Should I Prepay On My Home Loan Or Put It Into Savings?

I had a lengthy and interesting discussion with my wife this morning about the interest rate on our home loan. We are locked in at 5.875%, and I told her that at that rate, we were better off not paying extra on the loan and instead putting it away in an HSBC Direct account at 5.05%. At first, she said I was batty, but after I drew it all out for her, she came around to my way of thinking. Here’s why.

Let’s say that we have a $200,000 loan that’s fixed at that 5.875% rate over thirty years. Using the calculator over at BankRate, if we make no extra payments at all, we’ll pay a total of $226,137.30 in interest over the life of the loan. However, we’re also in the 28% tax bracket, so that means we’ll have $226,137.30 in deductions, which will save us $63,318.44 over the life of the loan, meaning we will effectively pay $162,818.90 in interest and taxes over that period.

So what happens if we pay $500 extra in principal each month? For starters, we pay off the loan much, much earlier, in just under 15 years. Nice! Over the life of the loan, we only pay $100,499.55 in interest. With that as a tax deduction in the 28% bracket, we will effectively pay $72,359.68 in interest and taxes over that period. In short, investing $500 extra a month into our mortgage will net us $90,459.22. Right now, you should realize where this is going, because you’re putting in $90,000 ($500 times twelve months times fifteen years) to only get $90,459.22 – and it’s even worse if the income tax is higher than that.

On the other hand, what happens if we put $500 a month into a 5.05% APY savings account for 15 years? I used Excel to crunch the numbers here and discovered that doing this will give me $133,912 at the end of those fifteen years. By putting that $500 a month into just an ordinary savings account, you blow away the return of putting it into your home mortgage.

The more astute folks out there will look carefully at that mortgage calculator and observe that after fifteen years without paying extra principal and instead putting that $500 into a savings account, you won’t be able to take that balance and pay off your home loan, while the other way you would have your home loan paid off. The difference is the income tax savings each year.

If you put the extra $500 into a savings account instead of against your principal, your income tax bill at the end of the year will be significantly lower than prepaying your mortgage. If you take that money you saved on income tax each year by putting the $500 a month into the savings account instead of the mortgage and put it into that savings account each year, you’ll have an extra $63,139.55 in the account at the end of the mortgage. That leaves you with a final account balance in that account of $197,051.50. You’ll only owe $142,249.76 at the end of fifteen years, so you can just write a check to pay the whole thing off and still have more than $50,000 in the bank. In fact, if you so wish, you could actually pay off the home at the end of year thirteen and still have several thousand in the account.

Utilizing a High Interest Savings Account

In short, if your interest rate is below 7% – and especially if it is below 6% – and you have willpower, you’re much better off putting mortgage prepayments in a high interest savings account or other investment than putting it in the principal of the mortgage.

After figuring things this way, our current plan is to just put our planned mortgage prepayment into Vanguard index funds (instead of HSBC Direct because we’re pretty sure we can get better than 5.05% APY over twelve or so years in index funds). We’re currently planning on double payments, so we would effectively put a payment into the mutual fund each month and then just let it grow. We never intend to prepay on our home loan; instead, we’ll just let it ride until we move on to our dream home, then sell it off at our own pace.

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  1. boomie says:

    your plan may seem good on paper but in reality it doesn’t. you only pay interest on the mortgage for the first few years, after that you are only paying principal so you lose your tax advantage. how old are you? if you are 30, you will be 60 and still paying off your mortgage. which would you rather be: 45 or 60 and mortgage free? if your mortgage gets paid off in 15 years, odds are you will be at a lower tax bracket in life (kids grown and out of house) and without a mortgage you can sock an awful lot of money away.
    betting on the stock market is a very bad investment. did you hear the news today about the terror plot exposed at JFK airport in New York? we aren’t always going to be so lucky. the stock market is not a reliable medium. FDIC banks are.
    Just my 2 cents. Forget the calculations and pay off your mortgage as soon as possible. you will be surprised at how tired you will feel of working and paying debts at the age of 60.

  2. MaddHatter says:

    One thing’s been forgotten here that usually is. And that is whether you’re truly recognizing the full benefit of the tax deduction. For that to be the case, you’d need to be itemizing your deductions, and be at $11,000 (or somewhere in that area) BEFORE tallying up your mortgage interest. If you itemized deductions, including mortgage interest, comes in at or under the standard deduction, guess what? You’ve gained NOTHING in tax benefit, at which point you WOULD be “better off” prepaying the mortgage (straight by the numbers, to say nothing about the opportunity cost). YMMV of course, some people easily meet the standard deduction amount and so the mortgage interest is all gravy. But I live in the midwest as well, have nothing to claim but property taxes and mortgage interest on a modest home, so I’m not anywhere close. Therefore, I’m employing a strategy of 1) emergency fund 2) max out the Roth (and 401k for employer match), and 3) pay down the mortgage a bit (which is “money in the bank”, a sure-fire return).

  3. Amy says:

    Have you factored in income tax on the savings account interest earned every year? I’m curious if that makes a difference.

  4. TheHappyRock says:

    I didn’t see any calculations on taxes on the money in savings(unless I missed it), and I suspect that most people are not able to take advantage of the full tax break since they probably barely pass the standard deduction amount when adding in the mortgage interest break.

  5. I agree with Amy. I too wondered the tax amount on the savings account. I wont even begin to try to compute the numbers myself, but if you have the figures, I’d be curious to know.

  6. Jason says:

    There is a possibility that you don’t realize the full benefit of the mortgage interest tax deduction. You also didn’t consider tax on the interest earned on the savings account nor the capital gains on the gains from investing in an index fund.

    And this is the most important overlooked feature: you neglected the utility of having your mortgage paid off at 45 versus at 60.

  7. Sarah says:

    And, on the other side, if your income is too high, you are liable to get slapped with AMT, and everything needs to be recalculated.

  8. Yep, you need to figure taxes on the interest earned in the savings account. Not sure that was factored in.

  9. Anne says:

    I did the math (okay, okay, I used an online calculator) and the $133M figure is a gross number–taxes were not accounted for.

  10. TJ says:

    I’ve never known anyone in the 28% tax bracket, but I’m sure that down-paying mortgage principal is an excellent idea for *most* people.
    Debt is not something to consider without serious thought, and it’s always wise to resolve it when we’re able… we do not know what the future will bring.

  11. Jamie says:

    I see two problems with this:
    1. As everyone else said, taxes were not included in the calculation.
    2. After time, the deductible amount of your mortgage decreases, leaving mostly principal payoff at the end. By pre-paying your mortgage, you will reduce taxable expenses later on in life (particularly in retirement).
    In reality, the only positives I can see to this is free cash flow if you’re worried about layoffs, etc.

  12. Thoglette says:

    You also need to look very carefully at your tax laws – for example, some countries exempt the “primary residence” from the tax system, but interest on savings is considered income. So reverseing the bias.
    The market is what we legislate.

  13. Hello. There are a couple other important points also missing but I am working on an article about these issues that I hope to finish soon.

  14. chazzman2000 says:

    I had this conversation with a friend and we ran the math. Sorry, its the weekend and I’m lazy now. So thanks to Google, I found an example that was very close to what we came up with. We figured in the tax on interest and it was still money ahead for paying off early.

    http://www.fool.com/foolu/askfoolu/2001/askfoolu010307.htm

  15. chazzman2000 says:

    Not only am I lazy this weekend…but sloppy. I should have stated that it is better to invest and not pre-pay. I had a long night up with the kidos!

  16. miguel says:

    I have thought about this a lot recently. What do taxes on your returns factor into your plans? After taxes I think you’d only be pulling in ~3%. Also you are assuming that you’ll live in the home for a full 30 years, and that you’ll put in $500.00 a month consistently.

    Have you considered what factors could cause the plan to fail?

  17. Jeremy says:

    I’ve heard various arguments in both directions. The most convincing argument for me is that the benefit of paying off early comes only after the loan is paid off. Since we have basically a zero probability of still being in this house after 30 years, let alone 15, I don’t want to “tie up” the money in such a long-term savings method.

    On the other hand, we are paying ahead on our second (10 year) mortgage which is at 7.74%. It will be paid off much sooner, probably before we move again.

  18. TheHappyRock says:

    I think miguel asks a poignant question. What will the points of failure?

    Often theory offers better numbers than other options, but most people don’t live in theory they live in the real world with their flawed selves. This may be one of those cases. I personally think that is why Dave Ramsey is so successful, the focus is on behavior not on theory. For most I think behavior might destroy the plan, especially if the money was in a very liquid account like ING.

    I think if we carried theory to the fullest, everyone would take a huge interest only loan out and never repay any principle. Business theory says that it is best for companies to use 100% debt, but in reality companies use no where near that amount.

  19. Mike says:

    “and even with the tax on the interest, he’s still better off. ”

    OK, modification #1: this assuming a 5.05% return rate. Change this number to 10%, and your taxes on interest now outweigh the mortgage interest savings 34 months before you have the funds to pay off the loan. But you pay off the loan in month 126 rather than month 150.

    The “sweet spot” seems to be at 5.9%, when the loan and savings balances are equal, as are the tax liability and deduction savings.

    Interesting. Playing with numbers….but as miguel and Happy point out, the theoretical plan may fail since there are so many variables that can change.

    -Mike

  20. Shay says:

    One thing to keep in mind that the interest rate on you savings account will fluctuate so be prepared to revise your strategy if interest rates fall.

  21. chazzman2000 says:

    The HappyRock has a point on behavior. It would feel great to have the mortgage paid off.

    But…what if in 5 years you were laid off, had a medical condition, or had to take a job that paid you half of what you had today. Would you take $50k in an ING account or $50k off of the $200k mortgage? Your payments are fixed and the banks could care less that you paid them extra money for 5 years. They want their payment on the month and every month until it is paid off. It is also hard to get a home equity loan if you are in these conditions.

  22. Jason says:

    One more thing: interest rates aren’t going to stay at 5.05% forever.

  23. Lisa says:

    The calculations are fluid as is are the markets, interest rate of 5.05% could go up and down, the return on the stock market could change, bull of 1982-1999 vs bear of 1972-1982 (my dates might be off but you get the point). Even tax brackets can change based on income and who is in political office. The only constant for 30 years, unless you pay off early or refinance is the mortgage rate. So your decision numerically might be good for today but should be reevaluated periodically. Also, many people without a mortgage talk about the lifting of burden from their shoulders and a sense of freedom and independence that is worth the difference in returns. This is also a valid piece of input into the decision. Quality of life based on comfort levels for each individual. Sounds life you’ve considered the quality of life and have decided to go with the numbers.

  24. Guest says:

    What happens when the government wipes out the mortgage interest deduction? What if your struck by catastrophic illness and can’t work?

    In either of these scenarios, your theoretical calculations are blown out of the water and you would have been better off with a paid off home.

    I keep seeing the same recurring problem over and over, too many people ignore the most obvious thing: PAST PERFORMANCE IS NO INDICATION OF FUTURE RESULTS. Ingrain this into your head and factor it in to your theoretical calculations.

  25. Trent, how is interest income taxed in the states? If it’s the same as Canada, then you’ll be taxed at your marginal tax bracket. If that is the case, then you are probably better off investing the money in something that is more tax efficient.

    FT

  26. Jacob says:

    This article is just plain wrong. The interest in the savings account is taxable. (Well, *I* can’t get 5.05% interest tax-free, so I assume you can’t either. Actually, I *can* get about 5.4% interest from Vanguard, so your choice of HSBC may be sub-optimal.) So you’re paying 5.875% interest on your mortgage, deducting it from your taxable income, and then investing some of that money at 5.05% interest, which is added to your taxable income. You lose .825% in the process, although you get a tax break on the loss. Silly, or it would be if it weren’t dangerously misleading. I think you should correct this article or remove it.

  27. Don@AffiliateWatcher says:

    Pay off the home. You have to figure risk into the equation and when you do, you’ll see paying off the home makes more sense and cents.

    Don

  28. Yan says:

    Trent, I am a little confused. When do you get to the $197,051.50 number which includes money you save on income tax? Do you accumulate that balance over entire life of your loan (30 years) or half way (when you are over with your monthly $500 deposits)? If former then you will not have $142,249.76 needed to pay your loan balance…

  29. Mike says:

    Trent,
    Real wordy article, but on the money. I have a deep six figure income and I bought a 171K house w/ a 21K down payment at 5.25% rate. I have no intention of paying off my note early as you reapeatedley pointed out, I am getting cheap money and extended tax benefits using the house as a write-off and allowing me to itemize and beating the standard deduction. I use the extra money to fund my 401K and Roth IRA accounts. It’s a no-brainer. I read your article and all of the illustrious comments and 5.25% is cheap money. Again, why pay off a 5.25 when I have been averaging 28.2% in stock index mutual funds in the time (2001) that I bought my home. Thanks for the math lesson, you are right on, but this so fundamental…get some sleep bro.

  30. Mike says:

    Jesus- I just re-read all the comments and and I -am guessing- only two or three repliers own a house.

  31. Mike says:

    “But…what if in 5 years you were laid off, had a medical condition, or had to take a job that paid you half of what you had today. Would you take $50k in an ING account or $50k off of the $200k mortgage? Your payments are fixed and the banks could care less that you paid them extra money for 5 years. They want their payment on the month and every month until it is paid off. It is also hard to get a home equity loan if you are in these conditions.
    chazzman2000 @ 7:41 pm June 2nd, 2007″

    – that’s why you buy disability insurance, esp. if you are single like me.

    mike

  32. jake says:

    Sounds very complicated, but the topic is interesting. I am also interested to see how you answer some of the problems raised by the other comments.

  33. Rob in Madrid says:

    Trent I would suggest a visit to a for fee financial planner/tax planner, someone who knows the tax laws and can give you all the ins and outs of your plan.

    On the other hand (and this is where my wife and I are leaning) a paid for house a guaranteed rate of return, for us 1000 a month in rent we wouldn’t have to pay if we bought own a place mortgage free.

    The other thing is few people are disciplined enough not to spend the money as it builds up.

  34. Maxcactus says:

    I have a gut feeling that our currency value will continue to fall and inflation is becoming more evident. Having a fixed interest rate will allow you to pay off that loan in cheap dollars in a few years. The mortgage can be viewed as a type of investment in that case, a diversification in your investment schemes.

  35. Hmm, I wrote a post about this recently on my blog, but I didn’t really take into account taxes on the savings or investments.

  36. Trent Trent says:

    With all of your scenarios about why it’s better to prepay, you’re all forgetting that you have all that money in the savings account. If the situation changes, just recalculate and see if the situation has become better for prepaying – then empty the account and prepay.

    As for people saying that the money in the savings account is taxable, only the interest is. So, on the 5.05% APY account, assuming you took money out of the account to pay the tax bill, you would still have north of $120K in the account, much better than the $90K you would have otherwise. Plus, if you put the money in a “real” investment, most of it would be long-term capital gains which are taxed at a much lower rate than that.

    I intentionally used HSBC Direct here because we can easily bead its rate – with stocks, it’s much more difficult to bead it. If I just used the Vanguard 500 as an example investment, I could have used the historical return of 12%, had almost all of that gain be long term capital gains, and completely blown away the other choices, but past performance does not represent future returns in equity investments, so that would be kind of moot.

  37. Trent Trent says:

    Yan: it’s at the halfway point. I got that number by adding together the money in the account with just the $500 a month plus the money in the account from dropping in the income tax returns. The true number would be somewhat lower than that (about $180000) because of taxes on the interest of the account.

  38. James says:

    Trent has finally seen the light!

    It is not hard at all to find investments that match or beat a fairly low-interest mortgage rate. And all you people saying “oh it’s better to own the house…what if something happens to you!!”…if you prepay and then lose your job 5 year before you’ve paid off the mortgage, the bank DOESN’T CARE. You still have to make a payment every month of a certain amount, even if you are technically 10 years ahead on your mortgage.

    However, if you had NOT been paying ahead, but investing the difference instead, you’d be able to weather the storm just fine and be able to keep your house.

    Home equity has no rate of return. The assessed value does, but the assessed value of your home is in no way affected by how much is left on your mortgage. Home equity cannot benefit from compound interest. Also, home equity is not that liquid. Be smart…keep as much money out of your home as possible and get it into a liquid, compounding investment where it can actually do some good.

  39. Mark says:

    Hi, I didn’t see a response to the issue regarding the full deductibility of your mortgage interest. If you don’t already, excluding the mortgage interest deduction, have enough itemized deductions to surpass the standard deduction you are not realizing 100% of the theoretical decrease in taxes. To the extent your mortgage interest is what pushes you past the standard deduction, your actual tax savings will be lower. How does that impact the numbers?

    Also, Mike from above is single, has a “deep six figure income” and still funds a Roth IRA. I think it would be valuable if he could explain how he is able to fund a Roth IRA with an income so far above the AGI allowable for a Roth. (Unless I am misinterpreting “deep” as “well into” when it really means “barely”).

    Thanks…

  40. shawn says:

    However, if you had NOT been paying ahead, but investing the difference instead, you’d be able to weather the storm just fine and be able to keep your house.

    Sorry, but this point is a non-starter. Everyone should have an emergency fund and long-term disability insurance to weather those storms whether they’re prepaying or not. In the 28% tax bracket you’re paying roughly 4.14% after taxes on a 5.75 mortgage. You’re only going to make about 3.64% after taxes on a 5.05% savings account. Even if you attained the fabled 12% return on the stock market you would make either about 8.64% at the marginal rate and 10.2% at the long-term capital gains rate. The stock market isn’t worth the risk at only a 6% rate of return IMO. BTW I’m only calling the 12% fabled because it’s not guaranteed.

  41. Tristan says:

    As others have said, you are wrong. You left out risk. What if we have another stock market crash like the great depression? You lose your job, you lose you home because you have no income and your home is not paid for in full. The bank takes it back. You can’t live in your car because you couldn’t make the payments. Your savings is gone and that FDIC that you thought would save you, takes years to reimburse your loss. You are screwed.

    If you had paid for your home you would, at the very least, have a roof over your head. You would have some cash saved at home to pay a years worth of bills and buy a stock of food. You’ve ensured your survival for at least a few months to a year.

    Desperate times came to this country once. They ALWAYS come in cycles and America is overdue for the next one. Risk might be fun on paper but it won’t fill an empty stomach.

  42. Mitch says:

    I think people are forgetting that he’s thinking of this as a “starter home,” not the home he’ll live the rest of his life in. As he hopes to move within ten years, he never intends to pay this mortgage off himself. Instead, he’s saving for the next house.

    If the economy implodes, he’ll have the cash to pay off the mortgage and stay put. If the economy holds kind of steady, he won’t have as much time pressure to sell this house when he finds a house he wants to buy–he could even turn it into a rental property or use it for some other personal or business use (mod zoning). This sounds lower risk to me in the sense that it gives him flexibility in the future.

  43. Getzly says:

    Wow, this post has caused a lot of discussion. The reality is that there’s no one correct action. It depends on the individual’s risk tolerance and the psychological benefit one might derive from owning a home outright. I think Trent is making a good decision for himself. For others, though, it may be a better decision (even if not in purely financial terms) to pre-pay.

    There’s an excellent article on this over at GetRichSlowly. Even financial experts don’t agree on the issue.

    http://www.getrichslowly.org/blog/2007/06/01/ask-the-readers-is-it-better-to-invest-or-to-prepay-a-mortgage/

  44. James says:

    Tristan,

    During the Great Depression the bank could just call you up and say “Hey…we need our money back, so pay us everything you owe now.” …It is now illegal to do that.

    But hey…those of you that think prepaying is the best option, go ahead…the rest of us will let compound interest continue to make us money.

    To shawn: I think you’re neglecting that as he pays his mortgage down, 4.14% of what he owes becomes an increasingly smaller number, while the 3.64% (by your calcs) he’s earning is becoming an increasingly bigger number due both to the additional money he’s putting in and the wonders of compound interest. And it really isn’t that hard to manage consistent returns >6% over the life of a mortgage.

  45. UncleOxidant says:

    Gotta agree with the AMT comment: More and more middle-class people are falling into the AMT category and oddly enough, congress doesn’t seem eager to change that (well, it brings in the $$’s so maybe its not odd). If you fall into AMT you can kiss your mortgage deduction (or a big chunk of it) goodbye.

    After figuring things this way, our current plan is to just put our planned mortgage prepayment into Vanguard index funds (instead of HSBC Direct because we’re pretty sure we can get better than 5.05% APY over twelve or so years in index funds).

    Just remember, past performance does not guarantee future performance (the stock markets have been on a tear for a few years now, don’t expect that always to be the case). Sounds a bit risky to me. I can recall back during the inflating internet bubble years (96 – early 2000) that people kept telling me I was crazy to pay off my mortgage early when I could make so much more money on tech stocks. Sure I dabbled in tech stocks at the time, but only about $2000 worth. We ended up paying off our mortgage (8% interest; rates were a bit higher then) in 1999 and by about 2003 I ended up liquidating that $2000 worth of tech stocks for about $450; some of my friends lost many times that and still have no home to show for it. I suppose the lesson I learned was worth it: Don’t gamble when you can get a sure return by paying off the mortgage early. It was very comforting to know that we wouldn’t lose our house during the lean years of the tech depression (2002 – 2004).

    One thing you could do that would be sort of a hybrid of the two approaches would be to pay an extra full payment or two every year until you’re at least 6 payments ahead. That becomes part of your emergency fund (in case you’re not able to pay the mortgage for up to six months for whatever reason). That way you do end up prepaying some interest and also building up your emergency fund at the same time (still, if it were me I’d do that and also pay an extra $100/month on the mortgage principal).

  46. shawn says:

    To shawn: I think you’re neglecting that as he pays his mortgage down, 4.14% of what he owes becomes an increasingly smaller number, while the 3.64% (by your calcs) he’s earning is becoming an increasingly bigger number due both to the additional money he’s putting in and the wonders of compound interest. And it really isn’t that hard to manage consistent returns >6% over the life of a mortgage.

    It works both ways. The mortgage is compounding as well, so the less he pays off the more interest is going to compound at the outset of the loan. This is why paying a small amount extra on your mortgage easily knocks years off of it. The 6% I referenced was the after-tax spread between the optimistic 12% stock market versus the 5.75% mortgage not the entire return on the investment. Furthermore it’s “easy” to earn the 6% spread when the markets up. What if we hit a large bear market?

  47. guinness416 says:

    I don’t understand why this has to be black or white. We put a couple of nice lump sums into our mortgage every year, and save very healthily. Also, and this may be Canada-specific, the small print in some mortgage agreements doesn’t allow me to pay the whole thing off in one shot as some above say is an option. Boomie’s point at the top, about being sick of still paying debt at 60, is one my parents have also mentioned to me. I think it’s worth listening to those who are a few years ahead of us. As ever, do what works for you! (And to fend off Mike’s sneering above, yeah I’m a home owner).

  48. Ted Valentine says:

    You’re basing this all on sending $100 to the bank to avoid paying the government $25. Think about that some more. There is $75 lost in that transaction you’re not accounting.

    If you want (need) a tax deduction, there are better ways than by giving it to a bank.

    My question is if you really do have this much extra cash a month (after fully funding retirement and college etc) then why do you have a 30 year mortgage instead of 15 year?

    Furthermore, isn’t this counterintuitive to your recent post about paying for all those points? If you can do better in the market, then why did you throw that money on an interest rate and throw away all that potential tax deduction???????

  49. Kristina says:

    Trent,

    All of the math aside (both for and against your perspective), I hope you do not discount your wife’s emotions and views on paying off the mortgage. It’s good to educate her with your numbers, but don’t pound the math over her head or use math/economics to minimize her sensitivities and fears. It’s not all about math. People’s relationships with money are very psychological and personal. Maybe for her, it’s worth having less risk and more financial PEACE to pay off the mortgage early even if this means earning a little less in interest savings. I imagine that a completely paid off house feels pretty nice and secure, and this is worth something to people like your wife. In a case like this where neither choice is stupid or irresponsible, it makes sense to take her needs into account.

  50. paula says:

    Kristina is right. Throw around the numbers all you want, but finances have a huge psychological component. If that weren’t the case, Dave Ramsey wouldn’t be so popular. Weigh the options, make a decision based on what you are comfortable with, and reassess frequently as your economic world changes.

  51. Elden says:

    What is your interest rate on a 15 year mortgage, Usually the interest rate is lower. Run the numbers on a 15 year mortgage and compare again. The monthly payment on a 30 year mortgage doesn’t mean the payment is going to be twice as high as a 15 year mortgage, you may still be able to put several hundred dollars more a month in a savings account and also have a home in 15 years.

  52. ck_dex says:

    I agree with Wall St Journal’s Jonathan Clements on this one: he says pay off the mortgage early and consider the equity in your house as the equivalent of a bond. So from that perspective, paying off a 5.85% interest loan will put you ahead of putting money into a bond fund earning 4.85% (at most right now) on which you are then taxed. That’s assuming that you aren’t someone who throws 100% of his investments into stocks.

  53. dare says:

    I’ve had this exact same discussion with my wife, but with a slight variation to your story. I live in Silicon Valley were the housing prices are in the millions. I’m tired of the rat race and feel we could sell our house and move out to Sacramento. Depending upon the house we may or may not have money left over, but we have a choice to eliminate our mortgage. I’m trying to convince myself however that we should have a mortgage and use the money to invest.

    If we took out a $500k loan (which is what we have now) and use the $500k and diversified it in the market (money market, stocks, foreign, etc..). I still suspect even in bad markets that we will ‘average’ 10%. If we wait 18 months before liquidating any money, we only be taxed at ‘Capital Gains taxes’ of 15%. I haven’t run the numbers yet, but it seems if our mortgage payments are $3.5k/month and the investment would make ($500k base + 75k (after 18 months averaging 10% return with no withdrawl) = $575k * (10% return – 1.5% taxes) = $48.8k a year or $4k a month. I’m still ahead with my mortgage being paid by my investment. This doesn’t even include the mortgage deduction and the fact my loan is paid down. I just have to work an additional 18 months before i could official retire if i choose too.

    Yes there’s a lot of variables, but overall i think i’m not taking advantage that interest of 6% is much lower then my average investments after taxes.

    This article comes close to my idea but does not discuss the idea behind using your low interest rate mortgage to jump start your retirement.

  54. JP says:

    I agree guinness416 – why does it have to be one or the other. If you have $500/month – do a 60/40 split and it seems like hedging against a downturn in the market as well as having equity in the house. This works for me in that I can pay extra on the house but continue to invest. Having invested right before the tech bust I have learned it can always get worse. How many people were thinking after the drop that they wished they had paid down some of their house – or diversified better (but it is easy to get caught up in the “easy” money)

  55. John says:

    Trent,

    One question that comes to mind is what happens to your argument if you make the assumption that at the 15-year mark you put the money you otherwise would have paid in mortgage into a savings account for the next 15 years (the term of your previous 30-year loan)? Your $90,459.22 figure for the pre-payment would be a great deal higher if that assumption is made. Would your choice be different with that change?

    John

  56. George says:

    Trent’s numbers didn’t factor in market appreciation (or depreciation) for the home’s value; the average annual appreciation is 4-6% nationally for the past 50 years, so your investments have to make more than 8-9% to break even. And he ignores the fact that in 5-7 years the income tax deduction will effectively go away due to the itemized deductions being less than the standard deduction (voice of experience!).

    15-yr mortgage is definitely the way to go since you automatically get a lower interest rate. Invest the rest for a few years so that your available funds are increased and you can use that to tide you over any rough times… then consider paying off the mortgage early (or moving). Yes, it’s worthwhile to pay the points if you’re staying in the home more than a couple years.

  57. Jim E says:

    The writers that believe you can’t lose money in
    the stock market must have not been in the market in 2000-2001. The less risk the less return. Basing return on more than 5.0% will increase risk which makes this much more complicated.

    I built my own home with the equity of my previous home and cash on hand. I thought of taking out a mortage to invest but resisted.
    Instead I max out my Roth and make a $20,500 401K
    (this offsets the loss of mortage deduct)
    annual contribution. The house was built on water front property I purchased in 1980 and this is my future retirement home. I have zero debt-keep trying to figure out what to do with my growing bank account balance. Could I use some of my equity to invest – sure – but its nice to not worry about it – or a monthly payment.

    As said before – different answers for different folk.

  58. Brian says:

    Did you forget about the taxes you will pay on the 5.05% interest you are earning?

    There clearly is no advantage. It would be better to pay off a mortgage in 15 years and continue putting your mortgage payment, after it is paid off in savings at that point.

    If you were earning 10-15% then of course it would be advantageous to save the money and prolong your debt.

    IMO

  59. Jason says:

    Forget all the in depth math. The bottom line is you are paying 5.87% on your mortgage, and only getting 5.05% on your CD. So first grade math tells you it’s better to pay down the mortgage. Yes the mortgage is tax deductible, but the CD is taxable, so the two offset each other. Not to mention the peace of mind you get from paying down a mortgage, without the temptation of blowing the 100k on 911 turbo.

  60. Ron says:

    Many of you are unclear on the benefits of tax deductions, return on investment and the return on equity which is there is no such thing as return on equity.

    The return is on the appreciation or depreciation of the home, the equity that you have built up in the home DOES NOT affect the value of the home.

    Two people on the same street each purchase a 200k home. One person puts a big down payment and the other guy puts down a small down payment. NOW which home is more valuable? They are both still only worth $200k.

    This last guy here Jason is totally confused – Tax deductible vs taxable offset each other, not correct.

    So 5 years later each person sells their $200k home for $250k which person had a better rate of return?

    New sales price minus purchase price = appreciation. Now divide the appreciation by the downpayment. You can make up your own numbers for the downpayment.

    While investing does require discipline. Paying off the mortgage faster is going to be very detrimental to you in the long run. Although it seems to make sense that paying less interest saves you money the truth is “SAVING MONEY IS NOT THE SAME THING AS MAKING MONEY.”

    I’ve done a side by side comparison of a 15 year mortgage and after the mortgage is paid off to invest that total amount and

    a 30 year mortgage and investing the difference in payment between the 15 and 30 year payment now.

    End result is you have a lot more money by taking the 30 year mortgage and not paying it off early. You are forgetting the opportunity of that money growing in a compounding interest environment.

    In fact, once you understand these concepts. You will NEVER want to pay your mortgage off and this works for everyone. However, most Americans don’t have the discipline not touch the money.

    Some very good books to help you understand this are Missed Fortune 101 by Doug Andrew, Stop Sitting on Your Assets by Marian Snow and The Lies About Money by Ric Edelman.

    The sad part is YOU DON’T KNOW, WHAT YOU DON’T KNOW and are simply making assumptions without actually having done the math.

    Probably everyone here at one point believed in Santa Clause, the Easter Bunny and the Tooth Fairy, however, as adults we don’t because we have been presented with better information.

    It’s the same thing here, you are being presented with better information. However, as adults we develop this “I know everything attitude” and are unwilling to learn new things.

    The definition of INSANITY is doing the same thing over and over and expecting a different result. How many of your financial situations have improved by going to your job every day and paying your bills? You have to change the equation.

    One guy mentioned the average appreciation of 4-6% yes this is based upon the overall value of the home and the less you put into the home the greater the return on your investment. The more you put into the home diminishes this return.

    However, when you put money into the stock market your return is on the money that you put into it.

    Give me a 4-6% return on the 10k I put into a $100k house any day over the 11% return I can get on the same 10k in the stock market.

    Also, most people ASSUME that by having the mortgage paid down that they can access their equity AT ANY TIME, not true.

    You must qualify to borrow money out of your home and if things have been tough your scores may be down and you may NOT qualify.

    So this means that if you have a smaller mortgage and you lose your job and miss a mortgage payment that you are actually at greater risk of losing your home than some one that has a large mortgage and put all the extra money into savings or investments (they have liquidity to utilize until they get a new job).

    Think….Will the bank lose less money foreclosing on the person with the small mortgage or the larger mortgage? They will foreclose upon the person with the small mortgage if they miss making a payment than the person with the large mortgage.

    The bank will be more willing to work with them in hopes that persons situation will improve and that they will be able to start making their payments again.

    The advice your parents and friends are giving you is incorrect, because they don’t know what they don’t know.

  61. JP says:

    So do all these people who think it is better to invest than prepay still feel that way. Warren Buffet has even said that 6-8% would be a great return in the future for the market – also with the drops the last couple of months – how long would it take to get the 20% drop back?

  62. andy says:

    wow, doesn’t seem so smart now, given the dow jones has tanked -40% in just a few months.

  63. Emma says:

    We have an offset loan and redraw capability on our home loan- does this then make for an easier choice? I pay as much as I can off the home loan, and if I get stuck the bank accepts that credit toward future repayments. Ie, if Im ahead by a few thousand, then I can miss a few thousand worth of repayments. Likewise, if I need down the track, I can redraw those repayments and get an instant ‘loan’ up to my scheduled balance.I did look at this article and wonder if I was doing the wrong thing, if I WAS better off putting my money elsewhere. I also believe a lower loan though when I sell it or an earlier debt free date is worth my weight in gold…

  64. Lee says:

    Hey Trent… how about an update? How is this strategy, which sounded so sensible in June 2007, working out in January 2009? The numbers sounded great, but you neglected the element of risk. Things have changed. A lot.

    We thought home values could only go up, never down. But they CAN go down, and in most markets they DID!

    Most of us didn’t really understand the purpose of equity. We thought equity was just potential profit, or the amount available for a HELOC. Some of us, like Trent, thought equity was just idle money… money that was being lazy. Well, it turns out that equity is also insurance.

    Equity is the cushion when home values shrink. It’s insurance against being upside down in a mortgage when an unexpected move or job loss occurs and we have to sell that home for less than we owe on it, leaving us nowhere to go except foreclosure or bankruptcy.

    Trent’s math was mostly right, but RISK was completely missing from his equation.

    Some said to use any available money to prepay the mortgage, and others said it would be better to invest the money and build up a big rainy day fund. Maybe the best course is to do both… use part of the discretionary money to prepay the mortgage and use part of it for a bigger emergency fund.

  65. JonnyA says:

    Money, money, money!!! You can do the numbers all day, but in the end it’s just money. And home ownership is now a word we used to describe someone with a huge amount of debt, a mortgage. This is not what home ownership should be. If you pay off your home as well as all your debts early in life you will not only feel relieved and happy, but will probably live longer, healthier and stay married. People have a mentality these days that you will just always have a mortgage and a car payment. It used to be just taxes and death, so why burden yourself with debt. No matter how you decide, just make sure that whatever mortgage and debt you have, you should not have a scheduled payment past your planned retirement age. The richest I ever was, was in college. No kids, no wife, no car, and NO MORTGAGE. If I had 87 cents in my pocket it was my 87 cents. With a mortgage the 87 cents in my pocket is just 87 cents less than the $300,000 dollars I owe the bank. Get rid of your debt and listen to Dave Ramsey!

  66. Warren says:

    Wow, so many comments, and recent ones at that for such an old post. Funny thing is, the worst did happen over the past 2 years and I would be interested to hear how Trent fared. I am also looking at mortgage options right now, but aside from interest rates etc, I also factored in inflation. Many people forget about inflation and that their fixed mortgage will actually be much less over time. There payments get cheaper every year. $300 today will not be $300 30 years from now. Factoring in inflation for a 30 year mortgage vs a 15 year mortgage, given that the interest rate on the 30 year is higher, I still ended up paying $70000 less because the fixed mortgage payment will virtually be less every year over time (inflation is about 3.42%). To me, that’s a huge savings. I don’t mind not owning the home outright when I’m 55 if that’s the kind of return I get. The tax deductions etc are just icing on the cake. Just another element to consider. I agree with the people that argued for a mixed approach, it’s always good to have money on hand in case the worst happens and you can’t get that back once you throw it to the bank in a mortgage payment. Plus, equity is basically a loan, what about the interest on that?

  67. Laura says:

    It’s NOT about money–it’s about having a roof over your head and not ending up on the street should finances or situation change. PAY THE HOUSE OFF!

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