I’ve previously written about this topic – should you pay off the mortgage early or invest – but I realize that post was sorely lacking the math. Today, I want to take a deeper look at the discussion to give a more thorough answer to the question – should you pay off the mortgage or invest? Watch out! I’m about to unleash the geek inside and let him run some math with the calculator.
This post is the first in a series that deals with home ownership questions. The series will cover the following topics:
- Is a house an investment or a home?
- How to know when you’re ready to buy a home
- How to pay off the mortgage early
Pay Off Mortgage Or Invest – Points To Ponder
I was recently talking with someone who wants a home loan. He likes where the average home mortgage rates are and he thinks you’d be crazy not to have one. At the time of this article, the national average for a 30 year fixed rate is 5.13 and for a 15 year it is 4.38 – wow those are some great rates!
However, we should keep in mind that over the last 10 years, the Wilshire 5000 index has basically been flat. In other words, if the next 10 years are just like the last 10 years, you could have paid around 5% to invest the money and get 0% return.
Canada Vs. United States
Your country of residence also influences this decision. In the United States, interest paid on a mortgage is tax deductible, while in Canada you do not get this deduction. If you are a Canadian, your numbers and calculations will need to reflect the proper Canadian taxation. It is better to pay off your balance in Canada than in the States.
Occupation
Ministers are eligible to receive lodging from the church free of income tax. In addition, ministers can receive a tax deduction for interest payments. This means that if you are a minister, your full house payments are tax deductible (along with the cost to maintain a home – called a housing allowance). While the IRS does allow a minister to deduct fair rental value of the home, there does seem to be some discussion on how ministers are impacted if they pay off the home early. Consult your local tax professional for guidance.
Personal preference, personal comfort, and personal security
A home is not just a place where the heart is, but it is also the place you feel most safe and secure. When you completely own your home, you reduce the possibility that someone will come and take it from you.
The “I-just-feel-better-having-the-house-paid-off” feeling is certainly worth something.
What if we change the formula – pay off the mortgage or spend it?
For most people, it is extremely hard to continue to be financially focused when they are already doing very well. Compared to national averages, anyone who only owes on the house is in a good financial position. Thus, the question is if you had an extra $150 per month, would you really invest it or would you blow it? Sometimes we have great intentions, but we don’t follow through on our intention to invest the money.
Your debt definition
Some people think that if they pay off everything but the house they are debt free. Dave Ramsey set that standard. However, you are still in debt, all be it a good debt on the account of many. Some people want to be REALLY debt free, and if that is your personal goal, you will be better off paying off the mortgage and then get to your investing.
Mortgage Interest Rates
If you have any other debts, there is a good chance that your mortgage interest rate is the lowest. With the exception of student loans, you are probably not going to get a lower interest rate for borrowed money. In addition, those who have borrowed on the house make the assumption that their property will increase in value. This may or may not be true.
It your mortgage a fixed rate or variable? What is the length of your term?
Guaranteed return vs. possible return
Paying off the mortgage guarantees that you will save yourself the interest. Investing the money means you are assuming the investment will make a larger return than your borrowed money. Anyone who has been alive more than three years knows the investment market can be quite volatile.
Inflation
When the dollar becomes less valuable in terms of the value of your payments, they actually decrease over time. If, like many think we are, we are on the verge of seeing a time of inflation, then you will be getting more of tomorrow’s dollars, but will still be required to pay the same dollar amount in the future. In other words, there is not inflation increase on mortgages (assuming it is a fixed rate).
Asset allocation and risk
There is really only one way to increase your investing return potential. Increase your risk. When you say pay off the mortgage or invest, you need to compare paying it off to different levels of investing risk. The more conservative you are, the less likely you are to make any sort of significant gains over and above your mortgage. However, the more risk you take, the more likely you are to do much better or much worse.
Thus, you need to find a way to take enough risk to make the investment worth it, but not to take too much risk to be in a worse financial position.
Igor the Intense Investor Vs. Matt the Mortgage Manic
| Igor the Intense Investor | Matt the Mortgage Manic |
| Both start off with a $150,000 mortgage for a 15 year 5% fixed rate mortgage. | Both start off with a $150,000 mortgage for a 15 year 5% fixed rate mortgage. |
| Igor pays only his minimum payments ($1286.19) and uses a $100 per month to invest. At the end of 15 years, his house is paid off and his investments (at 8%) are now worth $34,603.82. | Matt pays his regular payments ($1286.19) plus adds $100 each month to the principle. When the house is paid off, he invests his regular house payment plus the extra $100. He gains 8%. He does this for 19 months. At the end of 15 years, his house is paid off and the total value of his investments would be $32,728.87. |
| However, if Igor were paying 25% taxes, he would have also have deducted 25% of $63,514.28. Along the way, he deducted and saved $15,878.57 in taxes. | If Matt were paying 25% taxes, he would have deducted 25% of $55,826.56. Along the way, he deducted and saved $13,956.64 in taxes. |
| Igor cashes out his investment and pays 15% long term gains tax and he has $29,413.25. Plus his tax savings equals $45,291.82 | Matt cashes out his investment and pays 15% long term gains tax and he has $24,546.65 plus his tax savings equals $38,503.29. |
| At the end of the day, Igor ends up with $6788.53 (account value plus tax savings) more by focusing on investing. Over a 15 year period, that means he saved on average about $450 each year. If, however, Igor’s investments returned anywhere less than 6%, he would have lost money in the process of taking an increased risk over a 15 year period. |
Important Observations and Notes about Paying off the Mortgage:
- Since the Wilshire 5000 is flat over the last 10 years, it is hard to know if you will be able to find a relatively safe 8% rate of return over the next 15 years.
- Home loan rates are extremely low right now.
- During that 15 years, there was probably at least one period where Igor’s investments were down 30% or more. Would he have had the stomach to keep investing? Would he have bailed?
- As a side note, if Igor was investing in a tax deferred account (like a Traditional IRA or a 401K), then the numbers would be much more in favor of investing. Again, assuming an 8% rate of return.
- If you pay it off you will know that you will be better off financially in 15 years time. If, however, you invest, you may be better off – or you may be worse off.
- If you are in Canada, the difference is more like only $2,000 difference or $133 per year by taking the investment risk.
- Before paying off your mortgage early, even the most conservative financial advisers suggest you should first be putting 15% of your income into retirement. Thus, I’ve ignored the tax deferred accounts in this equation because you should already be putting 10-15% into retirement before considering paying off the mortgage early.
Here is a great downloadable excel document (and free) that will help you calculate your own mortgage prepayment options.
Summary
When comparing paying off the mortgage early or investing at 8% in a taxable account, the numbers reveal little overall difference. Neither one is a terrible math decision. Neither is the deal breaker.
So, what should influence the ultimate decision?
Thus, ultimately it comes down to the non-math factors to help you make the right decision. I’m sticking to my guns that paying it off or investing is not a math decision, it is a highly personal choice based on the preferences of each family.
Personally, the emotional roller coaster to come away with a possible $450 per year is not worth the risk.
Consider doing both. I’m a proponent of financial plans that make room for you to be both right and wrong. In that case, when the future unfolds you are never completely right or completely wrong. You could consider 1/2 of your extra money towards the house debt and 1/2 invested.
How To Determine if the Investing Risk is Worth It?
Questions to ask:
- Do both husband and wife completely agree about the decision to invest? If not, it is not worth the extra strain on your marriage.
- Are you already saving 15% for retirement? If not, pay minimum house payments and invest into your retirement account.
- How certain is the investment? If you can get an 8% CD, then you are completely removing risk from the equation. However, if you need to invest in aggressive funds to hope to get 8%, then just pay off the mortgage.
- Is greed driving your decision? Are you taking a financial risk with something that will provide a decent stable return?
Be sure also to read the following posts (by fellow Money Maven Network members):
Free Calculator: Pay off the mortgage or invest
Pay off your mortgage or invest your money?
12 Good Reasons Why You Should (and Should Not) Pay Off the Mortgage
Should You Grow Your Nest Egg Or Pay Off Your Mortgage?
What are your thoughts? How is my math? Did I miss any important considerations?
More Great Articles:
- Does Spending Cash Really Save Money When Compared to Using a Credit Card?
- How to Become an Accidental Millionaire
- Should I Pay Off My Mortgage or Invest?
- Mortgage Refinance Tips & Free Mortgage Refinance Worksheet
- Buying A House? Is it an Investment or a Home?
- How To Pay Off A Mortgage Early
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{ 10 comments… read them below or add one }
Wow, clear as mud, eh? Thanks for running the numbers and making them so presentable. Like so many financial decisions, it comes down to psychology. A house you can touch and feel, or investments that are flexible but elusive.
WOW….a really thorough job. I believe it’s all about priorities like you wrote. I personally feel much better with my mortgage gone. I could have made more money doing other things with it but..
a. I didn’t know that at the time.
b . I don’t care. It’s worth it to me.
Great summary, Craig!
While the US does give a tax deduction for mortgage interest to those who itemize their deductions, that deduction naturally decreases over time as the amount of interest one pays is reduced.
My mortgage interest deduction is now almost so low it hardly matters anymore!
All the best,
Len
Len Penzo dot Com
I think we aren’t going to see 8% returns on investments any time in the near future.
Wow, I never really thought that deeply about that. It’s something to think about indeed.
Interesting. 2 & 3 seem to contradict. If a mortgage is 6%, but risk free investments are 1%, then (absent a match) paying the mortgage may be the better choice over the 401(k) choices. It all depends, I suppose.
@Joyln
Yes, once again psychology becomes the deciding factor.
@Neal
I’m in the same camp as you. Even if it was a greater math difference I feel a lot better paying off the house.
@Len
Good point! The closer you get to paying off the mortgage the less the difference the deduction makes.
@Karen
That is of course the biggest unknown factor – will we see 8% returns. I honestly don’t know. It could be 15 or it could be 3. It is hard to do the math with the biggest variable is still unknown.
@Lencib
Your right. It is a very important decision.
@Joe
They do contradict. I figured if I didn’t write that someone would have thought I fixed the numbers buy running the math outside of a 401K account.
Very nice post Craig!
I agree with you that there are several risks involved when you are investing vs life is quite simple when you just have your mortgage to pay
Have you done the calculation considering a Smith Manoeuvre for Canadians? This would be a great advantage to consider since mortgage can’t be tax deductible unless you apply the Smith Manoeuvre..
It is better to use the extra money to pay back the loan instead of investing it. You can get a 5 year CD at 4 percent if you’re lucky before taxes. Getting a guaranteed 5 percent return from paying off loan is much better than getting a return of 4 percent.
Stocks are riskier than CDs. In 2008 the S&P 500 went down 37.22 percent which will take many years to recover from. So paying off your loan is the safest bet unless you are the Oracle of Omaha.
@David
I’m with you. Stocks can be dangerous – hence the extra risk factor. However, in my case my bank (overseas) is offering an 8.05% one year CD. My mortgage is 5%. Everyone needs to work the math based on their own situation. There is no open and shut case.
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