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.

Republic Wireless – $19 a month cell service

With the smartphone world being dominated by Samsung, Apple and the comm-nexus that is Verzion, ATT, T-Mobile and Sprint (er.. Softbank?); there’s barely any reason — or way — to try to move to a smaller independent wireless company. The big companies lock you in with their fancy contracts and cancellation fees. And the most important reason of all to have a big brand name phone/plan — most of the independent wireless companies have shitty coverage and even worse customer service.

I was sick of paying a monthly subsidy to Verizon for my $600 phone that I got for “free”. $80 a month, and for what? Data caps? “Free” upgrades every two years? I did what no one wants to do and took my business elsewhere; and switched to a pre-paid service that only offers one phone — and it isn’t an S3, an S4 or an iAnything.

I ordered the Motorola Defy™ XT for $199 and planned to use it along-side my Verizon Nokia Lumia 822 for a full month before decided if I could handle the downgrade or not permanently. I was pretty used to having 4G service and a powerful phone that could handle pretty much anything I could throw at it; and then I received this tiny 3G phone with almost no processing power in the mail.

While I still had access to both phones, I always found myself being reliant on the Verizon phone whenever I needed to make an important call; or browsing the Internet when Wi-Fi wasn’t available. So, I made a hard, but necessary call — I put my Verizon service on hold so I could truly test out Republic Wireless.

The hardest thing was getting over the lack of a 4G network. It felt like the TARDIS had dropped me off in 2007. But after a day or two, I had begun to adapt. I began off-loading the majority of my data usage to Wi-Fi. Most of my data usage on the cellular network was from checking my Gmail, or my WordPress site — nothing too data-, or processor-intensive. I realized within a week that I was going to be okay with my decision to downgrade — at least on the data side.

Even though I hardly ever make phone calls anymore, I had to test out the full-spectrum of the phone’s capabilities. I was impressed to see that Republic Wireless installs software on their devices that allows (and encourages) Wi-Fi phone calls as well, which are of surprisingly good quality. When you’re not on a Wi-Fi network, Republic uses Sprint towers to process their calls.

The most impressive part of Republic Wireless’s business model, for me, is the price. After buying the phone outright, the service costs $19/month. There are no contracts, no cancellation fees, and no gimmicks. As far as I’m concerned, everyone should try the service out considering how cheap it is. If you can deal with the downgrade, then this is the phone for you.

Overall I have to say that I’m impressed with Republic Wireless. I realize that 90% of the people that I know have the best phone on the market, and will continue to upgrade their phones annually. But for those of you that have absolutely had it with paying $80 or more for your monthly cell phone usage, rest assured you have a viable, low-cost alternative waiting for you.

You can’t save money when you’re spending.

Anybody that knows me — either through this site, or in real life — knows that I love to save money. I think it’s one of the best feelings in the world to know that I have a stash of cash at my disposal. I’m a firm believer of paying myself first which is the process of saving/investing just after getting paid instead of waiting until the end of the month when money might be tight.

While I’m putting away money every month and building my reserves, most consumers are saving in a different way; a way that isn’t really saving at all.

I’ll start this off with a questionIf person A goes to the store and buys an item that normally costs $10 for $5, and person B decides to put $5 into a savings account; who saved more money? Without reading ahead you might think that both people saved $5, but really person B is the only one who has committed his money to actual savings.

When referring to money the word “save” can mean one of two things. The first definition is the one where you end up having more money: “accumulate money: to set aside money for later use, often adding to the sum periodically”. The other definition is the one that marketers use to take advantage of consumers: “conserve something: to avoid wasting something or using something unnecessarily”.

With the marketer’s definition it actually sounds like they’re trying to hook you up, and make you spend less money. But honestly, how could they possibly be helping you “save money” when they’re trying to get you into their stores to spend money? “Buy a new car and save thousannnnnds!” — this may be the most illogical sentence on this entire site, because you can’t save money when you’re spending money.

Now if you need to buy something, and it happens to be on sale you should take advantage of the sale. While I highly recommend buying things you need while they’re on sale, I offer a word of caution: Just because something is on sale doesn’t mean that you need to buy it. If you go shopping without a clear picture of what you actually want/need, you’re going to end up spending more money than you anticipated. The sale does it’s job by getting you into the store, and — believe it or not — there are people who go to college to learn how to position sale items to make you spend more money!

Malls, and car dealerships aren’t the only places that take advantage of false-savingpromotions. When you go to the grocery store the front-end cashiers are trained to emphasize your savings amount before they hand you your receipt. Our standard grocery store, Safeway, prints the percentage “saved” right on the receipt so you can walk out of the store feeling good about yourself, because most people will feel better about spending money if they knew that they could have spent more.

We need to shift our mindset away from the savings and onto the spending. When you buy an item on sale for $50 that originally costs $100, you aren’t saving $50, you’re spending $50. We allow numbers to confuse us and we develop irrational mindsets towards future purchases whenever we see price reductions. There’s a reason why almost everything in every store is on sale almost all of the time! A brand new TV that retails for $1,999, might be “on sale” for $1,499 which stimulates something inside the average consumer’s brain: buy this TV, save $500! No, silly-pants, you just SPENT $1500!! SPENT, SPENT, SPENT!

Saving isn’t spending, so what is it? Saving can be broken down into two main categories. The first is long-term savings which is money that you don’t really have a plan for besides the fact that it’s going to help you afford things (especially when you’re retired). The second form of saving is also known as “delayed spending”. This is when you save up for something in specific, whether it’s a new laptop or a house; in other words: this money is pre-spent in your mind, even though it may take you a few months to accumulate. It’s kinda like the opposite of having a credit card payment.

How do we fix the problem and reclaim the word “saving”? It honestly starts with the consumer; with us. We need to stop buying in to the marketing speech. Whenever you hear an advertisement claiming that you’ll save money this weekend at the mall, you need to audibly scoff. Explain this concept to children, so they can grow up understanding that spending is spending and saving is saving, and these things are completely separate topics of finance. We can still take advantage of sales, and price-reductions, but we should know that unless we are transferring money into savings accounts or investments we aren’t actually saving anything.

The process of Optimizing your monthly expenses

It’s become common knowledge to JM readers that the secret to becoming rich is — in essence — spending less than you make. We also know that the money we are able to save has the magical ability to accumulate interest and will continue compounding through our target retirement date. For me, that’s about 6.5 years away now. Being someone who intends to Retire Early, I have to maximize my monthly savings, but I also don’t want to suffer by working more than I already do. Having a family comprised of two active duty service members, an infant and a toddler doesn’t really allow for the opportunity to have additional employment. Even trying to find a few hours a week to write a blog post or two is an almost impossible task, so I’m well-acquainted with the concept of not having enough time.

Since I knew I wasn’t going to be granted extra hours in the day to try to rake in more money, I realized that I had to make our monthly expenses as efficient as possible to reduce the amount that was being automatically drained from our bank account every payday. I wanted to accomplish true expense-efficiency in a way that would have the least impact on my family. No one wants to completely overhaul their expenses overnight and feel the sudden and dreaded shackles of budgeting. When you properly perform the action of optimizing your expenses, chances are you won’t really notice a difference in your lifestyle, you’ll just have extra money lying around that wasn’t there before.

I found a spreadsheet that I had created in May of 2011 which shows our income as well as our expenses. Together Mrs. Moneyseed and I had a combined income of $6300 per month along with $2125 in bills. That means that roughly 33% of our money was being spent in bills alone. Back then we were child-free and rented a 500sqft apartment. We thought we were doing an alright job with our spending, but didn’t realize that our finances were being eaten by bills. **If you don’t track your monthly income/expenses, you definitely should. It’s pretty interesting to see how your personal money management system can change over time.

Fast-forward to June 2013 and we’ve been able to increase our monthly income to about $8800. Our living expenses have also gone up, but only slightly. We now have two daughters in daycare (this makes up almost half of our monthly expenses). We’ve also purchased two houses in Maryland in the past 2 years. Anyone that lives in Maryland can attest to the fact that houses and land are outrageously overpriced and overtaxed; which helps to make Maryland the #5 most expensive state in the Nation to live in. Even with all of our new-found craziness, our monthly bills have only increased by $235 as they currently total $2360 (around 25% of our income).

At first glance it may seem like we’re spending more now than we were back in 2011, but when we moved to Maryland in late 2011 — without any lifestyle upgrades from when we were living in North Carolina — our expenses shot up from $2125 to $3490. Literally, overnight! The drastic difference is mainly a product of the disparity in housing costs between NC and MD, which is insane.

Since November 2011, when we moved into our house in Glen Burnie, I’ve looked at the line items on our anti-budget and tried to pinpoint where we could lower expenses; I hated the fact that “cost of living” was getting the best of us. Sometimes when I’ve tried to find areas to save, good ideas have hit me like a ton of bricks, and other times I have to fish around to pull a deal out of the woodwork. Sometimes there’s just nothing you can do to lower an expense, no matter how hard you try.

The first thing we did to efficifize our expenses and reduce monthly costs was install solar panels. By adding solar panels we’ve split the monthly cost of electricity by more than 66%. Our house runs on 100% electric, and this month (June) — for example — our total energy bill is projected to be $34. It used to be $180. **Please note that this is the only instance that we paid out of pocket to reduce a monthly expense. Solar panels can be installed for FREE by SolarCity with a small monthly payment (still totally worth it).

Another area that needed closer inspection was cable/internet. Monthly we were paying $135 for cable/internet. We decided to make our house cable free; but we kept internet (of course) and through the Roku we’re able to watch better programming daily (and we don’t have to watch dumb shit like the Grand Canyon tightrope guy). Our total cable/internet costs are $68 (FioS internet + Hulu subscription). Savings? Almost exactly 50%.

Some people get pretty motivated about their small victories during the optimization process. They’ll relish in the fact that they cut back in one or two categories, but that’s usually where the motivation dies. That’s when it gets hard. That’s when you need to get creative and inspect your finances closer. For us, I realized that our insurance (car and home) deductibles were too damn low. Why would I pay a premium to keep a deductible low when I have the cash on hand to pay the full deductible in case of emergency? I called up the insurance company and said that I wanted the deductibles raised as high as they could possibly be. That had an incredible impact on our finances, but it wasn’t an obvious fix, because it’s a semi-annual bill. **Don’t do this, unless you can comfortably pay a high deductible out of pocket.

By far, we’ve saved the greatest portion of our monthly income by paying off our vehicles. My wife came into this marriage with a Ford Edge with a $575 monthly payment. Even though the interest rate was 0%, I couldn’t handle the fact that we had such a huge monthly payment for a 4,000 pound hunk of metal that takes us to/from work. And good ol’ U.S. law states that you need to have full comprehensive insurance on financed vehicles, which can add a significant amount to monthly expenses.

The only thing that remains unchanged between May 2011 and today is the monthly cost of our cell phone plan. We’ve been paying about $140/month virtually every month for the past two years. I’ve been trying to find the best possible carrier with the best pricing plans to replace our super-expensive-low-data cap-Verizon-garbage plan. I think I have one picked out, which only runs about $20/month! Holy moly! Sounds too good to be true. I’ll tell you what: I’ll do the research and I’ll give an honest review about the company and their service. If it sucks, I’ll be blunt about it.

The other half involved in optimizing your monies is to increase your monthly income. There’s a very simple way to accomplish this without even filling out one single job application. Simply, all extra money that you’ve creating in the first half of optimization should be used as a base from which more money can grow. One easy way to accommodate this seemingly impossible-sounding task is by investing your “extra money” into dividend paying indexed mutual funds. A decent rough estimate with this strategy is that for every $1000 invested you should expect about $5/month in dividends. If you were able to invest $12,000 in a year, you would effectively add $60 to your income (and this isn’t even taking compounding interest into account).

Investing should be a constant, and should only increase as your monthly expenses go down. You should look at investment money, not as money that you’re losing, or can’t touch right now; but as money that is helping you to increase your monthly income. The best part about investing in dividend paying indexed mutual funds is that while you’re invested in them, they will continue paying you dividends for the rest of your life (until you divest your money or croak).

Every individual and family is different when it comes to their monthly expenses. The things that I save money on every month may not be things that you have the control to reduce the cost of. Alternately, you may have line items where you could save money, that don’t apply to me whatsoever. I’m not trying to lay out a map here, and say “These are the things you need to do to increase your monthly income”. I’m really saying you should take a look at every monthly expense that you incur, and apply the principle of optimization to them all. Try to find small areas to cut-back your spending. If you can find $20 worth of savings each month for 6 months, you’ve effectively increased your income by $120; or reduced your expenses by $120. It’s all about how you perceive your new-found “extra money”.

OPEN YOUR MIND, AND THROW OUT YOUR BUDGET

When I officially decided that I wanted to start acting like an adult — I was about 25 at the time — I created an Excel spreadsheet to track my month-to-month spending, because that’s what grown ups do, right? Little did I know that I would come to obsess over the numbers that I had written, my own self-imposed restrictions, eventually causing me to throw my budget system out the window (otherwise known as defenestration).

The system my wife and I were working with was pretty standard. It kept track of how much money we had coming in (income), how much we had going out (bills) and then how much we could spend on gas, groceries, gifts, electronics, burritos… Seriously, every single category had a dollar sign amount attached to it. A number that couldn’t be crossed, and if it was I’d end up stressing myself out. Budget snafus also resulted in deprivation. Even though there were 20 days left in the month, we’d become hermits, because our “fun money” was already spent. Who lives like this? People who stick to their budgets do.

I’ve been harboring resentment toward the world of budgets for a while now. I don’t know when it clicked in my head, but I realized, for myself, that there had to be a better way. I didn’t want to feel unnecessary stress. I didn’t want to stay at home on the weekends. I didn’t want to be the people who had tons of money in the bank, but were too “broke” to do anything. If we budget in too much fun, we won’t have enough for groceries.

Budgeting is a stepping stone to greater things. You never really hear people say things like “I’m super rich now, because of my budget”. So then, what is the next step after budgeting? The ability to spend money at will, on whatever you want, without having to plan for it before-hand. This is the way we live our lives, and we end up having more money unspent at the end of the month than we did when we were hooked up to the budget-defibrillators. THHHHHHHMMP! You’ve spent too much money! Thankfully, we’ll never have to hear that sound again.

The first reason that our method of spending works is that there is no pre-defined “this is how much you can spend” amount. Normally, a budget will say: “Groceries – $400″, or something similar to this. This magic number has two distinct properties, even though it’s only supposed to have one: a limit to your spending in this category. The other less realized property is the notion that you can spend all of this money. When the end of the month comes, and there’s money leftover in the “Groceries” account, why wouldn’t you throw a couple extra bags of chips, and Ben and Jerry’s in the cart? In your mind this money has already been spent, so you’ll do the rational thing and spend it.

Another reason why it works is because mentally we’ve moved to a higher level of consciousness. Not exactly spiritually, but emotionally. We began consciously spending our money. You’re probably unconscious every time you spend money, and you don’t even realize it, because you have a budget or you are still at the pre-budget stage. You may not be sleeping physically, but dammit, you’re sleeping mentally. You nickel-and-dime yourself into brokeness. You buy things you don’t really need, and discard them shortly after. You overspend when you’re eating out, because you don’t realize that you have a choice not to.

Conscious spending is all about spending money on the things that actually matter to you while eliminating wasteful spending from your life. It doesn’t mean that you can’t go out to eat, or buy a new car. If those are the things that actually matter to you then that’s what you should be spending your money on. If you were to log onto your Mint account right now, could you justify every transaction that you’ve made with your debit or credit card? Are there any transactions that you’ve made recently that you didn’t really care about? Did their satisfaction not justify the expense?

If nothing else, budgeting helped us to understand where we were spending the bulk of our money. It allowed us to see the categories, and more importantly, the sub-categories where our money was going. Without budgeting, we wouldn’t have understood how much money we were actually spending on things like food, transportation, baby stuff, etc. Once we knew what we were spending our money on, we were able to sift through the categories, and make a determination about each one: How much does each category mean to us?

After targeting and eliminating wasteful categories in your budget, you can toss your budget aside, and start spending money on the things you want to spend money on. If it doesn’t work for you, and you find that you spend more money than you’d like to, go back to budgeting. It means you aren’t ready yet for a conscious spending plan, but don’t let that get you down from trying again. Occasionally, I find myself buying stuff that I don’t truly value. Having an occasional “Oops!” is okay though. Especially when you realize that you’ve made an “Oops!” and don’t just brush it off.

You’re still going to need to pay your monthly bills with your income, so here is a good way to set up your conscious spending plan: First, create a document that resembles a budget (if you already have a budget, that’s even better). You should write down your income, then subtract every monthly bill you have from it. This will give the amount that is leftover, ie “Discretionary money”. You might think that I just described a budget, but it’s actually the anti-budget. It’s a manner to describe the knowns in my financial life. I know how much I make. I know how much I spend on bills monthly. The one thing I don’t know is how much I’m going to spend.

I don’t need to know how much I’m going to spend, because that puts a cap on my spending. It’s the feeling a child gets when they want a toy that costs $6, but their mom or dad will only give them $5, because that’s how much they told little Johnny he could spend. The other reason I don’t need to know how much I’m going to spend, is because I know that I’m not going to spend all of my discretionary money. Part of conscious spending is knowing yourself and how you spend. The other part is NOT spending money like a jackass.

You don’t need to cutback on the things you like, only on the stuff that you truly find no value in. I dare you to look at the money you spend, and try to justify every single purchase. Remove this waste from your financial future, and you’ll start to see money piling up in your bank account without effort.