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Is it Better To Pay Off Your Mortgage Early Or Invest?

Posted September 11th, 2011 in Debt, Investing, Real Estate by Jeremy Waller

Should you pay off your mortgage or invest?

Not long ago I talked about how to pay off your mortgage early. For many people that is exactly what they would like to do. Pay off their mortgage and be debt free. The idea of not having a mortgage payment each month may excite you. But is it really better to pay off your mortgage early or invest?

A lot of people I’ve talked to don’t care if investing is better or not. The emotional benefit of being totally debt free is more important than anything. If you’re in that boat, then that’s fine. Being totally debt free is a great goal to have.

But I hope you’ll stick with me and see if it is better to pay off your mortgage early or invest the extra money in something else.

First, let’s get real basic here so we’re all on the same page.

Say you have an extra $500 per month. You could make extra payments on your mortgage and pay it off several years early and save tens of thousands in interest.

Alternatively, you could take that same $500 per month and invest it.

Now, which is better?

Well, it depends on a couple of things. The first and biggest is how disciplined you are.

If you have an extra $500 per month, do you have the discipline to put than in an investment account no matter what? Be honest with yourself. Most people will say that they have the discipline for it, but when you look at their finances it’s obvious that the aren’t the best money manager.

A recent article on Love Money that talked about tips for saving money noted that most people don’t have what it takes to consistently save on their own. Even people who consider themselves to be good with money don’t to all that well in practice.

The second thing to consider is how far along in life you are. Someone who is under 40 has a lot more time before retirement than someone who is 60. For someone farther along in life it may not be a wise decision to invest in something prone to volatility.

Now let’s assume that you are going to be disciplined enough to invest the extra money each and every month and that you can tolerate the risk of investing in something with a sufficient return.

The Power of Leveraged Investing

Advanced financial lesson here: leveraged investing is an incredibly powerful tool. It allows you to invest with someone else’s money.

When talking about a mortgage you are essentially investing with the bank’s money. Rather than paying off your debt with the bank you are using the money to invest using leverage.

What if you took that extra $500 each month and invested it in a Roth IRA of paying down your mortgage?

You can easily achieve an 8% return with conservative investments. If the interest rate on your mortgage is less than 8% then you will come out ahead by using the extra money to invest.

For example, if you had a $200,000 mortgage with a 5% interest rate and paid an extra $500 per month you would pay off your mortgage in 14 years and save $101,000 in interest.

However, if you invested the $500 each month in an investment with an 8% return you would have $155,000 after 14 years.

In this case investing would have increased your net worth by $54,000.

In almost all cases it is more beneficial to invest rather than pay off your mortgage. There are two exceptions however.

  1. If you have a high interest rate mortgage you won’t be able earn enough on an investment without taking unreasonable risk.
  2. If you are in a high income tax bracket.

Tax Benefits of a Mortgage

One thing that you do need to consider when deciding whether to invest or pay off your mortgage is the tax implications of the decision.

All of the interest you pay on your mortgage is tax deductible. Since everyone’s tax situation is different it’s difficult to pin down a number. But the tax benefit could be high enough to offset any additional gain you would have from investing.

On the other hand, there can be tax benefits to investing. A Roth IRA is a great example. The contributions you make may be tax deductible.

If you are in a high tax bracket talk to your tax professional before making a decision.

Paying Off Your Mortgage Vs. Investing: The Bottom Line

Since this decision relies on so many variables it’s impossible to give an answer that is right for everyone.

Here are some general guidelines. If all of these criteria apply to you then it is most like better for you to invest than it is to pay off your mortgage.

  • You are disciplined enough to invest the extra money each and every month.
  • You have a low interest rate on your mortgage. 5% or less is ideal.
  • You have enough time until retirement to have moderate risk investments in your portfolio.
  • You are in a low enough tax bracket that the interest deduction on your mortgage doesn’t have a large impact on your taxes.

 

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6 Responses so far.

  1. Andy says:

    So this post is the litmus test and a hot button to me. The bank while stupid enough to do ninja loans, isn’t stupid enough to play the market with that money. That should tell you something right there.

    If it were BETTER to have the money in the stock market, the bank wouldn’t have loaned the cash to you at 5%. They would have played the market with it too.

    Let me put it another way. If you had a paid for home, would you borrow 200k against it to go play the stock market? Hell no.

    Well that’s what you are doing when you invest while you have any kind of debt.

    Let me put it yet another way. In 2008, I was really feeling uncertain about my own job future and the future of the economy. On Labor Day I came to the decision that a paid for house was going to be the best way for me to weather financial armageddon. The next day I cashed out enough to pay it off. Later that week s*** hit the fan and w/in weeks banks were falling like dominos.

    I’m a conservative investor and I use options to avert risk (far less risky that what normal people do). Even with that approach there was about 50k difference in my networth because of my decision to pay it off.

    100% of forclosures happen on homes with mortgages. Pay off the home, then invest.

    • Jeremy says:

      This is no doubt a polarizing topic. There are a lot of people that agree with your viewpoint.

      I’m a numbers person though. No matter how I look at it, the number don’t make sense for me to pay off my mortgage. You don’t have to look hard to find low risk investments with a return that is greater than what mortgage interest rates are at right now.

      I also don’t think you can say that someone shouldn’t invest because a bank isn’t doing it. A bank’s situation is far different than an individual. A bank has to worry about liquidity. It has to align cash flow from assets with cash outflow associated with liabilities. A bank couldn’t operate if it’s entire portfolio was structured like an individual’s retirement fund. Further, a bank has access to much cheaper capital than an individual does. It’s margins are still quite good even when lending at 5%. It also has to comply with the requirements of the Federal Reserve Board and FDIC which leads to the discussion capital adequacy ratio – which factors in investments risk. A bank’s portfolio simply can’t be used as any kind of comparison to an individual’s.

  2. This is a hottly debated topic. And I’m almost aprehenisve to comment on it.

    However, I’m not completely on board with this theory. I know that you can easily find an investment vehicle that would yield annual returns greater than the interest rate on the mortgage payment. But this does not account for two factors. Taxes and Risk.

    If you are paying 5% on a mortgage and are getting 8% on a taxable investment. Assuming your combine federal and state tax bracket is 40% then your effectively getting an after tax return of 4.8% on your money.

    Then you have to adjust for risk with through a discounted cash flow analysis or net present value analysis – then you’re left with significantly lower returns.

    I’m all for investing – but the for me, the yields should be closer to the 15-20% range (yes – there are those investments these days) before I would consider them over paying off the debt.

    In the long run, if something terrible were to happen I would say I’d feel a lot more comfortable with a paid of mortgage than a $150K in equities or moderately liquid securities.

    • Jeremy says:

      You bring up some great points. I think the biggest reason that this is so hotly debated is that there are so many variables that factor into the decision. There isn’t a blanket answer that will be right for everyone.

      To avoid the tax issue, you could invest in tax-exempt municipal bonds. Vanguard has several funds with returns in excess of 6% since inception.

      Like I mentioned above, you also have to consider the deduction you receive on mortgage interest. If your effective income tax rate is 25%, the APR on a $200,000 mortgage financed for 30 years at 5% is actually around 3.5%.

      With those 2 assumptions, you would have a net return around 2.5%. Is 2.5% worth the risk? That will depend on each individual’s level of risk tolerance.

      Edit: Reading over all of this, I hope I don’t come across too pushy. I don’t think there is one right answer to the problem. I just happen to like this side of the debate.

  3. David says:

    It’s better to pay off your loan or mortgage and get a guaranteed return of 5% on your money which beats any CDs or bonds. With bonds or stocks you have to pay corporate income taxes, dividend taxes and capitals gains taxes which diminishes your returns. If you are lucky enough to get an 8% return then after taxes and broker commission fees you get like a 5% return.

    Investing in stocks has high risks, the stock market or the S&P 500 went down -37% in 2008 which will take over 5 years to recover from

    • It’s really all about your risk tolerance. If all you do is invest in CDs and bonds, then you’ll have a very difficult time beating 5% after taxes. But, if you invest in growth mutual funds you should at least track with the market. The S&P 500 may have gone down 37% in 2008, but it’s averaged 10%+ over any 20 year period.

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