Still no house yet. But I have been reading about mortgages, and one common debate amongst mortgage holders is whether to send in extra money towards the principal in addition to the required monthly payments. Usually, the argument evolves into these two opposing views:
No, you shouldn’t pay extra because:
If you put that money in stocks instead, you would most likely get a higher return on your money in the long term. Mathematically, paying down a mortgage is like leaving money on the table.
Yes, you should pay it down because:
Stock market returns aren’t guaranteed, whereas paying down the mortgage is guaranteed savings. Debt is a burden, and it’s hard to put a price tag on the psychological benefit of owning your house free and clear.
Now, I understand both of these views, and in the big picture, I really think if this is what you’re worrying about then you’re already ahead of the game. You might even think you already know which view I personally lean towards. But what if there was another perspective that satisfied both sides?
What happens when you pay extra towards your mortgage?
With a mortgage, your monthly payments are amortized, which means each one includes a portion that goes to pay interest and a portion to pay down your remaining loan balance, or the principal. If you make an extra payment towards principal, then this in turn directly decreases the amount of interest you’ll be paying in the future.
So if you pay $1,000 towards your mortgage with an interest rate of 6%, then you’re saving $60 of interest that you would have otherwise had to pay every single year for the rest of your mortgage term.
Put differently, it’s like you’re earning an after-tax return of 6% every year on your money.
But wait, what about the tax benefits of mortgage interest?
Yes, mortgage interest is tax-deductible, but you have to temper this with a few realizations:
- Everyone already gets the standard deduction, which in 2007 is $5,350 for singles, and $10,700 for married folks. Only the amount that your itemized deductions exceed this amount actually saves you money.
- The amount of interest you pay on your mortgage decreases every year, so your tax benefit will decrease as well over time.
For example, let’s say you are a married couple with a $250,000 mortgage loan balance for 30 years at a fixed 6% rate, and in the 25% income tax bracket. $250,000 x 6% is only about $15,000 of interest paid in the first year. Subtract out the standard deduction of $10,700, and your additional deduction is only $4,300. So you’re only saving 25% of $4,300 and not the whole $15,000. This means your 6% interest rate only goes down to the equivalent of about 5.6%. In addition, according to the standard amortization schedule your annual interest paid will go down to less than $11,000 in year 15. So after 10-15 years, your mortgage deduction will be less than the standard deduction, leaving you with possibly no benefit at all.
Now, if you have a large mortgage or have lots of other itemized deductions, then your tax benefits may be much more significant. In this case, your equivalent interest rate may be extraordinarily low. But for many homeowners, it’s not as large as they might think. (If you have a ton of other itemized deductions, also be wary of the AMT.)
For this example, you could be conservative and say that paying extra towards your mortgage is only earns about a 5.5% annual after-tax return for the rest of the scheduled term of the loan.
A fixed rate of return, every year, for a long time. Hmmm… that sounds like a bond! In comparison the 30-year Treasury bond is currently yielding only 4.88%. After a 25% federal tax, that return is only 3.66%! I choose Treasury bonds because they also contain essentially zero risk of default.
In other words, paying down your mortgage can very similar to holding an attractively-priced long-term bond. (If you have a rock-bottom rate, it could also be an unattractive bond.) So maybe that’s how we should treat it. Just like you don’t compare stocks directly to bonds because they have different risk/reward relationships, perhaps we shouldn’t compare paying down a mortgage to stocks either.
Right now, I currently hold about 10% bonds in my retirement investment portfolio. My prospective interest rate is around 6% if I get a mortgage. I could simply decrease my position in bond mutual funds and put that money instead towards paying extra towards a mortgage. When looking solely at my mutual fund accounts, this would result in my percentage of stocks increasing. This way, I can potentially get the best of both worlds:
- I’m improving my overall investment portfolio. I am essentially buying a bond that brings me a return higher than what is otherwise available, perhaps by up to 1-2 percentage points. I do lose some liquidity as I can’t get my money out without taking a home equity line of credit and paying additional fees. But as long as it’s not my whole bond allocation, I can still rebalance as needed. My intended bond allocation will only increase as I get older, in any case.
- I also pay my house off earlier, complete with all the happy fuzzy feelings attached. 😀
What if you don’t own any bonds? Well, if you’re the type of person who’s 100% stocks, then you’re probably so confident in the markets that you wouldn’t want to pay down your mortgage early anyhow. If you do want to pay it down, then consider it a small allocation to bonds that will lower the overall volatility of your portfolio.
Now, this doesn’t mean that paying down a mortgage should be a higher priority than things like maxing out your IRA, paying down higher-interest debt, or even an emergency fund. But it does provide me a way to pay down my future mortgage without having to worry that I am losing money somewhere else.
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Paid off my mortgage about 4 years ago. Went through a very similar analysis to yours. Had a 15 year mortgage with about 8 years to go at the time. My interest rate was around 7 3/8% then and I was looking to refinance. I decided to just pay the mortgage off as in reality there was not going to be be a whole lot of interest left to deduct anyway. In addition, my current situation was that I was paying AMT and having my deductions reduced due to my income level and amount of state taxes we pay in CA. There are calculators out there to tell you how much you will save in interest if you pay off your mortgage.
The psychological aspects of having a paid off mortgage are to me worth the payoff as well. As the saying goes, when you have debt you are working for someone else and they own you.
Nice! I’ve been wondering about how the math for this would work out, but I’ve not gotten around to doing it. Thanks 🙂
It’s a nice idea, but is there a practical application? If you have 15 years before retirement, but 20 years on your mortgage should you take all of your bond money out and pay down your mortgage? Doesn’t seem like a good idea to me.
That’s a nice calculation, one I’ve thought about a lot. I have felt for a long time that people don’t really get this one right, so I’m glad to see you hit it spot on.
One subtlety about reducing your bond allocation and paying it toward your house is that you can’t easily reverse it in years when stocks do poorly. Those are the years when rebalancing would shift money from your bond section to your stock section, so you would forgo some of the reduction in risk that a balanced portfolio should afford you.
In my case, I have another incentive to avoid paying down my mortgage. My wife is on permanent disability and has no W-2 income. That means she has no 401k, 403b, or IRA opportunities separate from me. If I were killed unexpectedly, the only tax-sheltered investments she would have are those I created when I was alive. She can always pay down the mortgage with life insurance money.
So, while paying a mortgage down appeals to me personally, I have chosen to maximize 403b, Roth, and Traditional IRA contributions.
Between you and me I would wait to buy the house. I think we still have a ways to go with the mortgage bankruptcies and the sub-prime lending issues. This may go on for a few more years until these problem ARMS are off the market, IMHO…
http://www.hughchou.org/calc/payoff_v_borrow.cgi
This is a nice calculator for comparing. Your initial calc is flawed. Since you live in CA and are married both making over 100k, you are are both paying 20k alone in state tax which means you are going to itemize (blowing away the 10k STANDARD deduction). So any mortgage interest you deduct is already above the 10k. AMT is the biggest screwup when hit the 250k joint plateau. So max out your 401k’s and start a “money-losing” home business! 🙂
EXCELLENT analysis. However, I’ve got a twist for you. I’ve also read that home price returns themselves have historically been very similar to treasuries. The analysis continued to say that if you buy to big a house OR pay off your mortgage too quickly, you essentially become over-invested in real estate as an asset class (which you can lump with your bonds in your portfolio.) Have you looked at how much your payments would be relative to how much you will be adding to your stock portfolio, with and without speeding up your payments? Also, how does speeding up your payments compare to getting a 15 year mortgage?
See “graph 5” and more in:
http://www.fidelityresearchinstitute.com/pdf/wp5_equity_final.pdf
Don,
If your wife isn’t working, isn’t it true you can open a Spousal IRA for her? That would at least give you an additional $4000 to put away.
Jonathan,
I love articles like this, things I would never have thought about that open my eyes to a new way of thinking, thanks for that.
In certain cases, a reason not to pay off a mortgage is if it will leave you will very little cash or investments. If in an emergency you need money, it might be impossible to get it out of your house quickly.
I made the decision to pay off mine early as possible. Once I hit the five year mark I’m going to start dumping extra money I have at it, at least make an extra full payment a year. I did the math and for me the tax deductions drop amazingly after five years.
It’s never a bad idea to pay off your mortgage early, but I think it’s bad idea to compare it to treasuries. In a severe market sell off, the value of your house could (not will, but could) stagnate or even decrease, whereas treasuries tend to increase in value. So I think really what you’re buying is a long term corporate bond (or, obviously, a mortgage backed security). It’s just something to think about in the context of your overall portfolio. I’d recommend keeping your mental accounts separate, investment accounts for your retirement, and housing is just what you pay to have shelter (expenses).
I am not sure you are fully ‘pricing in’ the poor liquidity of your ‘home equity.’ Home equity is highly illiquid, one of the most illiquid positions for your money. As such, simple equivalency between after tax US treasury yields and after tax debt service obligation (i.e., your effective after tax yield on paying early) would argue strongly for keeping this money in US treasuries. I would argue that the ratio of your mortgage to your liquid net worth should determine the premium that is necessary to get you to consider paying down your mortgage.
If for example your liquid net worth is 200,000, and your mortgage is 600,000, (a very common situation for a young CA couple), your mortgage is 3x your liquid net worth, and paying extra toward your mortgage locks money up in an illiquid investment, which is a very substantial portion of your overall net worth, and as such demands a significant premium to compensate you for its poor liquidity. If on the other hand your liquid net worth is 600,000 and your mortgage is 200,000, a not uncommon situation in much of the US, then your mortgage is 1/3 of your liquid net worth, and investing further in it may be better for you even if you are only paid a small premium for the lack of liquidity.
One more thing. You should always think of debt from both sides. When you buy US treasuries, you are purchasing a portion of the debt of the US government. When you hold a mortgage, the situation is reversed. US treasuries cannot be called by the government and are backed by the full faith and credit of the US government. It is a riskless investment, and is priced as such. Your mortgage, from the bank’s perspective, (assuming you have no prepay penalty) can be called at any time (when you refinance to a better rate, or pay up early), and is backed by the full faith and credit of none other than you (and possibly also your spouse). As such, it is incredibly risky compared to a US treasury. By not paying your mortgage up early, you are forcing the bank to hold a riskier investment, and when the premium is as small as it currently is to do so, it just doesn’t make much financial sense to let them off the hook. This, in essence, is why a low fixed rate, long term mortgage is such a sound financial ‘investment.’ Be careful about detracting from its utility by paying it early…
I don’t think this is a very helpful suggestion as your mortgage interest deduction doesn’t exist in a vacuum. Here in Texas, my $150k house has $3.5k annual property tax that is also deductible. That gets you 1/3rd of the way to the standard deduction for married people. It doesn’t take a whole lot of other deductions to make the smaller mortgage interest deduction still have an impact.
This post also confuses me as to the exact philosophy behind some of the ideas supported in the blog. Just a day or two ago, it seemed generally universally accepted that the Roth retirement plans were much better than a traditional 401k which offered a known savings today instead of the promise of tax free withdrawls in the future. Today, the logic is completed flipped and the guaranteed plan is lauded while the plan with the promise of more future gain seems too risky.
A friend of mine in the mortgage industry was recently telling me about a type of loan that is coming over to the US from the UK/Australia. I believe over there, they call it a mortgage offset account or a mortgage checking account. It basically is a regular checking or savings account that is tied to your mortgage. Everyday when the interest is caluclated, they only apply interest to the principal of the loan minus the balance in your checking account. So the idea is that you leave your monthly income in the account as long as possible each month by applying regular bills to credit cards and paying the balance off all at once as late as possible in the month. Some of the scenarios he has as examples show a 30 year mortgage being paid off in as little as 8 years while only paying the normal 30-yr fixed payment. There is some more information and a short presentation about it at: http://www.tomvoli.com/mortgage-acceleration-without-extra-payments/
It seems like GMAC is the only lender that offers it right now. Personally, I’m not totally sold yet on paying of my mortgage any quicker. Although the potential freedom from that payment in 8-10 years is tempting.
You should at least max out all of your retirement accounts first, before applying any extra to your mortgage.
Mike H: yes, I’ve contributed to a spousal IRA for her for years. The point is, if I were hit by a bus next week we/she would no longer have W2 income. No more IRA contributions. Whatever she is going to have saved in “tax advantageous” form is limited to what I have put away already. So I work to maximize it.
Jonathan, I completely agree with you. I paid off my mortgage also, by paying extra every month. My rationale is basically the same. 1. The tax benefit of holding a mortgage is not exactly what it seems, considering the standard deduction we get anyway. 2. The risk free return of 6.25% which was my interest rate.
In addition, I was being hit with AMT.
I keep telling my friends to do the same.
Nice analysis from you!
It almost certainly made sense for my parents to pay there mortgage down early. They bought a house with a 30-year fixed rate mortgage when I was in preschool and paid it off when I was in junior high. The interest they paid was never high enough to justify itemizing. Back then, the mortgage rate was around 9%. In addition, they are very conservative with their risk tolerance for investments. Paying the house off as quickly as possible gave a very nice guaranteed return and, as you mentioned, the psychological benefits are tremendous. Owing no money really does provide a feeling of security and freedom.
Here in the Silicon Valley, the tax break from a home is huge (my first year of owning a house the intemized deductions were 22K mtg interest + 7K prop taxes + (add to that the CA state tax) and you are looking at 45K of itemized deductions.
But now I am in a 7 yr arm (5 yrs more to go) with 4.75% interest ( which is about 3.2% considering the tax break), so paying it down does not make sense since govt bonds and CDs are yielding 4.9%.
We paid it down a lot over the past 4 yrs we owned it, but now it is making more sense to invest in the stock market or in another home in another state as a rental investment property.
I don’t think I’m necessarily being inconsistent with regards to taxes… I still think marginal income tax rates will be higher in the future.
Deductible items come and go with time and politics. As was mentioned, state income tax deduction also disappears with AMT. That 20k potential deduction might go bye-bye once we run the number, it might not. More and more people, esp in CA, are being hit with it every year.
Either way, that was just a example without state income taxes. One should definitely include it in their math if they are subject to it. r AMT victims?
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Yes, if you are holding a very low interest mortgage, it may not even make mathematical sense to treat it like a bond. I’d personally keep it.
I forget to include the other view: You just have to ask yourself, are you willing to borrow money at XX% to invest in stocks? Because that’s kind of what you are doing if you pay down your mortgage loan. Just don’t forgot about the lost liquidity, as you can’t just get your money out easily.
Brilliant.
For the most part, I agree with your analysis. The one thing you left off is an analysis of the “option value” of keeping the money in bonds vs. paying off the mortgage. Once you pay the money to the mortgage company, it is very difficult (and expensive) to get it back should you need it (emergency, investment opportunity, etc.)
One other thing; NOBODY should EVER pay anyone for the privilege of paying down a mortgage early. Banks and mortgage companies love to sign people up for “Plans” that allow them to make an extrapayment each year. THIS IS ALWAYS a scam unless it is free. If you want to send in extra money, just do it.
I’ve been thinking about this question myself. One other element that popped into my head as I was reading this was how it might affect your credit score. i.e. if you pay off your mortgage early and have less debt, might it make it slightly cheaper for you to borrow money for some other purpose???
I love paid-for houses!
paid for my house in cash. people i know say im dumb but at least i sleep well at nite.
people keep giving me advice on taking out the equity on my home and invest it but i just shrug it off.
Jonathan, you’re missing something very key here:
Length of time in the mortgage.
Your numbers are basically useless without this number. Your very first assumption is in fact wrong:
So if you pay $1,000 towards your mortgage with an interest rate of 6%, then you?re saving $60 of interest that you would have otherwise had to pay every single year for the rest of your mortgage term.
This is basically never true b/c interest on mortgages isn’t calculated this way. I brought this up here, on another blog. Here’s a simple mortgage calculator with a 25-year mortgage on a 180k. You pay more interest each year until year 15 where your mortgage/principal are equal.
The interest on a mortgage isn’t flat. When you put an extra 5k on a 25-year mortgage, you’re basically paying down the last 5k, not the next 5k. If you’re early in the game, you’re basically saving money from 2030 to help shorten your mortgage.
If you’re in year 2 of 25, this answer is completely different from being in year 20 of 25. You’re right about the psychological aspect, but the math is way more complex than X dollars at 6%, especially when you factor in the extra tax benefits on the early years interest.
Truth is, if you’re 25 with 20+ years of mortgage ahead of you, a 5k investment in you (education, new business, etc.) probably has a way better long-term return than knocking off 4 months of mortgage that will likely be inflated away by the time you get there. I mean, if you only have a 10-year mortgage or you already have a PhD and you’re a licensed actuary, then those numbers are totally different (but then you’re not 25 either 🙂
As others have mentioned though, the big thing is “eggs in one basket” problem. Between mortgage and taxes and maintenance and bills, the home is also a huge expense. Getting rid of a mortgage feels like getting rid of debt, but the whole thing is also the mitigation of an expense. The home is “earning value” whether or not you’re paying it down early. Paying it down early is basically spending today’s money to save tomorrow’s money (less valuable money), why not just find a way to grow today’s money so that the extra 6 months of mortgage basically becomes irrelevant?
I mean, if you have 3-5 years left on your mortgage then maybe it’s not really a big deal. But if you have 20 years left on the mortgage, why keep throwing the little money you have at one big expense?
I can appreciate the tax deduction of the home mortgage, but it really doesn’t make sense. Since it is an income dedution it only reduces your taxable income, not a tax credit that reduces the amount of taxes you pay dollar for dollar.
If anyone is interested I will be more than happy to take $10,000 of their money and I will be very generous and refund $7,500 next year. Any takers?
Ryan talked about offset mortgages above. Becareful offset mortgages are often as scam, you can’t reduce your mortgage payoff time by years without large principal pre-pays. Plenty of examples about (and some scammers) in this FW thread http://www.fatwallet.com/forums/messageview.php?catid=52&threadid=741176
GatesVP – You are most likely right in that this may not work out to earning exactly 6% every year due to amortization. While amortization does complicate things, but I would be interested to hear your source for this statement:
“When you put an extra 5k on a 25-year mortgage, you?re basically paying down the last 5k, not the next 5k. If you?re early in the game, you?re basically saving money from 2030 to help shorten your mortgage.”
As I understand it, when you pay extra principal towards a mortgage, you are moving ahead in the amortization schedule. (The original schedule isn’t set in stone.) Accordingly, you are “skipping past” all the next payments (and the associated interest) that had to do with that principal amount, not taking them off the end. This results in the fact that now your regularly scheduled payments have a higher percentage going towards principal than without the extra payments, which in turn lets your loan end earlier. It’s hard to explain it much better here without pictures…
truly well thought out and a pleasure to read. Love your blog!
For me it’s as simple as this:
If I have a debt at a higher interest rate than I think I can make in the market, the money goes to the debt. That being said, I have 2 mortgages, 1 at 5.625% fixed for 30 years, 1 at 7.25% fixed for 15 years. I prepay my 2nd mortgage because I look at it as savings at 7.25% (every dollar I put on principal is another dollar that I won’t be paying 7.25% interest on). I have a savings account yielding 6% so I wouldn’t prepay the 1st mortgage seeing as how I can earn more than 5.625% on my money.
If anything, my house is a bond to someone else as I’m the one having to make interest payments.
You probably can’t earn more money on your 6% savings account than you pay on your 5.625% mortgage unless you are able to deduct your mortgage interest. Otherwise the taxes reduce the yield on your savings account.
Since I live in the Midwest where housing is comparably cheap (or perhaps I’m not in the same caste as the rest of you), I don’t find the interest deduction valuable.
At a low interest rate, it does make sense to borrow money to buy bonds (well, super safe bonds like treasuries anyways), because then you will have leveraged gains… same with a house. It doesn’t make sense to do it at a high interest rate or stocks however, because stocks are too volatile.
Finally an article on this topic that discloses YMMV with the interest write-off benefit. I’m going to relay my situation as one for which early pay-off makes sense (or at least I think so as it’s my plan). I took 80k at 5.625%. The interest/property taxes don’t even get me halfway to the standard deduction, so I have NO tax benefit. It’s a balloon up in 2009, so I’d need to refinance at an undoubtedly higher rate, and almost certainly a couple grand in closing costs. I max my Roth, and get the match from my 401k, invested rather aggressively. Personally, I’m not terribly confident in my job future, though the wife will surely stay employed. My HYS earns 5.05% (before taxes of course). I couldn’t shake the idea of trying to pay the mortgage off before the balloon is up and saving the interest+refinancing costs+future interest at higher rate. It’s aggressive to say the least, may need to float the last 10-15k on a 0% credit card, but this seems like a good choice to eke a little more interest out of the funds and in this case, realize the return before I’m old and gray.
Oh, and madame x, who knows how the secretive folks at FICO feel about mortgages. While you’d be inclined to think less debt would be a net plus to your score, there’s others who would argue the absence of an installment loan/mortgage would HURT your score as they seem to care about variety in your debt (i.e. not all credit cards). Best to not factor in credit impact in any payoff decisions as they’re not disclosing said impact.
Having cashed out of a high priced housing area two years ago and moved to a low priced housing area where we paid cash for a house, I can say that the psychological benefits are extraordinary. I feel good knowing that if something happened to me or my husband (or both, god forbid) the house is paid for. Being completely debt free is a wonderful feeling. Every dollar we save now is for us, not to pay some bank for something we bought a long time ago.
I’ve found that this calculator works very well to show how extra payments affect your mortgage: link
What are your thoughts about bi-weekly mortgage payments? They seem like a good idea, especially if your planning on living in your current house for a long time and have a bi-weekly paycheck.
I can’t see how having a fully paid for asset like a house would do anything but help you borrow money in the future.
I’m all for paid-for houses too………..;)
Actually, I’m still about $70K away from owning my house, but in today’s market that’s a pretty small #.
Here’s my plan……….(PLEASE FEEL FREE TO CRITIQUE!!!!!!!!!)……..
I’m at about $50K in liquid savings and what ***I*** want to do is get my liquid savings and my mortage to cross lines…………(approx the $60K mark???)………and then I’ll quit paying extra and just pay the mortgage amount ’til it’s zero.
My mortgage is 5.75%, which I think is about a wash in today’s MM funds, but I know it’s guaranteed long-term, so I think it’s still good. And it’s a 15yr loan started in 2001, sooooooooo approx 9 years left.
Yes, my wife and I currently max out our IRA’s, so I ***think*** I’m being smart.
Opinions?????
I pay a little extra on my mortgage each month (which is less than 1 year old), but I only allocate 1-2% of my gross income to the financial goal of owning real estate free and clear. It’s a last priority, but I can’t resist saving tens of thousands in interest (at least)–and being mortgage-free years and years earlier–simply by putting an extra $50-$100 bucks towards my mortgage each month. Plus, every dollar towards the principal I pay now is compounded over the life of my mortgage, so my prepayments now are more valuable than prepayments I’ll make down the line.
Most analysis you see about this issue focuses on having a paid off home already (i.e. losing the whole interest deduction). But that’s not really the best way to look at it. I’ll have this mortgage–complete with a huge interest deduction–for at least another 15 years. I’m only paying a little bit extra each month, relative to the payment (it comes out to just over 1 extra payment per year). I will ALSO tons of money in interest, though AND pay off my loan early. The interest deduction is not an either/or proposition, unless you’re talking about taking a lump sum and paying off your entire mortgage balance.
Hey Red:
Without some extra details, that’s definitely math to put a spreadsheet to. But first, check out this site and punch in your original numbers. You’ll notice that you interest portion is quite close to your capital portion, you may have a chart like this from when you signed up. What this means is that in the coming years, you’re actually paying less and less interest. So first, figure out how much interest you have left to pay and then figure out how much you’re actually saving by paying that down early (or as quick as possible).
Now, ask yourself how valuable it is to have 50k in the bank? What else can you do with that 50k that might make you some more money? Your house is appreciating whether you pay down the mortgage now or later. Could you afford to put 50k into a rental unit that would actually generate income? A small business? A month off for work training to get the next promotion? I mean, if you could spend 10k to get an extra 5k on your job for the next 9 years, would that be better or worse?
Jonathan:
My comment about 2030 dollars does depend on your mortgage terms and you’re definitely right that it could just “move you ahead” by some number and then reduce the interest. But what does that “move ahead” really mean? Is the bank really going to say “hey we’re just going to you ahead a couple of months and you can ignore all of these months where you were going to pay 90% interest and 10% capital?”, I don’t really think so, but I’d check your terms. The banks have this tendency of getting their money one way or the other 🙂
My point though, was that the bank was going to let you pay down 5k in principal in 2030 dollars and you’ve decided to do it now. When you’re talking about interest and payments over 20 years we can’t just ignore the inflation. I know that we ignore the inflation all of the time and that’s usually safe math, but it doesn’t feel right doing it here 🙂
If you put 5k on the 200k mortgage with 20 years left over, you’re basically eliminating the need to pay the last say 3-6 months and you’re reducing your interest payments. Of course, at 3% annual inflation, those dollars you’re not spending in 2027 are only worth 55% of the dollars you have now. Sure you’re saving a bunch of interest, but you’re also losing money by pre-spending depreciated dollars (unless someone sees deflation in near future)
Again if you have 5 years left on the mortgage, inflation is probably not an issue. But if you’re 25 with 20 years left on the mortgage, this is a big deal. The psychological value may be huge, but with 5 years left on a mortgage it may be just as good to say “Hey the bank has already collected 90%+ of their money, and the rest of this is going to be worth the same whether I throw money at it or not, so why not throw this money somewhere it can grow now?” If you think of the mortgage as interest that’s already been paid, then it won’t feel like such a “big debt”. But hey YMMV 🙂
Sorry if I’m a little uncouth Jonathan, I really do appreciate the posts and the wonderful forum/blog.
My tuppence worth…I came to the US from Northern Ireland where I practically had no mortgage before I left…Irish men all have short arms and long pockets, and so I absolutelty *hate* being in debt.
I am actively paying down my 130K 5% ARM mortgage right now, as well as maxing out my 401k, an IRA for me and her indoors, as well as dabbling with prosper.com (boutyebank), investing free money in HSBC from 0% cards and some stocks.
Despite working a lot on my savings and investments, I have to say that the 130k I owe on my 5% ARM obsesses me the most. I fall into the ‘psychological benefits’ camp having been so close before to having zero debt, and knowing how that feels. I want to be in that place again!
It’s better to look at the interest deduction on the marginal interest paid rather than to average out the rate over the entire amount of interest paid. You say:
“$250,000 x 6% is only about $15,000 of interest paid in the first year. Subtract out the standard deduction of $10,700, and your additional deduction is only $4,300. So you?re only saving 25% of $4,300 and not the whole $15,000. This means your 6% interest rate only goes down to the equivalent of about 5.6%.”
The 5.6% rate isn’t the one you should think about. When most folks think of prepaying a mortgage, they’re thinking about an extra payment or two per year. If you make just enough prepayments to move from an itemized deduction of $15,000 to an itemized deduction of $11,000, you’ve just cost yourself a deduction of $4000, or $1000 in your wallet. So for the additional money you’ve allocated towards your mortgage, you’re only “earning” ~4.5% rather than ~5.6%.
Having said all that, once you find out that you’re pretty close to the standard deduction anyways, the interest deduction isn’t worth much.
Gates VP – your interest payment in a mortgage is dynamically calculated each month against the current loan balance, so if you prepay $10k at any point in the mortgage you will see $60 less in interest in every following month (and $60 more going toward principal), as compared to the original schedule. So numerically speaking it is identical to a 6% investment no matter when it occurs in the mortgage, but I agree this decision often comes down to other financial factors (liquidity, etc.) than where the return is greater.
Sorry, meant to put $50 / month above.
I have a question…
I have a $600K 7 year IO arm at 6.25%, and I live in Southern California. We are planning on only staying in the house about 5-7 years. I was told that I would get approx. 25% of the interest and property tax back at tax time (asked the accountant).
I also have an $54K emergency savings account earning over 5.35%. I am wondering if it would make sense to just keep putting the extra money into my savings account since the interest on it is high. I was thinking with the tax break from the mortgage interest and the interest in the savings i would about break even. Am I kidding myself?
This is a new mortgage so I haven’t sat down and crunched numbers yet since we haven’t had our first income tax due yet.
I would never pay off my mortgage early… Cash is king and once you put that money into your house, you no longer have access to it except in the case of Home Equity Loans with really bad rates.
In TX and I’m guessing most other states , property taxes are deductible. If you are paying$ 3K in property taxes, that is an additional $3K that is put toward the itemized deductions. This 3K won’t be taxed at your marginal tax rate. In the example Jonathan gave, that would be an extra $750 in your pocket he didn’t account for. It also puts the effective interest rate on your home at near 5%.
If you don’t get married, you save a LOT more… (wasn’t able to convince my wife of that though…)
A GREAT discussion of this topic can be found in Ric Edelman’s “ordinary people, extraordinary wealth”. In fact, it is Chapter 1 he feels it is so important.
Most really wealthy, who can afford to pay off their mortgages, still have 30 year loans out. There is a reason these people are wealthy.
Also, heaven forbid you should lose your job or face an emergency and can’t make a payment. Then what? Do you think your bank cares? Nope… Having all your money tied up in your house is one of the biggest financial mistakes you can make in my opinion. A loan is based on your job and income ability more so than the property value of the house. You lose your job, and all of a sudden you can’t refinance, you start missing payments and you lose your house. The one thing you were trying to protect by paying it off early.
Seriously, you can earn 5% in a money market these days! Why would you pay off a 6% loan which after tax breaks is probably costing you close to 5%. It’s a wash and one option puts you in a liquidity trap until you sell your house and the other gives you tons of freedom.
I’ve never understood people who pay off their loans early… Then again, people still buy loaded mutual funds…
I’ve mentioned a few times on this site that paying off a mortgage is a bad idea.
In your presentation of the argument you ignored the many Risks of pre-paying a mortgage, namely that the house goes down in value – which means its not equivalent to putting money in a money market or bonds. With bonds you can diversify, pre-paying your mortgage puts money into one asset. You also reduce your liquidity when pre-pay your mortgage – bonds you can sell, ifi your income is lower or your house goes down in value you are screwed in that lenders aren’t goign to let you take money back out.
Here’s an article by Ric Edleman that outlines many reasons Not to pre-pay your mortgage. http://www.ricedelman.com/planning/home/BLTmortgage.asp
Another good article about why paying of a mortgage is potentially a Dumb move. The present value of money – your payments will be less and less in terms of what money buys 30 years down the road, why pre-pay with money now thats worth more that when it is due? link
Wake up people!!
Worrying about the tax deduction too much can cloud things. If you’re that worried about it, pay off the house and give what you were paying in interest to charity and keep the deduction as “charitable contributions”. There are other ways to give away money for tax breaks, you don’t have to use debt to do it.
Muary,
Nobody is saying “all your money will be tied up in a house.” If you use all of your savings to pay your mortgage, you are beeing foolish. Everyone should have cash on hand for emergencies, job loss, etc…
Instead, what if you have ample savings and a mortgage that is no longer giving you any tax benefits… why keep the mortgage? For what purpose would you pay interest at a rate HIGHER than what you get on your savings after tax?
Oh yeah, and in your example, the $3k is taxed at your marginal rate if you are married and if your other deductions total less than $7700 (which is true in my case). So if I already have over a year in savings and a minimal remaining mortgage balance that offers ZERO tax benefits, I can just treat it like a bond and pay it down instead of saving additional money.
Red and I look to be in a very similar situation!
Brian,
Yup………..that’s about where I’m at.
Since I can’t earn SIGNIFICANTLY more money in another liquid investment…….(FNBO 6% ends next month so I’m stuck w/ circa 5%)……then I might as well pay down my tax-worthless 5.75% mortgage.
While I’m not paying a *ton* in interest right now, it’s still a good chunk of money and I figure paying it down gives me peace of mind that I can’t buy.
Here’s my thinking…………….
If I pay my mortgage down to the point where I could collect cans to pay it off, then coast the rest of the way home……………then that sucker can’t be taken away from me.
If I save up tons of cash..(Let’s say *over* the amt of my mortage balance)………..BUT………….something horrible happens & I end up losing ALL of my liquid savings…………then NOT paying the house down may ALSO cost me my house too!!!!!!!!!!
love the site, but I have a bit of a problem with equating paying down the mortgage to buying a bond, especially if you intend to change the asset allocation of your investment portfolio. The role of a bond in an investment portfolio is more than just something that pays interest.
OK, I’ll admit, I’m a sucker, I ran lots of numbers (and I have some ugly spreadsheets to show for it).
Here’s what comes out:
http://gatesvp.blogspot.com/2007/08/paying-down-mortgage-early.html
That’s the long answer. The short answer is that the math is flawed, but that the interest rate just isn’t big enough to highlight the flaws. 🙂
I owned my first house free and clear at age 38 (a divorce came several years later). It was a great feeling.
In my current house, I make sure that I make a $1,000 payment toward the principal each month. You see the mortgage melt away.
I also teach my students to spend less than they earn and to keep a reserve account for unknown opportunities and emergencies.
BRILLIANT post! Keep up the good work. Best blog on the web!
I was very fortunate to have built my house in 1998 when I was almost 20 and getting married. I was obsessed with paying this mortgage down. My friends thought I was nuts and didn’t see the point of it. Well…at age 25, my husband was 29, we had a house that was paid in full. My friends have refinanced and taken more out, so now my friends owe more than they did almost 10 years ago. I will live rent free from now on. I did have to get a Line of credit when we built our addition, but that has been paid down as well. Any income is ours to now invest and save and we are free to travel if we’d like. Although, traveling with 2 children isn’t always the easiest. 🙂
I ran across your blog about a year ago, and this is my first response. We just recently got the Sprint Sero deal! 🙂 You are really helping many readers out here.
P.S. Homes here in my area of Florida in 1998 were under 150K. Didn’t want anyone to think I had a 500K mort. to pay down.
Yes, this was such a great analysis. Mortgage interest deductions are highly overrated. I used to think we’d get a quarter of our mortgage payment back in deductions (that would be about $3600 a year), but in reality it works out to less than $2400 a year and I’m not even really sure about that! And yes, paying down a mortgage is quantifiable money in the bank. But now I have a 20 yr mortgage and besides my pre-tax contributions to retirement, I have no real savings. So it’s just not gonna happen for me — but I think it’s a great idea in general when you have other liquid assets earning relatively little.
Another factor people don’t talk about is what happens the day the house is paid off. Let’s say you have paid it off five years early. That amount you were paying each month is no longer disappearing each month. You will have huge piles of money to invest during those five years and beyond (assuming you still have an income). So, you don’t lose the money into your house forever, only until you pay it off.
That said, I’ve decided that I’d rather buy my stocks across a longer span of time rather than waiting until my house is paid off early (dollar cost averaging). So I’m not paying my mortgage off early, other than having taken only a 15-year mortgage.
If you know you are refinancing, you should make sure you have at least 20% of your house paid off so that you can get rid of mortgage insurance.
One more note: after your house is paid off, you still have to pay property taxes and if you are wise you will continue paying for home-owners insurance and continue maintaining the house. If you suddenly can’t afford to pay your taxes, you can still lose your house. And if you don’t pay for insurance and a tornado blows your house into a tree, you have still lost your house. And if your roof wears through and you don’t replace, you can ruin your house.
Madd Hatter, I love your plan to try to prepay in your situation. Although if you can?t quite make it, it might be cheaper to pay the ballooned up payments than to use credit cards.
Red, maxing out your IRAs isn?t giving you much ($4000 each?) Some people say you should max out your 401Ks (or equivalent) AND IRAs. It seems like whatever you choose, it won?t be a bad choice, though. Having a paid-off house definitely helps with retirement.
Your comparison to a bond got me interested, so I did a simple spreadsheet calculation and verified your statements. There are a couple of things that need to be added:
– The interest rate return is simple interest, there is no compounding
– If you want to see the actual money saved, continue making the original mortgage payments to yourself once the loan is payed off. At the end of the original mortgage period, your accumulated cash will be equal to the interest saved, plus a return of the extra principal payments you made.
– You must reinvest this money to continue seeing a return.
Liquidity is a BIG issue. Many people who decide to put money toward paying off the house, don’t have enough emergency money available to keep going during tough times.
Ted Valentine Says: “I can?t see how having a fully paid for asset like a house would do anything but help you borrow money in the future.” Exactly…the liquidity problem. Paying off your mortgage is all well and good ONLY IF you have adequate emergency funds available.
I think there’s a great compromise solution for those of us trying to reduce risk: Take what you think you can pay toward your mortgage. Invest somewhere reasonably safe (and liquid). When you have saved up enough to pay off the mortgage, then pay it off…all at once. You will suddenly reduced your payments to 0, freeing up lots of monthy income or reducing the amount you need to live on. In the meantime, while you are saving, you have excellent LIQUID emergency funds in case disaster strikes your family.
– K.
Adding my two cents to so many comments seems a bit silly, but . . . don’t forget inflation (Gates VP mentioned it in passing) . . . the dollars you use today to pay down your mortgage are worth more than those dollars will be in the future. Inflation benefits debtors and hurts creditors. With the current credit crunch, expect a lot of money to be pumped into this economy; the printing presses at Treasury will be busy. This in turn will cause long term interest rates to rise. If you have a fixed rate mortgage — you’ll be in great shape paying a lower interest rate than your money market fund is paying you.
Jonnathan.
I’d love to hear more about which career to take which are most rewarding financially.
I know you did a couple of blog postings on it sometime back. Specifically I want to refer to this posting of your’s: link
I’m REALLY interested in knowing what folks like JCARM and TradingGamma did that they reached salaries of half million dollars+. I assume they did MBAs from best business schools, but a detailed comment from them or a detailed study from you would really be helpful.
Such a post would be EXTREMELY USEFUL for a lot of folks, esp. overachievers, who sometimes just switch careers and waste quite a lot of time in it, just because they did not make the correct choice from the very beginning.
Hey att;
I?d love to hear more about which career to take which are most rewarding financially.
I’ll level with you, you’re barking up the wrong tree. The most rewarding financial career is the career that you brings you health, happiness and enough money to pay the bills.
There are people making 100k+ at the top of their fields doing nearly any/everything that you can imagine, with or without degrees. If you want to suck out and grab an MBA in hopes that you can make 100k then you’re in for a rotten life. Figure out what you want to do more than anything and do it. If you’re an overachiever (as you state), then you will excel in your chosen field and find a way to grow that income.
If you pick a job just for the money and jump in the pool that’s not “overachieving”, that’s just following an richer crowd. Pick a job that you love and transform it into a million dollar business, that’s overachieving, it’s also the only guaranteed way to wealth AND happiness.
Of course, you’ll have to change this mindset:
who sometimes just switch careers and waste quite a lot of time in it, just because they did not make the correct choice from the very beginning
B/c if you believe that there is some holy “correct choice” or that any career can be a “waste of time”, then you’re just in the wrong headspace altogether. The people who think this way are the unhappy ones who figure that more money will solve their “problems”. The Wealthy AND Happy simply don’t think this way.
Okay I am 22 years old. I think some of you guys are correct in saying that you have more financial liquidity by investing your money. Yes it is also good to invest in yourself and your education. A huge huge issue is being missed though. I could invest my money into liquid assets like stocks, but is that really doing me so much good? The market goes up and down and it ties up my money too, although less so than a house. What about LIFE liquidity??? What if you want to move, you get transferred ect. If you stay in one house for 30 years great. In that case go for the mathematically true formula of investing all extra in stocks!
Four or five years later when you decide you want something else or have to move. You will realize you are hardly paying your house down and just throwing away thousands on interest.THINGS change all the time. You have to find a balance between all of these . If you refinance, move or buy a different house you are resetting back to the beginning of the loan. With the exception of the little principal you have been paying and the increase in the value of your house you are not getting ahead. You have been renting your house from the bank while slowing gaining some value. Some of this value will be lost by paying a realtor/paying finance charges for a new loan.
Now it is true you could keep your 30 year note and rent the house, but this requires all the right circumstances. Me personally, I don’t want to be a landlord.
I would take the advice of the author of the article and view paying down your house as a bond and a safer alternative to stocks. Then if you move at least you have significantly dwindled your principal and you have more equity. Just make sure you have some good emergency funds and you invest in stocks also!
I am going to pay my house off in 10 years. I was considering 4 years, but I think that is a bit overkill. I am a free spirit so for me the psychological aspect is very much so worth it.
The biggest risk I see from paying extra and paying a house off early is the risk of falling in love marrying and then risking a divorce, which leaves the asset vulnerable. It is easier to protect other assets such as companies.
What about those of us who have an ARM for property we don’t plan to stay at for long?
I have until 9/2011 on my ARM. Should I still try to pay more off?
Thanks, I have been wondering about issue too for sometime as well. I have listened to Edelmann’s tapes and also thought something was missing.
Unfortunately, various money sites harp on mortgages being evil creations of the banking industry to enslave the masses. Nothing could be further from the truth.
A mortgage is calculated so a borrower pays the same amount of money each month. The payment is determined by taking the yearly interest rate, dividing it by 12, and multiplying that number by the outstanding balance for the month. Then, enough principal is added to equal the monthly payment.
Because your balance will be higher at the beginning of the mortgage, your interest payment will be higher. Simple math. As long as you have no pre-payment penalty, you are free to add as much principal as you wish to your mortgage payment.
While paying off one’s mortgage early gives you a warm fuzzy, what happens if you lose a job before it’s paid off? You have your money tied up in your house, you still owe the same mortgage payment, and you probably can’t get your mortgage refinanced to reflect your lower balance. Edelsman’s arguments make sense – it’s better to put your payoff money into savings and investments. When the balance becomes big enough, you can payoff the house.
I paid my house off less than a month ago, 8 years early. I spent months looking at mortgage calculators, and seeing what different amounts of extra principal would do. My mortgage was at 8%, financed in ’95. The mortgage interest never did me a bit of good on my taxes, so that was never an issue. I still smile when I go back to that mortgage calculator and see all those payments I would have had to pay (with the interest I am now saving), and the piece of mind is unbelievable. I paid my regular mortgage payment on the first, and then paid as much as I could on the principal only a few days before the next payment was due. That way, I was able to hang on to my money until the end of the month, so I could leave it in savings, or use it for other things if necessary. Don’t pay your extra principal when you make your regular payment because that money is not counted towards the interest reduction for a whole month, when you could be earning interest on it in savings. It makes no difference when the extra principal is paid, as long as it’s paid and posted before your payment is due for the next month. The bi-monthly mortgage payment plan is a farce. I was able to cut my mortgage interest down by huge amounts by using my system. Paying extra on your mortgage principal does not take it off the end of the loan. It takes it off when you pay it, and immediately lowers your interest for the next month.
Already, I am socking away all that extra money in savings and investments, and laughing all the way to the bank, not the mortgage company.
I always make extra payments on my mortgage when I have the extra money to do it, but a word of caution. Make a check out to your bank, put in the memo, on the principal only! I got screwed by another bank I first had my mortgage at, I gave them cash when I did this and they would put it on my mortgage as a future payment, not the same thing! Make 100% sure that it is going on the principal! Pretty much don’t have the teller do it unless your sure she won’t screw it up.
I liked the paradigm. While it may not be totally accurate it’s certainly worth thinking about. Personally, I like Scott Adam’s 9-Point Investment Plan:
Do these steps in the order shown:
1. Make a will
2. Pay off your credit cards
3. Get term life insurance if you have a family to support
4. Fund your 401k to the maximum
5. Fund your IRA to the maximum
6. Buy a house if you want to live in a house and can afford it
7. Put six months worth of expenses in a money-market account
8. Take whatever money is left over and invest 70% in a stock index fund and 30% in a bond fund through any discount broker and never touch it until retirement
9. If any of this confuses you, or you have something special going on (retirement, college planning, tax issues), hire a fee-based financial planner, not one who charges a percentage of your portfolio
What are the programs that show how to pay down a mortgage in about 1/2 the time?
after reading all this, I am still trying to find out, can one report the additional principal (not the mortgage interest) paid upfront in addition to the regular mortgage installments, on the tax return.
JAI,
I donot think you can do this…just the two numbers on the tax form sent you.
Someone correct me if I am wrong.
Do yourself a favor, pay off the house. The comment in 2007 about not clouding things and not trying to use your debt was spot on
Some interesting ideas about paying off a mortgage early-
1). The return of cash flow used to service the mortgage is “tax free”
2). If the returned cash flow is reinvested systematically (eg DRIP) this will offset the loss of the interest tax break. You “pay yourself” monthly and accrue a liquid asset with a yield that can be structured in many ways.
3). The reinvested savings over time that may have gone to the mortgage may be enough to provide a bridge to early retirement while you wait for the “retirement age” to kick in to give you access to your traditional IRAs, 401(k) etc. And you have the house still that could be monetized.
4). Cash flow is far more flexible, especially in the event of job loss or change in income.
5). Your homestead in many states is legally protected in the case of a lawsuit.