Recently, I mentioned that I encouraged people to invest instead of paying ahead on their mortgage. It left me thinking quite a bit about debt repayment and how I should handle my mortgage.
Our situation My wife and I are planning on eliminating our student loans in the next year to a year and a half, leaving us with just our home mortgage as a debt. Our plan has been to eliminate that debt as a top priority, probably via double payments on the mortgage – our plan is to be debt free by the time our son has his thirteenth birthday and then build a home in the countryside.
What double payments on a mortgage does On a thirty year mortgage of any size, making double payments each step of the way reduces the payoff date from thirty years down the road to nine years and two months down the road. It truly does make that kind of impact.
The best way to look at it is to look at your advance mortgage payments as an investment with a certain rate of return – a rate equal to the interest level on your mortgage. So, if you have a mortgage at 5.75%, an advance payment on that mortgage is basically an investment of that money at a 5.75% annual return. Most importantly, though, one should look at these returns as being after taxes (because, for most people, there isn’t enough interest there to create a huge benefit for itemizing versus taking the standard deduction).
Obviously, to beat this we would want an investment that could reliably return more than 5.75% after taxes per year over a ten year period. If you look at the returns on various index funds, like the Vanguard 500, you’ll see that since their inception, they’ve seen returns of over 12% on average. If that would persist over the next decade, one would definitely be better off putting their cash in such an investment than in the 5.75% mortgage.
The other factors This argument would seem to lend itself towards investing the money, then withdrawing it to pay off our mortgage in one swoop when the time comes. However, it doesn’t take into account several other factors that are worth looking at.
The variability of the market Past performance is never an indication of future returns. You can never just assume the stock market will do what you want. The next ten years could be utterly painful on Wall Street, or we could see another economic boom. My personal feeling is that 2008 will be rough, but the election of a new president will bring about a mini-boom, but even I take that with a grain of salt. The variability of stocks is a risk – is it a risk worth taking?
Flexibility With the money in a taxable investment account, it is accessible if I ever need it. If I prepay on the mortgage, the only way that money is accessible is if I take out a home equity line of credit. Let’s say I wish to buy a car. By having the money in the account, I have the flexibility to just pay cash for the car or to take out a loan on it, whichever makes more financial sense. It also serves as a giant emergency fund in the event of job loss or something else disastrous.
Willpower This is a lesser concern, but still significant. Having a significant amount of money just sitting there in an investment brings forth a desire to spend it. Do I have the willpower to resist it? I believe I do, but that doesn’t mean that when I have $50K sitting in an investment account I might not feel differently.
My conclusion The higher your mortgage interest rate is, the better it is to pay in advance instead of investing it. Where’s the cutoff line? It depends on a lot of things, but the big one is your risk tolerance – if you’re fine with a chance for a down market in exchange for a very good chance of being able to pay things off earlier, then it’s probably for you. Prepaying on your mortgage is very steady and reliable, but investing gives you the chance to hit a real home run and become debt free earlier than you thought possible.
For us, this possibility plus the liquidity of the money if we needed it has convinced us to put our money into an investment account instead of prepaying our mortgage, something we’ll likely begin to do by the end of the year.