I am thrilled to welcome back Jon to the blog! He’s written before about non-traditional wireless phone plans, financial resolutions for the new year, and paying off $89,000 in student loans with his wife – and living to tell about it. And today he has another treat in store for us! Jon and Heather (his wife) recently purchased a home, and in the time since that big-ticket buy, they’ve been weighing the pros and cons of paying off the mortgage early vs. investing their extra income (they were debt-free, after all…). In this post, Jon breaks down all the components of which is best – mortgage free… or huge investments?
Mortgage Free or Huge Investments – Which is Best?
When it comes to getting a mortgage, in the personal finance community I’ve heard everything from: “Pay off your home as early as you can,” all the way to: “put down as little as possible, and never pay extra on your mortgage.”
When purchasing our home, we did the best we could to make a wise decision.
We took the time to figure out how much we wanted to put down, whether to do a 15 or a 30-year mortgage, and whether or not to buy “points” to reduce our interest rate.
Ultimately, we settled on a 30-year mortgage
We had a baby on the way and while we intended to pay off the mortgage early—with uncertain incomes and rising expenses, it was worth it to us to have a slightly higher interest rate with a lower payment. This would give us the peace of mind that comes with having extra money each month to cover miscellaneous expenses if our expectations for our new life didn’t quite match up with reality.
Once we settled into the house (and mortgage), we found that we were still bringing in more than we were spending each month. At this point, we were still waiting on our daughter to arrive, but we felt comfortable enough with what we had in the bank to begin paying extra on the mortgage each month.
We started off by paying an extra $1,000 each month on the mortgage
After tasting debt freedom over the last 2 years, we knew we wanted to pay off the mortgage early and that this was a surefire way to get back to debt freedom—but was it the wisest?
The decision to pay extra towards mortgage principle was a quasi-calculated decision. I knew that I would get a guaranteed 4.25% rate of return on anything we paid down (our interest rate), but I hadn’t done a cost-benefit analysis to see what we could have if we invested each month instead of paying off the mortgage early. Guaranteed money is great, but the potential for more was calling my name.
After paying down enough extra principle (~$9k) in 8 months to knock 3 years off the back end of our mortgage, I decided it was time to take a closer look to determine if this was really the best decision for us.
If investing instead would put us way ahead, I’m all ears.
To figure out what’s best for us, I had to make a few calculations
- When would the mortgage be paid off if we continued paying extra?
- How much could we instead have in investments at that point if we invested that money each month instead?
- When would the mortgage be paid off if we stopped paying extra?
- How much could we have in investments at that point if we invested that money each month until then?
My calculations look at what we could make by investing instead of paying extra towards mortgage principle each month.
Assumptions used in my calculations:
$1,000 extra per month for investing or principle reduction – Don’t have that much? These calculations will still help you to get an idea of what may be best for your situation, even if you have less (or more). This amount is a nice round number and is meant to be an example of an aggressive amount. If you have less than this (like us now that our baby is here), it will skew the math and put you less ahead by investing. Think about it like this: less money to be growing at a higher rate of return than the mortgage interest rate, so it makes less of a difference in the long run.
7% rate of return – I decided to do my calculations assuming a 7% rate of return. This is the rate of return of the S&P 500 net of inflation, historically.
Investments will be made in a non-retirement brokerage account and gains will be taxed at the current long-term capital gains rate of 15% when they’re cashed out – My stated investment values will have this subtracted out to best compare each scenario with tax implications already considered.
Calculation One: When would the mortgage be paid off if we continued paying extra?
If we continued paying an extra $1k/month on our mortgage, it would be paid off in 8.5 years. I would be 36!
Calculation Two: How much could we instead have in investments at that point if we invested that money each month instead?
If we invested that $1k/month over the next 8.5 years, we would instead have $132k in investments.
Before you flip your lid, it is important to factor in that the second option is not $132k better than the first. The mortgage balance under the investment scenario is still $124k in that same 8.5 years. This means investing could put us ~$8K ahead over the next 8.5 years.
This means we could choose to cash out our investments and pay off the mortgage on that same date in 8.5 years and have 8 grand left over.
Not to turn up my nose to 8 Grand, but due to the uncertainty of what the actual returns would be over that period, it’s just not worth it to us. I would rather have the mortgage paid off in 8.5 years (guaranteed) than maybe have an extra 8 grand, and maybe not if the market didn’t perform well.
Calculation Three: When would the mortgage be paid off if we stopped paying extra?
If we stopped paying extra on our mortgage, it would take 26.5 years to pay it off. Instead of paying off our mortgage at age 36, I would be 54.
Calculation Four: How much could we have in investments at that point if we invested that money ($1k) each month until then?
If we invested $1k/month over the next 26.5 years (not paying extra on the mortgage, and not paying it off early at the 8.5-year mark out of those investments), we would have ~$788k in investments.
Of course, I have another caveat here: to compare this number apples to apples to the alternative scenario (where the $1k/month went towards paying off the mortgage early), if that extra $1k/month plus the mortgage principal and interest were being invested once the mortgage was paid off early for 18 years until age 54, we could have $695k in investments.
If either situation were to play out as expected, the hard work and sacrifice would have us in great shape heading into our mid-50s
The differences? The main difference is obvious: We could come out about $93k ahead by investing. Similar to the first scenario, the other key difference is risk. Paying off the mortgage early can be guaranteed with extra payments, but investing subjects the money to unknown market fluctuations.
Over the 26.5-year period, the mortgage would be paid off in either scenario, based solely on minimum payments. Having the mortgage for an extra 18 years and being tied down that much longer just isn’t worth the $93k that we could have by investing instead. And remember—could. It is possible that we would go through all of the heartaches of ups and downs and come out less ahead than that for the trouble, or (while less likely given the long investment period and the market’s history)— behind.
Paying off the mortgage early:
If your goal is to pay off the mortgage early, and you can do it aggressively, you are better off just paying extra on your mortgage (in my opinion). As demonstrated in my example, the amount you could gain by investing instead over the short term is minimal. With that, there is also increased risk of losses over a shorter time horizon. You don’t want to find yourself stuck with a mortgage when your investments take a dive if your goal is to pay it off early.
Paying off the mortgage later:
When talking about a 26.5-year period of time, the risk of losing money when investing wisely goes way down. The stock market should generally perform well over this long of a time horizon. It is likely that you would come out ahead, but still not guaranteed. And it needs to be weighed if the amount that you come out ahead was worth keeping the mortgage for the full term.
Other things to consider:
After doing the math, it appears quite likely that we would come out somewhere in the ballpark of $93,000 ahead by keeping the mortgage for the full term instead of paying it off early. This is no small sum; in fact, it’s actually more than half of what our mortgage was to start with.
Nevertheless, we intend to pay off our mortgage early, if we can swing it
Here are the reasons why:
1- While I don’t know that we can, what I know for sure is that if we do pay off our mortgage at this aggressive pace, we will save $74,000 in interest and be debt free 18 years sooner—guaranteed.
2- Freedom. Maybe 9 years from now, having the flexibility in our budget to not make a mortgage payment every month will free up opportunities that dwarf the $93k that appears to be attainable by investing for the length of the mortgage. Maybe those opportunities won’t be “worth” more than $93k, but we may value them more. Maybe the peace of mind of not owing anyone anything, alone, will make it worth it.
3- Returns are not guaranteed. When assuming a rate of return over a long time horizon, every percentage point makes a huge difference. If that return turns out to be much lower than the 7%, we could come out behind, and that’s just not worth the risk to us. You may look at this and say, “or you could come out that much further ahead,” that’s okay if you want to think that way, just be cautious (also see point #5).
4- Market fluctuations. On good days when the market is doing well, I would be able to look at my investments and think all about what a good deal we’re getting: borrowing at 4.25% and making 15% in a year in the stock market. On bad days, however, I don’t know that my stomach could take it. My retirement investments went down 20% in 2 months last year, and I don’t know that I could put up with the mortgage sticking around if the money we need to be debt free is taking a nosedive in the stock market.
5- While I have demonstrated that the gains are there to be had, we are actively investing towards retirement in the stock market already. If the market performs as well as this model predicts, where investing comes out ahead, then our retirement accounts will be plenty healthy towards retirement age. If they perform better, we’re that much better off in these other accounts. As a result, the money we could have made instead of paying off the mortgage early will matter that much less in the grand scheme of things. If the market performs worse, however, it will be good to know we have a paid for house and can afford to save more as needed moving forward without the burden of a mortgage payment.
Notice something missing?
The mortgage interest tax deduction:
To me, this is the major mortgage “good debt” myth number 1.
With the new increased standard deduction, it is estimated that only 10% of Americans will itemize deductions for their taxes. This means that the overwhelming majority of Americans will not be getting a tax deduction for their mortgage interest paid.
Due to this fact, it is absent from my calculations. If you do itemize your deductions (even with the increased standard deduction), keep in mind that you are only saving your tax rate on your mortgage interest, not the full amount—don’t overweigh this tax benefit in your decision of whether or not to keep debt around.
So what do you think? Are we making the right call or is there something else we’re not considering? Let us know in the comments below!