As promised, with our home currently in the process of being refinanced for the fourth time since 1997, I have finished doing an analysis on whether or not to continue prepaying the mortgage early. After running the numbers, I have come to the conclusion that I should continue to prepay my mortgage, as I have been doing faithfully ever since buying the house. In fact the more I looked at it, the more I realized that prepaying my home mortgage has been among the smartest financial decisions I have made as the family household CEO!
For those of you that missed my earlier post where I discussed the benefits of living within your means (one of which was being able to refinance in hard times), here are the statistics regarding my new (and previous) mortgage(s):
Approximate Balance: $120,000 ($118,000)
Interest Rate: 4.625% (5.5%)
Term: 30-year fixed (20-year fixed)
Total Interest Paid over 30-years: $104,000
Approximate Monthly Payment: $640 ($1120)
My analysis considered two options which I creatively dubbed, um, Plan A and Plan B.
Plan A continues to make payments on the new loan at roughly $1250 per month (the same payment I was making under the previous loan) in order to ensure it is paid off in slightly under 10 years. For this option, I end up paying roughly $31,000 in interest payments.
Plan B would forgo paying the extra $480 in principal each month, instead writing a monthly check for only the minimum $640 payment over 30 years. With this option, I end up paying about $104,000 in interest over the life of the loan.
Of course, to realize the $73,0000 in interest savings from Plan A I will need to commit roughly $5760 per year toward the extra principal payments. That’s a commitment of about $55,000 across the nearly 10 years it would take to payoff the mortgage that I don’t have with Plan B.
Comparing Returns on Investment
By prepaying my mortgage with Plan A, I am essentially earning an annual return of 4.625% on the extra principal.
But those in the Don’t-Pay-It-Off (DPIO) crowd like to point out that I could make more money on that extra principal by investing it elsewhere! Sounds great, but can I really?
Their argument generally goes like this: The stock market is earning returns of 10% over the long term, therefore the money I put toward extra principal payments would be much better spent there, where I could be effectively earning an additional gain of 5.375% (i.e., market return minus my mortgage rate). But that doesn’t count any taxes paid on the investment returns nor does it include the effects of inflation! And I expect inflation to rise substantially in the coming years as all of the market liquidity unleashed by the Fed finally gets into the economy.
Here’s another thing to consider. That 10% annual market return the DPIO crowd loves to quote is based on a period of over 100 years. But this conveniently overlooks the long periods known as secular bear markets where buy-and-hold investors saw market returns approach zero.
One such secular bear market occurred from 1966 to 1982 where the annual average return of the Dow was just over 1%. That time period was marked by a long bout of high inflation not unlike what I expect to see hitting us in the coming years.
It is generally agreed that we are currently in the midst of another secular bear market. People can debate exactly when it started, but there is no denying that between Jan 2, 1998 and Jan 2, 2009, the Dow declined 200 points from 8799 to 8599 — a net loss of roughly 2%. So while those who chased mythical 10% returns during that long period lost money, the roughly $30,000 I put toward extra principal payments returned about 5% annually!
Considering the depth and magnitude of the current economic crisis I think the current secular bear will continue for another 7 to 10 years and, as a result, the average buy-and-hold investor doesn’t have a prayer of averaging 10% annual returns over the next decade.
Of course, the DPIO crowd will tell you that money can always be made in secular bear markets by buying on the dips, but this argument is folly for the average investor who has neither the time nor the insight to make the correct moves year in and year out.
I think it is clear that prepaying and retiring the mortgage in 10 years actually is a better investment bet than stretching the payments across 30 years and playing the market.
So much for the effective gain the DPIO crowd loves to talk about.
Inflation Effects and Time Value of Money
The DPIO crowd will cite the effects of inflation and the time value of money as being in the debtors’ favor because high inflation makes your loan cheaper over time. Yes, I did say high inflation can be a blessing for those who carry high amounts of debt, specifically saying that people with fixed-rate mortgages should be rooting for high inflation. While that is true, it must be remembered that there are caveats that high-debtors must adhere to if they intend to benefit from high inflation, two of the biggest being: 1) income has to continue to keep up with the rate of inflation; 2) temptation to take on additional debt must be avoided.
So does high inflation over a long period of time make it more reasonable to keep the mortgage?
Remember, by paying off the mortgage early, Plan A offers a savings of $73,000 in interest payments. If the Fed managed to keep inflation to roughly 3.5%, my interest savings would be over $51,000 in today’s dollars. And if inflation is 8%, which is what the United States experienced from 1973 to 1982, the interest would still be worth roughly $33,000 in today’s money.
In either case, those are still impressive numbers. So the time value of money argument doesn’t work here either.
Tax Benefits
One last argument the DPIO crowd likes to make is that mortgage interest is tax deductible. If you itemize, and assuming you are in the 25% federal tax bracket, a 6% interest rate could cost as little as 4.5%. But this has always been a weak argument as the tax benefits dramatically decrease the longer you have the loan. And if your total itemized deductions fall below the standard tax deduction, then this benefit ceases to exist.
Conclusion
As an engineer, I spend much of my time identifying and analyzing risks and then making trades based on those analyses. In this case, the analysis shows that choosing to limit my interest payments today provides me with a guaranteed rate of return in a secular bear market and more cash to invest in the future — even after considering the effects of high inflation.
Sure I could gamble and try to beat the market, but those of you who have been following this blog know that my goal for success is about finding and maintaining financial freedom, not getting rich.
For most of us who are not professional investors, paying the mortgage early is clearly the right choice. This is especially true for those who want to reduce risk by agreeing to trade the desire of making more money over the short run in exchange for the security and promise of a steady, risk-free return.
Early mortgage payoff is smart. It’s secure. In fact, it’s an absolute no-brainer.
Quick question. Why didn’t you get a 15 year fixed? You could have reduced your interest rate even farther, thus reducing your interest expense.
Adam,
There were two reasons I did not go with the 15-year mortgage:
1) The primary reason was that I wanted to lower my monthly payments so that I had flexibility in case I lost my job. This decision was influenced by the bad economy we are currently in. I am the sole bread winner in the family, employed in an industry that can be very cyclical with respect to employment. With my new monthly payment reduced by almost half to about $640, I can make that payment working at most any temporary job if I had to, assuming I got to the point where I exhausted my 6-month rainy day fund cushion. Keep in mind that as long as I remain gainfully employed, I still intend to make the necessary payments to get the loan off the books in 10 years.
2) The second reason was actually, believe it or not, the spread between the 30, 20 and 15 year loans were nearly identical. Even if they weren’t identical, the monthly payment with a 15-year loan would have been close to my old payment of roughly $1120, which limits my flexibility in the event I lose my job.
Len
holy crap that’s some good analyzation (is that a word?)!!! Man, keep doing your thing over there – the more you know and research stuff, the better your confidence grows 🙂
Thanks for the props, J! lol 🙂
Len
Awesome post. My math is nowhere near as good as yours–certainly not up to this level of complexity–but long ago I came to the same conclusion. Over my financial advisor’s protests, I paid off the mortgage. And I’ve never regretted it. Now that we’re looking at a likely worldwide depression that sooner or later will lead to the elimination of my job, I sure am glad I don’t have a mortgage bill coming in every month. I may go hungry, but at least I’ll have a roof over my head. In the heady days of our run-up to economic implosion, not having to share half my monthly income with a lender has allowed me to live (and live well) within my means and put much more money into savings than I could otherwise have hoped. The alleged tax benefits pale in comparison to the financial and psychological benefits of owning the house free and clear.
Amen, Funny. The peace of mind that comes with not having a mortgage and owning your house free and clear is a big benefit that is impossible to quantify. Thanks for the mention in your blog!
Len
Len,
Finally, some common sense in the wacky world of real estate.
Millions of DPIO believers are losing their homes and it’s tragic.
I’m a big fan of paying off the mortgage early and enjoying the freedom.
Who says people can’t invest money and pay extra on their mortgage too.
It was probably some financial advisor, angling for a comission.
Thanks for the brilliant post.
Bret
Bret,
Thanks for the kind words. 🙂
I do believe that hindsight on this topic, brought about by the rapidly degrading economy across the US and rest of the world, will now make paying off the mortgage more in vogue. Unfortunately for many in the DPIO camp who used up all of the equity in their home, that is tantamount to closing the barn door after the horses are gone.
Len
Sorry I haven’t read the website. But if you aren’t maximizing a 401k and Roth IRA contributions you are losing money by prepaying the mortgage. After you maximize your retirement savings you are welcome to pay off the mortgage. Otherwise the tax break and the no taxes for the Roth are a money loss. You can’t go back and fund either account after the fact.
I save 30% alone on maximizing my 401k. 5% state and 25% federal. Who knows what my bracket will be in the future. Plus you can control your withdrawals to minimize taxes. And you may live in a state without income taxes.
Thus that 30% should be weighted into your calculations on prepaying the mortgage!
Cheers. I have other reasons but read my blog in 2 Wednesdays about why I won’t prepay my mortgage. Hint – diversification of net worth.
So taxes will likely be higher than 30% when you retire. Matter of fact, they are going up in January. Why does it make sense to defer taxes in a 30% bracket only to withdraw and pay taxes in a higher bracket?
LAL,
You are correct in that you should first make sure you maximize your 401(k) contributions, at least to the point of your employer match, before prepaying your mortgage. But anything over that is not a sure bet. If you don’t believe me, just ask a lot of people who, after many years of making the minimum mortgage payments, what their 401(k) plan is worth today. That being said, I do maximize my 401(k) contributions to the current $15,500 limit. 🙂
You say you are choosing not to prepay your mortgage because you want to diversify your net worth. That is interesting. I can see the value of diversifying your investment portfolio, but why your net worth? What’s the point of that?
That kind of logic leads suggests to me that you are making the same mistake that many folks who jumped into the housing market during the last decade did. That is, they looked at their house as an investment first and a “home” second.
To me and those who think like me, a home is not an investment. It is a place to live. Whatever money I make on it when I finally decide to sell, is a fringe benefit. That’s all.
I look at it this way: If I choose to pay off my mortgage early and the world economy goes in the tank, I still have a rent-free place to live that I can always call home.
However, if I chose to buy more stocks in an effort to “diversify my net worth”, and they suddenly became worthless in an economic downturn, then I have a lot of scratchy toilet paper. 😉
Worse, I also continue to be responsible for paying my mortgage in a bad economy, which is a scary thought. If I lose my job, I become at risk of losing my home.
Before you finish your blog entry on why you shouldn’t prepay your mortgage, I wish you would at least take 5 minutes to read mine. Maybe it will change your mind. 🙂
Blogs like this is what we blog addicts are looking for, will visit often.
Thank you, James. I appreciate the kudos and I am glad you enjoyed the post! 🙂
Len
Len,
Interesting post. I have been trying to save for over ten years just for a down payment on a house. Unfortunately in sales…there are months when you don’t hit goal and get a very small paycheck. In that sense in order to not take money out of savings for every day items I found myself charging for the things I needed. So with credit card debt and a decent savings…some would say I should pay off the debt with the money saved. This I understand, but if I did that then I would basically never be able to buy a house one day. It was always my understanding that I never wanted to go into a 80/20 loan because of exactly what is happening now. Many people are underwater and have to walk away from their homes. I ran into a short sale opportunity where the bank is about to foreclose on a property.
We put in an offer for way less than the woman bought it for. This woman bought the house for $305k 2 1/2 years ago. We put in an offer for $235. Now I saw some comments on here about not looking at a home as an investment, but isn’t it reasonable to think that if and when the market returns…there will be a good potential for equity to build? I know it is still a gamble, but these days everything is a gamble unless you put your money in a safe deposit box. Isn’t it safe to say that this years tax rebate for first time home buyers, which is $8k and doesn’t need to be repaid, is worth holding onto that credit card debt so I have liquid for the down payment out of my savings? Then next years tax rebate can be put towards that debt I hold.
Forgive me as I am not college educated and don’t really have the smarts like you so my decisions are more or less uneducated guesses lol. I know you must be reeling over my decision to hold onto the debt a little longer. Hell if need be…I’ll work two jobs even maybe three. I do know that I was smart enough to wait on a house. When I moved back from CA I worked for World Mortgage for two months and just knew they were putting people in bad loans that would take about three years for them to reach Negative Amortization. Let me know your thoughts. Incrediable web page by the way…never knew ya had it in ya. Keep the posts coming!
Anthony,
Well, I am not sure where to begin. I think the first thing I would suggest is you reconsider the purpose of a savings account. Savings accounts are, after all, specifically supposed to be there for you when you have months of less-than-expected income. If you look through my blog, you’ve probably already noticed I believe credit cards are the devil in disguise. I hate paying interest to anybody for anything, although I can make exceptions for homes, college and businesses.
Pay off those credit cards pronto! I understand your concern about fluctuating income, but the solution to that already appears to be well within your means (I am assuming you have some decent savings already built up). Here’s how:
If I were in your shoes, trying to save for a down payment on a house with the fluctuating income, I would therefore establish multiple savings accounts: 1) one to accumulate funds for your home down payment; 2) a rainy day fund equivalent to at least three months of living expenses; and 3) a smaller “paycheck insurance” account with one month’s living expenses to handle the shortfalls that would arise during months your income is below par.
I would prioritize funding the savings accounts in reverse order. That is, “paycheck insurance” account is the highest priority, followed by the “rainy day” fund, then the “house down payment” savings account. If you don’t want to keep multiple accounts, you could keep track of this purely on paper too.
As for being “under water” when buying a house, that should really not be of concern to you if you are buying your house in an area where you truly enjoy living AND are sure you won’t be moving within, say, three to five years after buying the house.
You can be upside down on your mortgage for a long period of time and I have first hand experience.
I bought my first house in So Cal at the top of the previous housing bubble in 1990 and I was upside down for seven long years. When I finally got somebody to assume my loan in 1997, I was still underwater. The good news is that I then bought a new home that same year at what turned out to be the bottom of the last run up that ended in late 2006. If you are buying the house to be a home rather than to try and turn a quick buck, the upside down issue becomes almost moot.
And Anthony, you are right, if I were in your shoes and I couldn’t quite scrape up enough money for a down payment quick enough I would get a second job rather than pile up credit card debt in order to avoid cannibalizing my home down payment savings!
But that’s just me. I abhor paying interest. 🙂
My $0.02 (after taxes)
I completely agree that paying off one’s mortgage is a great idea and a wise investment, but there’s no need to bash on other forms of investing to prove that. The market returns you reference do not include dividends, nor would they represent the real returns of people who practiced automatic investing each month *throughout* the periods you mention. Which is how they are behaving when the pay their mortgages down.
Here is a good article explaining how the smart money had returns of ~4.5% annually throughout the so-called “Lost Decade” that just ended. And by “smart money” I don’t mean magic managers or hindsight, I mean passive investing in index funds with even a minimally-broad asset allocation and annual rebalancing. Allan Roth tracks a simple allocation of 40% US Total Stock Index, 20% International Stock Index and 40% Total Bond Index using the most common, low-expense Vanguard funds: http://moneywatch.bnet.com/economic-news/article/why-it-wasnt-a-lost-decade-for-investors/375568/
Hi everyone. I am looking for ways to pay my mortgages paid off early. I have two rental properties that are under water. I am trying to keep up on paying the mortgages.
I think for me, if I can hold this properties for 13 years and actually pay them off, I’ll just sell them and use the money to retire. I am just trying to save up some floating money that I can use for money shuffle.
There are a lot of softwares out there that will help you or guide you how to pay your mortgage off years sooner. Some of them cost with an arm and a leg and some cost cheap but does not give you an access to the software. There is one website that will print you out a financial forecast report. It will lay out the transaction for you almost in daily details. It’s cheap but it’s worth a try to see if you could actually pay your mortgage early without paying a lot.
You don’t have to use a HELOC or refinance your mortgage. A savings account will do. Of course, you are going to need an emergency fund stashed somewhere. Tha’s why it is recommended to use a HELOC. I’ve already seen my report and it makes sense for me. But if there is another way out there that can show me a better way on how to solve my rental property problems beside loan modification, hook it up. Thanks for reading.
I don’t agree with Len’s article. For the following reasons.
1. Len’s calculation didn’t include the effect of inflation on the 15 yr loan. If there’s high inflation in the next 15 years, the 30 years mortgage will be more advantage because the outstanding balance on the 30 yrs will have less purchasing power at the end due to the erosion of purchasing power from inflation.
2. Len has talked about taxes will reduce the return on the extra cashflow from the 30 yrs mortgage. Not true! I can easily obtain tax free annual yield of 6% or up by purchasing AAA grade municipal bonds. (I did a bond search on finance.yahoo.com on 12/01/2010)
To make it simple, my argument is that you can purchase AAA rating tax-free muni-bonds that gives you 6% plus Yield to Maturity while borrowing from your mortgage for less the 5%. The 1% difference is yours to keep.
Plus my analysis even omitted the effect of income tax reduction on your 30 yr mortgage interest. It’s a no brainer to go 30 yrs. I will go 50 yrs if I have the opportunity.
lol at LAL’s comment above. It’s funny how people refute/rebutt a particular article but they haven’t even read the particular article in question. It demonstrates a narrow mindset.
And wtf is “diversifying net worth” lol… sounds like LAL is creating his/her own investment terminology. I’ll have to visit that blog so I can learn what “diversifying net worth” means… 😉
These past two to three weeks I’ve been saturating myself with PF blogs…it’s so interesting to gaze into other ppl’s financial history and status. It’s so much more personal than haunting stock trading and property investment forums.
I’ve actually written a few articles about paying mortages off early as well myself (whilst also acknowledging the opportunity cost of funds invested elsewhere). Just like diversifying your investment is a good choice if you’re not Warren Buffet, paying down your mortgage is also a good choice if your employment future is shaky and you may need to fall back on those extra repayments in hard times.
I’m not American, but I’ve read so many tidbits about penalties for withdrawing those 401ks/IRAs (whatever their names are) that if those penalties were worked into your mortgage equasions above, then it would justify keeping some savings flexible for hard times…
Anyway, hope it’s all ok with you on the job/income front.
As someone who is reaching on a loan I am try to ascertain as much information about paying off a loan the quickest way without it backfiring and this way seems a good way to do it. There is the investment way of making money instead of or paying extra every month but you have to be careful with some investments as you could lose money instead on gain some interest. The main thing to remember when paying off your mortgage is can you pay off the monthly charges set up and if so what money is extra to live off and then you can judge whether inputting more money each month can be done without affecting your living expensive and putting you into financial problems at the end of the month.
Dear Mr. Penzo,
I am 48 and owe $180,000 on my house. I have 9 years left to pay. I could reduce my 401k to the minimum 3% and use those funds to pay my house off in five years. I have ($425,000) in my 401K.) My interest on the house is 3.5%. I make over $100,000 a year. I have no other debt, and am not upside down. The kids are almost gone and I am in great shape. I would like to pay off the house early and release myself from this debt. There are no articles that I can find that discuss the current markets conditions I face in 2011 and how that may change the discussion on paying your house off early with investment funds. I like your site very much and would be interested in hearing your thoughts.
Appreciatively,
STP
Hi Steve: Ultimately, the decision to pay down your mortgage is a personal one. Awhile back I wrote an article laying out 12 reasons why you should and shouldn’t pay off your mortgage:
http://lenpenzo.com/blog/id1131-12-good-reasons-why-you-should-and-should-not-pay-off-your-mortgage-early.html
Because of the fiscal insanity demonstrated by the government’s runaway spending, aided and abetted by the Fed’s relentless money printing campaign, I’ve since changed my stance since writing this article. See: http://lenpenzo.com/blog/id617-paying-off-the-mortgage-early-not-so-fast.html
In short, I believe extremely high inflation is now virtually inevitable. Assuming I am correct, it makes little sense to pay down my debt early with today’s more-valuable dollars, knowing that the greenback will be worth much much less in the future. Until the government — and the Fed — show a commitment to protect the value of the US dollar, I will refrain from paying one-cent more than I have to on my mortgage every month.
when you consider all the options, it does not make mathematical sense to pay your mortgage off early.