Categorized | Featured, Investing

To Prepay Your Mortgage or Not?

This is a question I have heard discussed quite frequently… especially recently. I’ve heard it from both family members and co-workers.

It’s a good question and one I love to hear. Often times I believe the people have reached the wrong conclusion, but the important thing is that they are thinking about their financial situation.

If you do the wrong thing but had the right intention, I couldn’t give you more credit. In the end, we can educate you to make the right decision for the right reasons.

housemortgages

The Question

A typical question might be framed as:

My husband and I owe another $60,000 on our house (mortgage) which has a fixed-rate interest rate of 5.25%. We have about the same amount of money invested in mutual/index funds in a taxable account. With the current economic crisis, the taxable account is down about 25-30% from its peak. Wouldn’t it be wise to sell of those funds and pay off the house? That will ensure we keep our house if we get laid off and have money problems.

The Answer

Like I said earlier, I give you insane amounts of credit for thinking about your financial situation and trying to guard yourself against a possible financial catastrophe.

However, I think you’re going about preparing for your worst case scenario in the wrong way. What could you do better?

First off, let’s assume you have more than 10 years left on your mortgage. With that being said, you’ll likely earn a better return on your investment in the market. The 5.25% interest rate on your mortgage probably only costs you closer to 4% once you itemize for deductions and itemize your mortgage interest. Remember, that’s one of the advantages of mortgages.

Do you think you could get better than an annualized 5% return (which after capital gains tax would be close to the 4% cost of the mortgage)?

If you can get more than a 5% return on an investment, it does not pay to get rid of your mortgage. And with prices as depressed as they are now (just look at your taxable account), that shouldn’t be too difficult. When looking at index funds of the market, this is especially true in the near-term of five years or more. Even CD’s had an average return of over 5% in the 90s.

So all in all, I would keep your money in the taxable account and keep paying off your mortgage as normal.

What Am I Overlooking?

I am overlooking the psychological impact of the mortgage hanging over your head.

I am not swayed much by the psychology of debt or investments, I am swayed by the actual math and rationale of the situation.

So, with that being said, some of you may read this and say “MLR, you’re an idiot!” And what it probably boils down to is a difference of opinion.

You could combine both the mathematical and psychological approaches by keeping your money in the taxable account but investing at a slower rate. You could use the extra money to make extra payments each month. Each extra payment will go towards the principle and shorten the life of the mortgage.

In the end, if you only care about the psychological effects of debt, pay off your mortgage early! I wouldn’t, but it may be the best solution for you!

Recap

So a quick recap:

  • It is great that you are thinking of your financial situation and coming up with ways to avoid potential problems.
  • Don’t make decisions emotionally, make sure to run the numbers. Unless of course you are someone who cares more about the psychological impact, as I mentioned.
  • Your decision depends on how long you expect to stay in the market.
  • This is a perfect example of how you can leverage your debt to get an investment return. This isn’t always true, but don’t fall into the trap of believing that debt is always bad.

Good luck, feel free to add on to my advice!

Get to know the author!

MLR is passionate about saving for his future while maintaining a high quality of life. He currently resides in a great town, has a wonderful girlfriend, adopted the cutest puppy ever, and works for a Fortune 500 company.


has written 204 posts on MyLifeROI.com.


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25 Comments For This Post

  1. Trees Full of Money Says:

    MLR,

    I respectfully disagree with you. My wife and I are currently in the process of paying off our mortgage as fast as I can and here’s why…

    1) We are still funding our retirement accounts.

    2) We would like to purchase a vacation home before our kids are out of the house and this will be difficult if we have two mortgages.

    3) Your advice in the example above leans toward the couple paying off their mortgage and keeping their $60,000 in investments. This is essentially the same thing as borrowing money from a free and clear house to invest in the stock market. The “math” MAY work in after 10 years, but most people (including myself) are not willing to put their homes at risk in a volatile securities market.

    Thanks for provoking me to do a little thinking this morning!
    .-= Trees Full of Money´s last blog ..Disadvantages of the Cash for Clunkers Program =-.

    [Reply]

    MyLifeROI Reply:

    @Trees Full of Money,

    I’m glad to have someone disagree! It means you are thinking critically of your own situation and my generic advice!

    1) That is excellent. I would highly suggest fully funding your retirement before even considering prepaying a mortgage.

    2) A vacation home sounds nice ;) But my question is, if you have the money to pay off your house aggressively now, why wouldn’t you have the money to pay off both mortgages at the same time? If you are pulling money from taxable investment accounts, you could always do that down the road if something catastrophic (like a job loss) were to occur.

    3) The math may work in even 5 years! It really depends on where the market is now, though, I’ll give you that. But notice I did mention that CD’s got greater than a 5% return in the 90′s. You don’t need to go high risk to get better than a 4% return in the near-term. In the short-term you probably do.. but not the near-term or long-term.

    Thanks for the comment. I think you have made me think about this… and it is probably more risky than I make it out to be. The problem with the stock market and investing and what not is that there are so many if’s! IF the stock market recovers in 3 years my math may be right. And IF it doesn’t? Your plan may work out better!

    As always, for anyone considering what I am saying, your situation may be completely different than the above example. Consult a professional who will be more than glad to run your exact numbers!

    [Reply]

    Brad Reply:

    Ultimately it’s completely dependent on your expectations of the stock market, or whatever you’re investing in. If I can borrow money at 6% and deduct the interest, then I’m borrowing at something like 4%. If I expect to be able to invest this money at higher than 4% (after taxes) then I SHOULD borrow money to invest elsewhere. The whole reason most people buy a house with a mortgage is to get the leverage. All that being said I don’t feel particularly confident that stocks will perform at their historical norms in the near to moderate future. The assumption that if I stay in the market for 10 years I will outperform what I’m spending on my mortgage doesn’t seem as clear as it might have 10 years ago. Fortunately US stocks are not the only things I can invest in. Obviously however, paying off your house is a safe play, especially if you’re not confident about alternatives for investing your money.
    .-= Brad´s last blog ..Some Thoughts on “Dollar Cost Averaging” =-.

    [Reply]

    MyLifeROI Reply:

    @Brad,

    It’s definitely a gamble on both accounts. To me, I think in the 5-10 year term stocks will outperform an average return of 4%. If you diversify in regards to sector and country, at least.

    I don’t think paying off your house can ever be labeled as a bad move, but there could definitely be better alternatives (on a case by case basis).

    [Reply]

  2. Jason Says:

    Funny I had just talked to a few people on twitter about this same concept and just wrote up my thoughts on it myself.

    I came to the conclusion of course that there are to many variables to give one answer for everyone, but most people can’t completely discount the psychological impacts of debt, especially for people who have been terribly underwater.
    .-= Jason´s last blog ..Fund Retirement or Pay of Mortgage? =-.

    [Reply]

    MyLifeROI Reply:

    @Jason,

    I read your post and I have to agree with you that the decision is a very personal one.

    I just think that sometimes people treat “personal” as “emotional.” I think numbers always need to make an appearance in your logic.. even if they aren’t the basis of your decision!

    [Reply]

  3. The Dividend Guy Says:

    No matter what, if someone does decide to pay off their home, I would always suggest that they automatically invest whatever they were paying in mortgage payments into some form of investments. I think too often people think that once the mortgage is paid off they will be able to just spend that money. Of course, it depends on where they are in their investment cycle, but if it is early enough then that extra money into your retirement account could be worth a lot of money down the line.
    .-= The Dividend Guy´s last blog ..Investing and the Government =-.

    [Reply]

    MyLifeROI Reply:

    @The Dividend Guy,

    100% agree. If someone chooses the psychologic win of conquering their debt, I can only hope they take those mortgage payments and funnel them into investments. Otherwise, they are just setting setting themselves up to be behind a few steps.

    [Reply]

  4. MoneyEnergy Says:

    Yeah, this is a tough decision – I’m not near a mortgage yet, but I hold the same debate regarding loans and CC debt (which I realize are very different breeds of debt!). Ultimately I always end up in that middle ground – trying to leverage the debt but still just wanting to get it out of the way and wash my hands of it. Numbers are compelling to me, and I run them, but I can’t ignore the psychological effects of it, either.
    .-= MoneyEnergy´s last blog ..Still A Good Time for Canadians To Purchase US Dollars While The Loonie Is High =-.

    [Reply]

    MyLifeROI Reply:

    @MoneyEnergy,

    It’s definitely a challenge to ignore the psychological effects. But, I think, in the end… that should be your ultimate goal.

    If you make the wrong decision because your brain feels better about it, you are taking your debt shackles off and putting some emotion shackles on ;)

    [Reply]

  5. DoneToZen Says:

    Psychology isn’t the only reason to prepay a mortgage.

    Another thing to consider is the risk of carrying a mortgage. It doesn’t make as much sense in the example you gave above, since they have enough in taxable accounts to cover the mortgage, so they can always pay off the mortgage later. However, if these people had $60K in taxable accounts in 2007 and the market crashed in 2008 and they lost their jobs, they might have been unable to pay the bills and lost the house to foreclosure (I’ve known people who haven’t found jobs after a year and a half of searching).
    .-= DoneToZen´s last blog ..Fees in Traditional IRA =-.

    [Reply]

    MyLifeROI Reply:

    @DoneToZen,

    Good example, that is one I hadn’t thought of.

    I guess in your example you have a good point.. if you lose your job the town is going under anyways, so why not have a larger e-fund?

    Good thinking, and you are the perfect example of why everyone needs to evaluate their situation differently.

    [Reply]

  6. ChristianPF Says:

    MLR – Being a numbers guy, I can see where you are coming from – I make most of my decisions that way. However, with the abundance of job loses and other financial challenges, I would much rather have the bird in hand than two in the bush – so to speak.

    Having your house paid off puts you in a tremendously secure position. Assuming other debts are paid off, you really don’t NEED much income to survive – which is very comforting with all the layoffs the last couple years…
    .-= ChristianPF´s last blog ..Amazon Gift Card Giveaway =-.

    [Reply]

  7. Augustine Says:

    CD’s could have yielded 5% in the 90′s, but the 30yr-fixed mortgage rate ranged between 7 and 10%. Nowadays, CD’s yield some 2% and the mortgage rate, some 5%. It seems to me that, after running the numbers, paying off one’s mortgage today is as good as in the 90′s. What one cannot do is to compare CD’s rates in the 90′s with mortgage rates in the naught’s.
    .-= Augustine´s last blog ..My Lord and my God! =-.

    [Reply]

  8. Yvette Says:

    I recently had the same question. I didn’t pay off my mortgage because of deductions (tax) reason. Instead, I review how I was invest funds and re-allocated money to better investments. However, it would have sure been nice not to have a mortgage.
    .-= Yvette´s last blog ..CD Ladder Get Paid Every Year =-.

    [Reply]

  9. Shalom Says:

    We faced this same decision recently, and decided to not pay off the mortgage, but not for any of the reasons yet raised here.

    We are a single income family and we live in a small town. I work at the headquarters of a large corporation, and the town’s economy revolves around this company. If the company were to fail, or if it were acquired, this town probably would be toast. In that situation we’d have to move to find work elsewhere, and it would be very heard to sell the house (since everybody else would be selling, too).

    We decided it was more prudent to have savings to support us for up to 12-18 months until I got a new job, rather than have money tied up in a house that may take years to sell.

    [Reply]

  10. Roger Says:

    I’m inclined to agree with you. It seems as if this couple is running for the hills based on the fear that they might end up unemployed. This isn’t certain, unless they are both in risky occupations or already have their jobs on the chopping block, and drastically altering their financial plans to accommodate such a bad situation seems like a bad plan. If they do pay off their mortgage and then DON’T get fired, they’ll have to put much more money away to rebuild their funds.

    Instead, the better move would seem to be (a) making sure they have an adequate (6-12 month) emergency fund (b) attempting to pay down some of the principle (as per your suggestion, MLR), and (c) only considering selling their investment when they’ve actually lost their jobs and have nearly exhausted the emergency fund. But then, that’s just my view on it.
    .-= Roger´s last blog ..Determining Your Ideal Asset Allocation =-.

    [Reply]

  11. Penny Stocks Says:

    Great info here, nice site I will be checking out the other articles you have and linking back to your site.

    [Reply]

  12. James Mucci@Michigan refinancing Says:

    I am torn becuase you are correct in that the numbers tell the story, that someone who is in that scenario, should keep the mortgage, however I believe if they are near retirement, it may make more sense to pay off the mortgage. The psychological effects and freedom that comes from the security of knowing that your home is free and clear is one that may halp some people enjoy their retirement. On the other hand, if someone has a large protfolio and 60,000 is only a very small percentage of it, then the numebers and the returns from the markets may make more sense.

    Or if they are just starting out and have many year until retirement, then they probaly should keep the mortgage and the investments.

    Depends on their retirement goals and their appetite for risk.
    .-= James Mucci@Michigan refinancing´s last blog ..Michigan Refinancing – Stages of the Loan Process =-.

    [Reply]

  13. Joe Says:

    it’s ironic that people always think of things like this *after* their investments have dropped in value. That precisely the time you should invest more (assuming proper diversification, of course), yet so many cash out. Your hypothetical person would be better off taking some money while stocks are going gang busters and paying down the mortgage then.

    Maybe that’s hindsight, but the other misleading thing is that paying off the house now will help them if they lose their income. Couldn’t they also just use their funds to pay the mortgage in the event of that lay off, but only after it happens? Two things stand out in that scenario:

    1. If they never get laid off, their investments continue to grow.
    2. If they do get laid off, they might owe less in taxes when they cash out their investments, due to less overall income.
    Joe´s last [type] ..Living on a Single Income- 7 Years and Counting

    [Reply]

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I'm MLR. After graduating from college debt free, I decided to write a blog encouraging people to adapt responsible and sensible personal finance rules.


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