Should You Overpay On Your Mortgage?

Recently, I had an email exchange with a reader about whether or not they should overpay on their home mortgage or take that overpayment and invest it. I spent some time with Excel and Bankrate.com’s mortgage calculator and I made a few interesting discoveries. I don’t want to bury you in numbers, so I’m going to minimize them in this discussion; you can verify the information here pretty easily with Google Spreadsheet and Bankrate.com.

I work best with examples, so I started out with a 30 year home mortgage of $200,000 at 6.25%. I wanted to figure out which was the better deal: investing $300 a month or paying $300 a month extra on the home loan. I assumed that the borrower was in the 28% tax bracket, so I took the value of the tax deduction and invested it or paid towards the mortgage, depending on the goal. Let’s also say that when the pay ahead plan pays off the house, they begin investing the full payment plus the extra $300.

What did I find? It took an investment return of 5.92% to match that of the value of paying off the mortgage early. In other words, it is in fact true that a good investment can make you more money than paying off a home loan early.

There are, however, one big factor to consider. Investing that extra money instead of putting it into the mortgage introduces an extra level of risk. In essence, you’re taking a home loan and investing the money from it if you choose to invest ahead. You’re investing when you have a significant level of outstanding debt. Never forget that outstanding debt is a significant risk, particularly if you do not have emergency funds to pull you through. If you do not have investments already before you begin paying off the mortgage, the extra risk simply isn’t worth it; using your home as collateral so you can play the market is not a healthy situation.

In short, you might get ahead using a home loan to invest if you already have a significant emergency fund and other assets. If you’re in this situation, you’re likely already living fairly frugally, as you’re not stretching your funds to pay for your home as many Americans do, so you’re probably not interested in such a scheme anyway.

The key here is risk management, and your home is not something worth risking when you can just get a 5.92% return (or so) just by paying ahead.

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  1. Kevin says:

    You might find this article interesting.

    I don’t agree with everything that he says… but it kind of goes along with your thoughts here. You make a good point about the risk, but what if you put the money in an ING/HSBC account earning 4.35/5.05 APY? Sure, it is less than the interest on the mortgage… but the key point of the other article is that a mortgage is a loan on your income, not your house. If you have $50,000 in equity in your house and lose your job with no savings, you can’t get a HELOC to bail you out while you find a job. You’re screwed.

  2. Don says:

    Here’s an interesting read, I think I found it on AskMetaFilter. On why you shouldn’t pay your mortgage early or extra.

    http://www.ricedelman.com/planning/home/rule21.asp

  3. Bill says:

    Ric Edelman’s article has a point, but for me the math doesn’t work. I’m too risk averse for that.

    Sure, I COULD invest the extra money I send to the mortgage, but A) I plan to move in other 7-10 years to a bigger home, so I need equity somewhere for that house (he’d say invest it, but what if I lost it?) and B) to get better than a 6% return my risk is generally too high. He’s also assuming that I’m never upside-down on a house, which is unusual, but it could happen.

    So I’ve struck a balance between the two… I’m close to having enough equity to ditch my PMI and I’m going to start investing an equal amount in investments.

    Ultimately Ric forgets that on top of a mortgage, a lot of American are in credit card debt up to their eyeballs. Sure he says 6% is better than 18% interest, but he doesn’t acknowledge that a lot of people have both of those plus a car payment.

    And one last thing about owning a home… if dire straights ever stuck me and my emergency fund was spent, I could always sell the place, take my equity and rent for a good long time.

    For me personally, I have one thing for Ric, “Face it. You’re beaten.”

    Trent, good work as always. I think my vision, much like yours, of owning a home outright and having my income able to go to whatever I want is a solid one.

  4. Phil says:

    Well, according to Edelman I did the wrong thing by paying off my 15 year mortgage early (back in 1999 after 9 years), however, I don’t agree with him at all. First off, it is possible to lose your home for not paying your mortgage. Yes, it can take several months for the lender to jump through all the hoops, but you are not totally immune from foreclosure as Mr. Edelman seems to want you to believe. I know of a case where the borrower was about five months behind and the bank was going to sell the house and keep all the proceeds (no equity for you!). The borrower was fortunately able to sell in time, but it was down to the wire.

    In my case in the late 90′s everyone was making money in the stock market (or so it seemed) and people told me I was nuts to pay off my mortgage early when I could get such wonderful returns on tech stocks. My reply was that I couldn’t live in stock certificates. Now in my case the mid-to-late 90′s were very good. I’m a software engineer and in addition to paying extra on my mortgage I did a little bit of investing as well. In 1999 the house was paid off. In 2001 I lost my job. In 2002 I was able to find work that lasted for 3 months. In 2003 I only worked the month of December. The tech depression was quite deep where I live. Had I not had my home paid for it’s quite possible our family could have been living in our car. It certainly helped our savings to last longer not having to pay a mortgage payment and I had absolutely no worries that my house would be foreclosed on – it’s difficult to put a pricetag on peace of mind.

    Oh, and those tech stocks I dabbled in in the late 90′s? By 2002 most of them were worth a mere fraction of what I had bought them for – in a couple of cases it would have cost more to sell them than what they were worth. I’m fortunate that I didn’t dabble much, but I knew people who lost a substantial amount. So the lesson is that you shouldn’t become overconfident about your investment abilities vs. the solid 6% (or whatever your mortgage rate is) that you can save by paying off the mortgage early. Given the recentness of the tech depression (from 2001 through 2003 or so) I’m surprised that this Edelman character is able to give such reckless advice – short memory I guess.

    …oh and one more thing: Edelman assumes that incomes will continue to rise like they did for his father from the 50′s through the 80′s when he was paying $58/month for a mortgage. However, those years were mostly pretty good for the American economy (the 70′s excepted). The US still had lots of good-paying, family wage manufacturing jobs where a person with only a highshcool education could support a whole family on one income. Those days are long gone – it takes 2 incomes now and if things keep going the way they are parents will start putting their kids to work. Incomes aren’t rising anywhere near as fast as they used to. By some measures incomes in the US have been stagnant since the late 90s.

  5. I think Kevin has a point. Once you pre-pay your mortgage that money is gone. If you lose your job and can’t make next month’s payments too bad, you are in default. However, if you save your pre-payments elsewhere, even in a mutual fund, if you lose you job, you can cash that mutual fund to buy some time to get you through – even if the fund is at a loss at a time at least you don’t lose your home on top of a lost job.

    Furthermore, while paying off your home is a riskless investment, there is “virtually” no risk in a property diversified portfolio over a 30 year span. I say “virtually”, because there’s always risk in the market, but I don’t believe there’s been a time where a diversified portfolio has lost money over 30 years. Typically you’ll make another 1-3% in the market vs. your home mortgage. That might not seem like much, but compound it over 30 years at big numbers like 200K and it will add up.

  6. Bill says:

    “However, if you save your pre-payments elsewhere, even in a mutual fund, if you lose you job, you can cash that mutual fund to buy some time to get you through – even if the fund is at a loss at a time at least you don’t lose your home on top of a lost job.”

    Lazy… that’s the point of an emergency fund in savings, it will float you for 3-6 months. During that time you can make the decision to sell the house and pull out all of that equity that is supposedly “gone.”

  7. Kevin says:

    Good discussion we have going on here. All I am saying is would you rather have:

    A.) $50,000 in equity
    B.) $50,000 in a savings account or, as mentioned by Lazy, in a highly diversified portfolio

    If you lose your job, you’ve got that 3-6 month emergency fund. You decide you are going to have to sell. Have you noticed the housing market recently? What if you can’t sell? What if you had to sell at a $50k loss just to sell? That $50,000 pays your mortgage for a long time.

    The mention of tech stocks and the tech bubble also seems to make the assumption that you would have your whole portfolio in tech stocks. Again, as Lazy mentioned, a diversified portfolio would not take as big of a hit.

  8. Phil says:

    There seems to be an ‘either-or’ assumption here: either you’re paying ahead on your mortgage or you have an emergency fund. Actually being 3 to 6 payments ahead on your mortgage could be considered an essential part of your emergency fund and making those extra payments early on in the life of the loan can shorten the length of payment time significantly (who wants to pay a mortgage in your retirement years?). You can have an emergency fund and be paying extra on the mortgage.

  9. Bill says:

    Phil good point… and if you’re really lucky you can be doing all three… paying ahead, investing and saving.

    Kevin… I get what your saying… as for the housing market, depending on where you are, it’s soft. But, it’s soft because people started playing the “flip” game and thought they could make tons of money. Those people are in trouble under my scenario, because they could end up upside-down on their home. I know that if I needed to get out of my house, I could price it to sell easily and still take plenty of profit. Maybe not as much as if I could wait 3-6 months, but I’d be fine.

    That’s just my personal situation though, so I realize it doesn’t apply to everyone out there.

  10. phil says:

    Lazy said: “Once you pre-pay your mortgage that money is gone.” Edelman made a similar point, mainly that a mortgage is a loan against your income and if you don’t have any income you can’t get a 2nd mortgage on your house to tap the equity. However, couldn’t a similar argument be made about 401K contributions? The argument being that once you contribute to a 401K that money is tied up until you reach your retirement. You can only borrow against a 401K if you are employed – if you lose your job, your previous employer will not give you a 401K loan. So is contributing to a 401K a bad idea? I would tend to think that prepaying one’s mortgage can also be a way to plan for retirement when cashflow will be lower and not having to pay a mortgage payment will be a welcome relief.

  11. Jeremy says:

    The way I see it is this: If you mortgage rate is 6%, paying it down is basically an investment with a 6% guaranteed rate-of-return, TAX FREE. Where else can you get that, outside of a Roth IRA? Not many places.

    I’d make sure I had at least 6 months of emergency funds in a high-interest savings account before I started paying down the mortgage.

    I treat extra payments against my mortgage as part of a portfolio of monthly investments (including stock mutual funds, CDs, and 401k). The way I see it, the tax-free returns on paying down my mortgage rival the returns of stocks in my taxable accounts.

  12. LH says:

    Lazy, Your logic is flawed. Eliminate revolving debt, build reserve, max 401k contributions, then pare down mortgage. Suggesting that prepaying your mortgage as a form of retirement savings is ignorant. Pre-tax dollars are ALWAYS the way to go when saving for retirement.

  13. Trent says:

    “Pre-tax dollars are ALWAYS the way to go when saving for retirement.” That’s way, way off. That’s only true if you believe that interest rates won’t go up and that you’ll be in the same or lower tax bracket in retirement. A cursory look at long-time income tax rates shows that they’re currently at all-time lows since the introduction of the income tax.

    If in 30 years the income tax rate has gone up even a little, then putting pre-tax dollars away in a 401(k) versus paying off a mortgage early will look like a very bad idea.

  14. m says:

    I love it when people disagree on this subject. I spent the last 3 years working a ton of overtime to get my house paid off, (the house was mine before we got married, hubbys name was not on the house) someone offered to buy it, our area is going commercial, which wasn’t the case 15 years ago when I moved in, they needed our property to expand. So here we were with a delemaa, should we leave a house that could be paid off in a year and end up living in a commercial zone or move on. After much soul searching we decided to move on, no we didn’t get a ton of money, our house on it’s own wouldn’t be worth much with out the larger property next door if we were to put it on the open market, there were no realtor fees, no open houses, no strangers walking through during showings, and they would take it as is, so we figured we gained at least 7% by not having to pay realtor fees and more by not having to make repairs after inspection. But by putting extra down on the house, not only did we save on intrest we had more to put down on our new house. So will I start the cycle all over again and pay more on the new mortgage, you bet. When we take out our 30 year loan, we will have it paid off in 9 years saving $170,000 in interest (I used the Dave Ramsey calculator), I will be 51 years old and debt free. Yes we max out our retirement and we have started investing in stocks, so when retirement comes a few years later we will be set and trained to live on what we live on now. I was brought up “owe no man, because he then owns you”. The mortgage will be our only debt and if one of us loses their job, we can stop paying extra if necessary, I have to disagree with Trent on being “way way off” on the idea of Pre-tax dollars are always the way to go. In our case those pre-tax dollars, as well as the medical savings plan have saved us a fortune in income taxes, we don’t have any deduction as there are no children and you can’t deduct Vet bills as medical expenses.
    Very few people will have someone come knocking on their door offering to buy their house like we did giving us our chance to buy a great house in the country with a few acres. But if I hadn’t put so much extra down every month with the goal of paying off the house (the only reason I worked all that overtime), when those people came knocking we wouldn’t have had the option to move at all.

  15. Jessica says:

    What about paying down the principal on your mortgage while building up your savings at the same time?

    My mortgage is a monthly plan paid biweekly. Because of this I am able to keep more money in savings and actually build an emergency fund while paying it off at the same time.

    My husband and I are also prepaying on the principal on our mortgage. I have to agree with the poster that said a paid off mortgage equals peace of mind, as you have a place to live should something go wrong.

    I personally think that the only time you should invest is if you have an emergency fund in place and all of your debts are paid off to include your mortgage.

  16. Maury says:

    Wow, I’m amazed at how much bad financial advice there is in the comments. I don’t have time to correct it all, but suffice to say… Edelman is right. There is a reason he is paid to write while anyone can comment… : )

    People make comparisons not based on apple to apples. For example, the guy who compared putting money toward a house to putting money into the tech market in the late 90s… not apples to apples at all and a completely misleading and outright wrong post. It’s a straw man argument that appears to make his point, but the math doesn’t back him up.

    FYI, this is a 30 YEAR loan too. People think short term. Think about this for a moment. Even if someone did invest their extra monthly mortgage payment into ONLY the tech market… do you think technology companies as a whole will appreciate less than the 4.5% per year over the next 30 YEARS. (Because, if you are paying 6% on your mortgage and you get a tax benefit for paying interest those extra payments are earning in essence 4.5%)

    Also, the guy who said Edelman is wrong because people have credit card debt and car loans made the WORST possible argument I have seen.

    In essence, that poster is saying instead of paying off his credit card debt or car debt, you should put extra payments towards your house. I don’t need to point out to the people on this blog how stupid it is to borrow at 18% to invest at 4.5%….

    Trust Ric, he knows what he is talking about.

    Also, as for the risks of investing in the market, over the long term, they are pretty much nil.

    There has been no 10-year period in the previous 50 years that has resulted in a loss in the S&P 500. If you look at ANY 30 year period (the length of the mortgage) the results typically destroy the 4.5% return you would get by paying off your house early.

  17. vern says:

    Gee, all of the ‘experts’ who said you shouldn’t pay off your mortgage early have been pretty quiet these last couple of years haven’t they?!

    By ignoring these bozos I’ll be paying off my home loan this April. Thats 12 years on a 30 year loan for anyone keeping score. (The real estate bubble won’t affect me because I plan on keeping this house.)

    Don’t listen to the snake-oil gurus…”Paying off your home loan is only 6%, if you put that money in the stock market you’ll earn 10%.” Go your own way and do what you know is right.

    Oh yeah, read a little about the Dutch Tulip craze too while you’re at it!

  18. deRuiter says:

    Phil #8 “Actually being 3 to 6 payments ahead on your mortgage could be considered an essential part of your emergency fund” No, Phil, NO, NO, NO! You don’t want to pay 3-6 PAYMENTS early, that’s wasting money. You want to prepay on the principal. Especially the first third to half of the mortgage, the investment for paying a few extra dollars on your mortgage each month is enormous. The older the mortgage is, the less beneficial it is to prepay on principal. Where can you pay the amount of principal on the next loan payment, AND SAVE THE ENORMOUS AMOUNT OF INTEREST ON THAT NEXT PAYMENT?

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