Category: Mortgage

Should you pay off mortgage quickly or invest?

A few months ago I wrote a post about why I think paying off your mortgage early is dumb— and nothing has really changed on that front, even with interest rates climbing almost a full percentage. There was much debate from both sides of the argument, so this time around I’m going to bring some actual numbers to help paint the picture.

First, let me start off by saying that paying your mortgage off completely is an awesome thing. I’m not against anyone paying off their mortgage, I dream of the day when my mortgage(s) will be paid off completely. It’s one of the best things you can do to increase cash flow and it’s a huge financial weight off of your shoulders. However, I don’t think any American should pay off their mortgage earlier than the full life of their loan. Circumstances do exist where you should be putting every last dime into paying your house off early, such as: having an interest rate that’s too damn high (5% or higher), or having an interest only loan.

Why are you paying off your mortgage early?

There are three reasons why people overpay their mortgage. The first is that they have been convinced by the big-media finance gurus that making extra mortgage payments is the smartest thing you can do financially (and logically this brainwash can start to make sense). The second is the fact that most Americans don’t trust themselves with saving money, so they’d rather apply “extra money” to their mortgages, because it’s like savings that you can’t touch. Kinda. The final reason is that the majority of Americans are fucking terrible at math.

I’d like to challenge the average person’s standpoint as someone who isn’t afraid to invest. I currently have two mortgages, and I don’t pay a dime over their respective monthly mortgage bills. Instead I take all of the “extra money” that I could throw at the mortgage and invest it. The main reason I do this is that the APR on both of my mortgages is 3.25%. As an investor I can reasonably expect to earn way more than 3.25% annually from my investments — of interest that has the ability to compound. Mortgage interest is simple interest which means no compounding. So, even if my earning rate was exactly the same as my mortgage’s APR, I’d end up ahead in the long-run.

The thing is that I don’t really care if you decide to pay off your mortgage early, invest or do both. I just want to set the record straight that you have a greater potential for earning more money over time if you pay the minimum balance on your mortgage and invest any overages. The reason for this is that money needs time to really see the phenomena that is compounding interest. Again — this is how the numbers actually work out, I’m not flipping numbers around here or anything. And I’m not going to get into the “peace of mind” discussion or anything, just the numbers.

Let’s imagine that you have a brand new $200,000 mortgage with an APR of 4.5%. That means a principle and interest payment of $1013/month (I’m going to ignore taxes and insurance because those are variables, they will not have an effect on the principle balance of your mortgage). After creating a nice anti-budget, you see that you have an extra $500 to spend every month. You can do three things with this money: apply it to the principle balance of your mortgage, invest it, or spend it.

Applying the $500 to your mortgage payment

If you were to pay your mortgage off in the full 30-year term you’d end up spending over $164k in interest! That sounds awful. Damn banks, taking all your hard-earned money! So, you decide “Shit, if I apply my extra $500 to my mortgage every month I’d split the total interest pretty much in half!” This is exactly right — the mortgage would be paid off in 183 payments (just over 15 years) and you’d end up spending around $76k in interest.

The inherent facts of this situation are that you have spared yourself from spending $88k in interest, you own your home in half the time, and you free up around $1500/month in spending (you’re still going to have to pay taxes and insurance though, sorry about that).

Assuming that you can pay the mortgage off in half the time — 15 years — you’ll have $1,513 now to put into investments every month. The following table shows what your money will look after a 15 year period.

Interest Rate Total Accumulation Total Interest Mortgage Interest Net Interest Gain
0% $272,840 $0 $76,000 -$76,000
4% $373,245 $100,905 $76,000 $24,905
5% $405,465 $133,125 $76,000 $57125
6% $441,235 $168,895 $76,000 $92895
7% $480,988 $208,648 $76,000 $132,648

Looks like you’d need to earn over 7% interest to cancel out the interest damage done by the mortgage.

Applying the $500 to an investment account

Let’s see what it would look like if you took that same $500 and put it into an investment account instead. Obviously in this scenario, we are going to take the entire 30 years to pay the mortgage off, and we’ll have spent $165k in interest; but in this scenario we should be earning compounding interest as well.

Over the 30 year period, we’re going to end up putting $180k of principle into the investment account. At a 0% interest rate over 30 years, you’d end up with your principle balance of $180k untouched. You’d have a house and $180k, but you wouldn’t have accumulated any interest on the money. Since you couldn’t at least match the interest damage done by the mortgage, you actually end up behind in the end (even with your $180k). This isn’t an ideal situation, but it does show how money can add up over the years.

Interest Rate Total accumulation Total Interest Mortgage Interest Net Interest Gain
0% $180,000 $0 $165,000 -$165,000
4% $348,681 $168,681 $165,000 $3,681
5% $418,363 $238,363 $165,000 $73,363
6% $505,268 $325,268 $165,000 $160,268
7% $614,043 $434,043 $165,000 $269,034

As evidenced by this handy graph you can see that even with a 4% interest rate, which is lower than the APR of the mortgage, an additional $3,681 is earned in interest over a 30 year period. This is what it would look like if you were investing very conservatively. Seasoned investors can testify that 4% is a very conservative estimate, most likely the kind of rates you’ll get from long-term bond investing. No matter if the interest rate seems high or low to you personally this shows that you can earn more interest over the long-term by investing rather than paying down your mortgage.

The inherent facts of this situation are that you spent $164k in interest over a 30 year period, but now you own your home. Depending on the interest rate of your investments you have an extra $3k-$270k in net accumulated interest. That means you generated more money in interest over the life of the loan than the loan charge you in interest. If you were earning 7% on your investments you’d end up with more money in interest alone than would be needed for the full amortization of the original loan! That’s pretty incredible.

There are all kinds of things that can throw these numbers out of whack. One such thing is the frequency that people move from one house to another. As long as you are moving laterally — to a house of equal selling price — then the numbers are unaffected (as long as you are using 100% of equity as a down-payment for all recurring home purchases). If you’re upgrading every time you’re buying a home and starting a new loan every time, you’re going to be locked down to a mortgage for the better part of your adult life.

While there is no blanket solution for everyone we look at the above numbers and have a pretty decent idea what our future investment accounts might look like if we started regularly investing any money that would rather go against the mortgage. If you do want to cut time off of your loan, but don’t want to pay any more than you’re obligated to, I would suggest two half payments a month instead of one full mortgage payment. This will help reduce the total interest slightly without causing you any financial strain — and you can do this even if you don’t have any extra money to invest or throw at your mortgage.

Paying off your mortgage early is silly

My initial introduction to the world of personal finance was through a friend turning me on to a gentleman named Dave Ramsey. You’ve probably heard his name thrown around. You might have seen him on TV or maybe you even listen to his radio show. I personally take everything he says with a grain of salt. It’s kind of hard to trust multi-millionaires, who have already made their millions, trying to tell you how to save a few bucks at the grocery store.

His vision is for everyone to have financial “peace of mind”. I interpret that to mean having no debt, and money laying around in case of disaster. And I totally agree. He touts a 7-step plan that will get you out of debt and into the black that he refers to as “The Baby Steps”.

When we were still in debt, Mr. Ramsey’s Baby Steps were an incredible tool that ultimately helped us get into the right mindset to eliminate debt completely. It wasn’t the Baby Steps themselves that made us save, but they did help us form a plan to become a debt-free family. So, thanks Dave.

A few months after discovering his site, we were a debt-free family. We graduated from the Baby Steps program and that’s when I think we outgrew his philosophy.

I consider my family to be debt-free, however, we carry a 30-year mortgage on our house. The interest rate is so low (3.25%) that after the mortgage interest tax deduction, we are essentially paying a rate LESS than inflation for our house. Why in the world would I want to pay off our mortgage early? Why would I ever even make a larger than normal mortgage payment?People all over America and beyond flock to him to learn the power of being debt-free. His anti-debt message is so strong that he even encourages people to pay off their mortgages as fast as possible. In some cases, he’s encouraged people to pay off their entire 30-year mortgages within 5-10 years. Amazing right? Well, I for one, think it’s silly.

Since we only spend about 50% of our income, we could take the other 50% and dump it on our house every month for about 5 years and pay it off completely. Then I wouldn’t have a mortgage payment any more. “Yay!”, right?

Well I’m not “Yay”-ing, because I just wasted 5 years of investing so I could pay into a liability. Yes, a house is a liability, because it doesn’t produce any income. It could, but only if you’re in the market to sell, and your home’s value has appreciated (or if the property is a rental). Remember that home values mean nothing unless you plan on selling**.

Over that same 5 year period, I could tuck away that other 50% of my income into savings and other investments instead. 5 years later I’ll have a bunch of money in the bank (like a baller), which would be great padding were we to have another recession in the near future.

The people who choose to put all that extra money into the house will just owe less on their principle balance. It won’t change their monthly payment, and in a financial pinch they’ll still have to keep making payments without that sweet cushion.

The good thing about paying my mortgage off as fast as possible would be the guaranteedreturn on investment. When you have a debt that is negatively impacted by interest like a mortgage, personal loan or credit card it’s like having a portfolio with a negative rate of return.

Every dollar applied against your “portfolio’s” principle balance early is guaranteed to grow at whatever the interest rate the debt is set at. If you make all of your payments when they’re due (instead of early) you’ll end up paying all of the interest as well. This is no bueno.

Basically, any pre-payments on my mortgage will grow at a rate slightly better than CDs. Abysmal. For you this may not be the case.

I don’t worry much about paying off my mortgage early since it has such a low interest rate and because the house should hold it’s value. That means, if someday I want to sell the house, I can sell it at a break-even price (enough to pay off the mortgage) and I would have only lost what I paid into interest.

People always seem to be worried about the possibility of losing money, but with interest rates for mortgages being so low right now the risk is almost negligible. Just remember that risk is never “negligible” for someone that can’t pay their bills on time.

As long as you aren’t buying more house than you can afford, and you aren’t paying PMI (mortgage insurance) then I think a house is a pretty solid investment. If you end up with an interest rate of 4% or less and you let someone convince you that paying off your mortgage early will grant you “peace of mind”, don’t buy what they’re selling. Your money is worth a lot more than 4% annually.

If you are paying PMI on your house, I would get on the Ramsey program and dump a shitload of your money onto your mortgage until you get to the point when you’re PMI-free, then continue paying your mortgage like I do: Minimum balance due. PMI is a good way of flushing money down the toilet. You’ll never see it again.

Obviously none of this applies to people who are being crushed by 6%+ interest rates. -6% is a pretty significant weight in your portfolio. If you’re able to, contact the bank and see if you’re eligible for a streamline refinance. After owning our house for one year we were able to do a streamline refi through Wells Fargo. No credit check. No appraisal. We had to re-pay closing costs, but it was worth it financially for us, especially because we are going to be renting the house out. The less we owe every month = The more profit we can generate.

Owning a home can be pretty sweet, but it takes a lot more work and caring than renting does. All a renter needs to worry about is paying the rent, and maybe mowing the lawn. A homeowner needs to worry about the mortgage, the lawn, maintenance, the roof, safety, random house-related-bills, etc. If you’re a renter and you knock a hole in the wall, you might just let the landlord eat your security deposit. If you’re a homeowner you gotta fix that shit on your own (or at least hire someone to). Either way, the responsibility is yours.

While Dave Ramsey isn’t a bad guy and I love anyone that tries to help people financially, I can’t and won’t trust anyone who is out of touch with common folk like you and I. His cookie cutter plan is a “you can’t fuck this up” kinda thing and that’s why it resonates with such a broad audience. It’s a message for the masses, not for people who have figured out personal finance. Let me know if you’re ready for the next steps, the Big Boy Steps.

**Home values also matter for tax purposes. Appraisals may be necessary for some refinancing programs.

**I’m sure this post will be debated like crazy and I’m open for the challenge!