I wonder how this conversation would change if the year on the posts was 2009 (now) versus 2008 (pre-recession topics).

I also see both sides, and the issue I have with pre-paying the loan is that it locks it up where you need to re-borrow it to access the money, and who knows if that will be possible.

And, investing instead assumes an average return that may not be realistic. Look at the last 10 years. We’re basically flat on all stock markets, so pre-paying would have given you at least your 5 or 6% return based on the rate of your mortgage. Who knows what the next 10 years brings.

For the record though, because of these points, I am doing a mix of both. Since the recent 40% losses, I’m considering putting more into the investment side, with a focus on where that money will be 5 or 10 years from now, not the 5.5% return I’d instantly get by pre-paying an extra amount.

If anyone from 2008 is monitoring this board, let me know what you think of my views today – 2009.

Thanks and once again, a great lively discussion!

William Shakespeare:
“Neither a lender nor a borrower be.”

IMHO pay it off as quick as you comfortably can.

My formula is this:

1. Eliminate all other debts first. After that never carry a balance on a credit card or take any kind of consumer loan ever again in your life. Visa and Mastercard are not your friends.

2. Max out your 401-K, IRA’s or whatever pre-tax retirement plan you have at work.

3. Have 6 momth emergency fund in the bank.

4. Take whatever is left and apply it to paying
off the mortgage as quickly as possible.

You shouldn’t sacrifice your retirement investing to pay the mortgage off early. But to me you shouldn’t use any of your net pay after 401-k deductions and taxes to invest in the market unless you are debt free.

You are already maxing out with pre-tax dollars to invest for the future. If you combine that with having no debt you will have more than enough money to retire on.

You don’t need as much money to live on at retirement if you don’t have any debt.

With this formula I am currently on schedule to pay a 30 year mortgage off in less than 9 years.

It can be done and you do not have to live like a pauper to do it.

I hear so many arguments against paying your mortgage early if you have a good interest rate, but I come from a school of thought where you’ll be able to build more wealth once all of your current debt is paid off.

Michael @ 8:55 am February 12th, 2008 (comment #74)

That quote would be the first time I thought you were wrong.

I’ll take the two pronged approach, pay down some in a reasonably safe investment (for those who say it will burn down, ever heard of insurance?) and pay some into more risky investments, with a better opportunity for return, but also the opportunity to go to nothing.

you do not get a mortgage, and you do not have a mortgage.

You GIVE a mortgage in exchange for money. You get a loan. The lender has a mortgage, not the borrower.

As far as the discussion. Pay off the loan. Why, 2 foolproof and irrefutable reasons.

It is almost always the highest risk free rate of return that exists for most people.

If most billion dollar banks think that loaning out much of their money with some risk is the best investment they can make (which it is…that is why you have a loan with them), then paying off that loan equals that same desired rate while eliminating all of the risk because the “investor” is the payee.

Forget the tax issues. They offset (interestdeductibility vs taxable income from the investment account)

Pay off the loan. Don’t try to beat the system. Use it to your benefit.

Now, since nobody else is reading this let’s all table the discussion until Trent’s next post about mortgages.

Investments are liquid, provide more flexibility, more opportunities, better rates of return, and even increased safety. Home equity provides 0% rate of return, is not as safe as people think, is not liquid, and can prove much more costly than investing over time.

There are plenty of low-risk investments out there that return over 6% (my tax-free bond fund yielded greater than 6% last year even with the financial meltdown, other funds I own were even greater returns). All it takes is a little education and research to find one you like.

As for real estate, investing in real estate is a great way to invest and you can do so with little money invested, yield great tax benefits (ie 1031 Exchanges, depreciation, etc.) and even extract cash out of properties to improve liquidity. Again, some research can show you how this can prove real estate investing to be a great way to diversify your investment portfolio.

As for my earlier comparison, the $200,000 investment versus mortgage payoff, why would you pay off the mortgage when you have all of that money working for you? Sure, the mortgage carries a cost, but it is far less than what your return is through investments, so you make money through arbitrage the way banks do.

Again, strategies I write about and suggest are not for everyone, but they do need to be looked at. Even the Federal Reserve did a study showing nearly 70% of all Americans would be better off employing other strategies instead of paying off their mortgage. Food for thought.

@Steve — Thank you for your example. I did read my link. Like its author, I assume the borrower makes his payment on time, giving the mortgage no chance to compound. Mortgage or HEL repayments have a compounding effect because they lower principal, not because the mortgage or HEL interest compounds. You can see this yourself by roughly recreating the example in my previous reply to you in Excel.

If you apply inflation you must apply it consistently. 3% inflation means money is lost by putting it everywhere. If the real return of paying off a 6% mortgage is 3%, the real return of investing in a 6% savings account is also 3%. Inflation makes money worth less whether you paid it to the bank or the bank paid it to you. It does not affect prepayment vs. investment scenarios.

You are right that houses are illiquid and cash is liquid, but you are confusing two things. If I take out a loan, it does not matter what I bought. It doesn’t matter if I took out a loan to buy stock or a house, because I will owe the money no matter what. Whether my house doubles in value or burns to the ground, I owe the money. The return on mortgage prepayment has nothing to do with the value of the house. It has to do with saving interest by making principle payments.

The liquidity of investment accounts is something different. It’s true there is an advantage to liquidity and that it can save money to have money around. But because there is no investment that guarantees a return the way loan prepayment does, liquidity has a cost. For a $100,000, 6% loan, putting $1,000/month in a risk-free, 3% ING account instead of making extra payments costs about $10,000 in extra payments. That is the cost of liquidity.

Let’s say for example I have both a 10000 dollar HEL from Crudtastic National Bank and a credit card from them as well. Both offer an incredible yearly rate of 365%, or a daily rate of 1%. My payment is 3200 per month.

In January, I pay both the credit card and the HEL 4 days late. Here is what happens for the HEL:

Day 1 – Principle 10,000 – Interest 100
Day 2 – Principle 10,000 – Interest 200
Day 3 – Principle 10,000 – Interest 300
…
Day 34 – Principle 10,000 – Interest 3400
Payment – 3200
Day 35 – Principle 10,000 – Interest 300

For the Credit Card:
Day 1 – Principle 10,000 – Interest 0
Day 2 – Principle 10,000 – Interest 0
Day 3 – Principle 10,000 – Interest 0
…
Day 30 – Principle 10,000 – Interest 3000
Day 31 – Principle 13,000 – Interest 0

With the HEL, the interest is left as money still owed, but the principle does not increase. Because I was late with the credit card, they added the interest to the principle. This means that on Day 60, I am going to owe interest on 13000, not 10000 plus the interest that I still owe. This is how interest compounds on a credit card and not on a HEL or mortgage.

Finally, remember that when you make more payments on simple interest loans, the interest resets to 0 owed and starts recalculating the new balance, which means that if you can pay the loan weekly, you are lowering the daily interest accrued with each payment; something that does not happen with either a mortgage or a credit card.

Finally, extra principle payments paid against a mortgage go against the last payments of the loan; you still pay the full interest payments up front when they are higher, and you are paying the last payments with todays dollars rather than future dollars, which means you are losing 3% compunded by paying off the principle. Savings, investments, and inflation, unlike mortgages and HELs, do compound.

My whole point of the original post was that there seems to be this idea that paying off the mortgage is the safer investment, but that isn’t always the case, and there are risks on both sides of the coin. I would rather have the risk be in liquid cash than an illiquid asset like a house. Tangible assets can go to zero, and that is a big risk in itself. Paying off a mortgage has its own risks, and if you feel better with that risk than with investing, then go for it, but understand all risks before labeling one as being safer than another.

Why? As I have said before mortgages do provide a compounding effect, however not the same as an investment. And I am not talking about a savings account that pays 3%. There are plenty of ways to earn over 6% tax-free and many can break 12% or more. The possibilities are endless, that is unless you stuff your money into home equity (pay off your mortgage).

Home equity does not have a rate of return and while paying off your mortgage is noble, the time value of money proves that investing first instead of later is the better route. Take the rule of 72 to heart and let’s look at a $200,000 at 6% and investments at 6%. If you could send $1,000 extra to the bank or investments, which would be better (I am leaving out tax benefits)?

Well, if you sent it to your mortgage, your mortgage would be paid off in 10.17 years. If you sent it to your investments, you would have enough money in your investment account to pay off the mortgage in 10.17 years. Hence, the same effect, except for the investment account provides liquidity and more flexibility.

Now, if you decided not to liquidate your investment account to pay off your mortgage, guess what, you have around $200,000 compounding as opposed to $0!!! So, where would you rather be? Also, think about what would be the effectou could invest elsewhere and get even greater rates of return? What about real estate investing options to grow your portfolio tax deferred as well?

The bottom line is trapping your money in your home is not a wise investment, even if it costs a little by maintaing your mortgage. So, you can listen to Michael and just ignore me, or you can visit my blog at Florida Mortgage Report and learn more.

NOW (at least, SOON) MAY just be a great time to invest in MORE “never sell” real-estate (income producing).

Prepaying a mortgage increases equity, but in a very illiquid asset (compared to a savings account)

A HELOC can access part of that equity, but is a debt that must be repaid.

And unlike a mortgage, which can’t be called, your lender can cancel your HELOC at any time – such as the morning after the night your local news showed your house burning to the ground.

http://loan.yahoo.com/m/q_sim.html

Mortgage prepayments have a compounding effect because each payment not only pays interest and principal, but lets future payments pay more principal and less interest. Because of this, prepaying a 6% mortgage is just as good as putting the prepayments in a 6% savings account. Consider this example:

I have a $100,000 mortgage, 6%, 30 years.

1. I pay double payments on the mortgage. I finish in Month 108 with $774 extra.

2. I pay regular payments on the mortgage and put the extra payment in a 6% savings account compounded monthly. In Month 108 the mortgage principal stands at $85,298 and the savings account has $86,072. That’s enough to pay off, so I do, and I have $774 extra. It’s just as good. This would be the better way to go if 6% savings accounts existed.

The exact numbers would vary slightly, but you see how prepaying a mortgage, even if it is simple interest, is like earning its interest rate compounded.

It is also not true that mortgage prepayments stop compounding when the mortgage is paid off. Consider these examples:

1. I have a $100,000, 30 year loan at 6%. Each month I send one payment, $600, to the mortgage and invest $600 in a 3% ING account. At the end of 30 years my mortgage is paid and I have $350,516 in the bank.

2. If I double my payments I finish in 9 years. After that I put all $1,200 in the 3% ING account. At the end of the 30 years I have $421,596 in the bank. That is $70,000 more because I prepaid! It’s true that in year 9, when the mortgage was paid, I had $0 in the bank, but since I didn’t have to waste half of my $1,200 on that 6% loan for the next 21 years, I made much more money.

Simple Dollar readers, please do not listen to Robert Ashby. When you prepay your mortgages, you use the full time value of money, just as if you invested. And since mortgage rates are much higher than savings account rates at the same risk (zero), mortgage prepayment is an excellent investment.

I’ve got a home loan that has about $50000 outstanding. I’ve got a home loan offset account that is got as much money in it. Hence, I am not paying any interest on the home loan. I’ve not paid up the homeloan yet as there is a 2% penalty on the original loan amount if I pay up early. Also, I like having the money around in case I need it for medical emergencies (health care cover is not very good). It is effectively giving about 12% in returns after taxes. I now let the monthly payment reduce from the offset account. I currently have no need for the money in the offset account, but the security of having this money around allows me to invest in risky assets like stocks and managed funds.

I now invest about $1000 a month in long term savings through equity managed funds and about $400 for medium term goals like a new car, painting the house etc by investing in balanced funds. These are still actively managed funds, as India, where I am, the market is not yet that efficient. I also have about $80,000 in stocks and invest in IPO’s when the company makes sense. Managed funds return bout 20% a year on average, but is much more volatile than the US stock market.

My only debt is the house loan and my net worth not including the value of the house but including the liability of the home loan is about $140,000.

I reckon I need about $500,000 in 20 years to retire comfortably.

My question is, is there something I should be doing differently? Any feedback is welcome. The actual amounts are in Rupees, but have been converted into US Dollars

What many people don’t realize is that paying off a mortgage has its own risks. Houses are a tangible asset, unlike the stock market or a savings account. Fires, flood, earthquakes, tornadoes, etc. can destroy a house and leave the worth of the house at zero. When was the last time the S&P500 was at zero? And if that happens, having a paid mortgage is the least of your concerns. Even with insurance, there is still the cash needed to live while a dwelling is rebuilt, or the waiting period to even receive the check (ask Katrina victims.) You still need to get your life back in order, and having more, not less, cash on hand will help in those situations.

And you will never own your house free and clear. Ask the people in Central and South Florida about insurance rates and taxes, and then look at all the houses for sale because they are no longer affordable. If I was in Florida and had a 30 year mortgage and invested the difference, at least I would have the flexibility to sell at a lower price for a quicker sale and move somewhere else because I have the cash on hand to make the move, rather than relying solely on the sale of the home for the money needed for the next place.

There is risk on both sides, and simply saying that the mortgage is paid and therefore “safer” is not always true. Personally, I would feel better emotionally having more options for a financial exit strategy rather than having all my money tied up into one, tangible and highly illiquid asset.

Couple that with the fact that you now start your investments at $0 in the future and you will need a lot more money to achieve the same financial results. (Time value of money). Now, add to that that every dollar that you send to the bank robs you of added liquidity, and receives a 0% rate of return. (Home equity itself has no rate of return).

So, to say that the mortgage compounds the same is FALSE and an invalid comparison.