Paying your mortgage off early
July 19, 2015 at 1:02 pm #137858rusinaParticipant
I completely disagree with this Sundays article (3 Simple mistakes) in regard to paying off your mortgage early. This writer suggests putting you money in your 401k instead of paying off your mortgage.
He is wrong by assuming that most 401k plans offer a match. He also does not take into account the interest you are paying for that home mortgage which accounts for a lost savings. Yes, I know it is deductible on your taxes (but not a real big deal).
Finally he assumes tax rates will be lower when you start drawing on your 401k. Big wrong!
I would rather have my mortgage paid off first and then pay into 401k.July 19, 2015 at 4:59 pm #137883Dan SchointuchKeymaster
@rusina, the numbers are going to be different for everyone, but there’s a calculator you can use here that will show you whether you’ll have more money pre-paying your mortgage or investing the difference: http://www.globalrph.com/prepay.htm
For example, I said I had an extra $500 per month that I could either put towards my mortgage or invest in a retirement account, was paying $1,072 per month for principle and interest on the mortgage at 4%, and have $225,000 left to pay off (essentially, a new 30 year loan for a $280,000 home with 20% down). Using the $500 to pre-pay the mortgage would have it paid off in 16.2 years, so that’s the point at which we’ll compare net worth between pre-paying and investing the $500 instead.
When selecting an 8% investment return, matching the average long-term return of an aggressive investment in stocks (something like a 90/10 split between stocks and bonds in a portfolio), not pre-paying my mortgage and investing the $500 a month would leave me with a net worth $79,386 higher after 16 years than if I’d used the extra $500 to pay off my mortgage faster.
Now, let’s say my investments only earn an average of 5%, closer to long-term moderate bond yields. I’d still have $27,834 more by investing the $500 a month instead of using it to pre-pay the mortgage.
Or what if we get lucky and have a long-term bull market averaging 10%? By investing the $500 instead of pre-paying the mortgage, I’d have an extra $124,992 in net worth.
In fact, I’d actually have to earn less than 3% on my investments before pre-paying the mortgage starts to work out in my favor.
Now, what if I used a taxable brokerage account for the $500 a month investment instead of a tax advantaged retirement account? Earning 8% interest and after 16 years, I’d have $35,648 more in that account than my remaining balance on the mortgage. So at that point, I could simply sell enough of my investments to completely pay off the mortgage, leaving me owning my home free and clear after 16 years, and I’d still have $35,648 left in my bank account that I would not have had if I’d been using the $500 to pre-pay.
There’s also the fact that by putting any extra money into a single investment, the home, you’re not diversifying and exposing yourself to incredible risk that something goes wrong. Maybe sink-holes are found in your neighborhood, maybe the house next door is foreclosed on and starts a chain reaction driving down the value of every other home in your neighborhood, maybe the style of your home ends up looking really dated 30 years from now and isn’t worth what you thought it’d be worth. Any number of things could sink the value of that single investment.
By putting money into a properly diversified portfolio, you’re protecting yourself against something like that, the sudden decrease in value of any one investment due to circumstances outside your control.
Note: No employer match was used in these calculations, they do account for the deductibility of mortgage interest, and they assume a constant tax bracket.July 19, 2015 at 5:37 pm #137884rusinaParticipant
I could go on and on with this discussion, but only want to say that if I invest my money only in my 401k regardless of the investments, a 8-10% return is unrealistic. Glad you mentioned 3% as this is what you will probably earn. And depending on your 401k picks, they also can drop just as much as your house and even quicker (2008). And the average investor in 2008 did not hold on but panicked and sold and most now stay in cash or safe investments which average much less than 3%.
The only thing I can agree with you is diversification.
By properly figuring a budget and maintaining it, you can pay down your mortgage early, save for retirement, stay out of debt, and live the good life. This is what I call properly diversified.
I am glad you mentioned luck and lucky. Because all investments need both!July 19, 2015 at 6:05 pm #137885Dan SchointuchKeymaster
I’d encourage you to play around with this tool: http://www.moneychimp.com/features/market_cagr.htm
It’ll give you the compound annual growth rate (what you’d actually earn) of the S&P 500, which can be easily and cheaply invested in with an S&P 500 index fund from someone like Vanguard or Fidelity. For example…
Investing 5 years ago, your investment would’ve grown at 17.28% per year.
Investing 10 years ago, your investment would’ve grown at 7.93% per year.
Investing 30 years ago, your investment would’ve grown at 11.22% per year.
Investing 60 years ago, your investment would’ve grown at 11.00% per year.
Since we’re only interested in the long-term averages, and not what the market did over a short period of time, 8% is a conservative estimate.
But yes, even with a 3% return, you’re still better off putting extra money in your retirement account than pre-paying your mortgage given the example I outlined above.
Of course, you do have to hold your investments for that period of time. If you sold them all when the market was down and bought back after it’d gone up, that would eat into your net worth. Similarly, if you sold your house at the bottom of the market and bought another at the top, you’d experience a loss there, too. But those are terrible investment practices, and trying to time the market is rarely going to work out.
For the purposes of this example, we’re assuming that the investor is not bungling their investments, but regularly buying in as they would by regularly paying a mortgage so that we can determine which plan offers a better outcome mathematically when comparing the two on even ground.July 20, 2015 at 9:22 am #137909ZigzaggerParticipant
Most financial gurus advise paying off your mortgage as soon as you can. There is one notable financial guru who advises just the opposite. His name is Ric Edelman. His website is http://www.ricedelman.com. I recommend you peruse his site. Currently, his home page features an article entitled, “11 Great Reasons to Carry a Big Long Mortgage.” Whatever you choose. Good Luck.May 21, 2016 at 6:03 am #email@example.comParticipant
Just want to point out that often mortgage interest is not tax deductible. It is only deductible when your itemized deductions exceed your standard deduction.May 25, 2016 at 12:31 pm #171361SherrieLParticipant
Remember that “deductible” does not mean that you get that much back in taxes. If your tax bracket is 25%, for example, your taxes will drop by 25% (at most) of what you paid in interest.May 27, 2016 at 10:24 am #171628PhilDanleyParticipant
Long term the market does better. 8% average return the past 20 years including the meltdowns in 2001 and 2008.
The problem is you cannot guarantee that return on the day you need to begin accessing your retirement account. If you retired in 2008 then your retirement account dropped 37%.
Once your mortgage is paid off, it is done. House value can rise or fall but you’ll never have that debt payment again. We paid off our mortgage two years ago so the market can fluctuate and it will not impact my housing situation.
Plus I still claim our standard deduction.
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