wins, especially if it’s in a retirement account. But it can be more nuanced.
December 12th, 2007 at 10:20 pm
This isn’t just a numbers question; it is also an emotional one. It is hard to trump the “investing wins” card because if you look at the numbers alone, it does. However, if you are the type who sees the paid off mortgage as freedom then you may be better served paying down the mortgage.
Whether you invest or pre-pay your mortgage, you are improving your financial life and should feel good about yourself.
December 12th, 2007 at 10:28 pm
The bottom line is one route is more conservative than the other. Paying off the mortgage gives you a guaranteed lower ROI, like a bank CD. Leveraging gives you higher ROI (at times) and tax benefits on the mortgage debt side. Personally I would do certain things at certain times. If the right opportunities are there, I would leverage. When I’m older and looking towards wealth preservation I’d pay off the note to get it off my back.
December 12th, 2007 at 10:33 pm
But, what happens when their math is all wrong? I DON’T save 28% on my mortgage interest. I save MUCH less than that, because the first $10,500 of interest each year I would get as a deduction anyway (married filing jointly). That makes the return look much closer to 6.2% than 4.5%. Then, once you are inside your standard dedution, you get no savings, so the full 6.2%
I detail some of that in my post from a while back. http://realworldfinances.net/?p=21
December 12th, 2007 at 11:34 pm
best middle class conundrum of our time. i say diverisfy. you got your house. you got your stock market money. too much of one at the expense of the other, not good.
December 13th, 2007 at 6:56 am
We were actually faced with this. 3 months after we started paying the mortgage on our previous house we suddenly were in the circumstance where we could pay off the entire thing (and have a bit left over). After some thought, we decided to go with the “sure thing” and pay off the mortgage-why? Well we decided that regardless of what happened, by paying off the mortgage we KNEW we were saving thousands of dollars-so even if it wasn’t the best we could do, it was still saving us a lot and providing peace of mind.
December 13th, 2007 at 9:19 am
I believe Curtis is correct. You must consider the standard deduction when comparing the tax implications of mortgage interest. Why not invest in both paying your mortgage off sooner as well as in the market, making sure you have your emergency fund intact.
December 13th, 2007 at 9:31 am
A great problem to be sure and clearly one where both math and emotions play a role. Knowing yourself here helps too. Once you pay into the house, it’s harder to get that money back (you’d have to sell the home again or borrow against the equity - along with the related costs). That’s a good thing if you won’t actually do so and if the difficult access to your wealth serves as a deterrent from future overspending.
I agree investing wins, but only if you have the discipline to see that the money is invested appropriately and that it stays there. In this way the discussion has parallels to the “buy term and invest the difference” argument I would also support.
December 13th, 2007 at 10:08 am
Quoting the article: “if you are investing for a near-term goal and don’t want to take any risk, you can make a stronger case for prepaying your mortgage.”
Huh? How is prepaying a mortgage with 25 years left on it considered a “near-term” goal? Locking your cash in home equity doesn’t seem like the place to stash cash you need in the near-term. Perhaps they think you should take out a hel(oc) to pay for Christmas gifts.
Also @ Jenn: Paying off your mortgage doesn’t “save you money”. Your mortgage does not exist in a vacuum, it is part of your portfolio alongside your savings, investments, and retirement accounts. So a decision to do one thing over another doesn’t save or cost you money, per se. It’s just an investment with a given return. You can talk about the money you did not pay in interest, but you should temper that with the returns you could have made investing. The risk of investing in, say, the stock market should be tempered with the risk of locking a majority of your net worth into your home in a down housing market with a potential recession looming.
Saying you “saved money” is an oversimplification. Finally, peace-of-mind can also be had through a giant pile of money…trust me on that one.
December 16th, 2007 at 11:45 am
[...] All Financial Matters covers the financial dilemma of using funds for prepaying your mortgage or for investing purposes (care of Money Magazine). Though “investing” may make the most financial sense, it may not necessarily be the action you should take depending on your profile and circumstances. [...]
December 22nd, 2007 at 3:10 pm
The fact that Money Magazine does not realize that the standard couple deduction wipes out the first $10,700 of the mortgage interest deduction tells you more about the airheads at CNN/Money than that article does about personal finance.
I have a variable rate, 30 year loan, and I pay extra each month. As a result, every year my required payment goes down. It is like getting a raise.
With a recession on its way, is now a good time to invest in the stock market? I’ll take the guaranteed return by paying down the mortgage, thank you.
February 4th, 2008 at 3:56 pm
[...] Money Magazine Takes On Six Financial Dilemmas [...]