Updated on 06.19.07

Prepaying On Your Home Loan Is Just A Conservative Investment

Trent Hamm

One of the regular debates here on The Simple Dollar is the eternal question of whether someone should prepay on their home loan or not. Any time you discuss a particular home mortgage situation with real numbers, someone will always say that it makes more sense to invest it somewhere else, while another person will pipe up by shouting that debt is bad and that you should get rid of the debt.

Indeed, the issue of prepaying on your home loan is a complicated one, because both people above are right. Most likely, there are investments that can put more money in your pocket in the long run if the investment goes well and your circumstances don’t change. On the other hand, getting rid of debt is always a good idea unless your income continues to grow and the interest rate on the loan is low.

What’s the difference between these two scenarios? Risk. Choosing not to prepay and instead invest the money in other, potentially more lucrative options is a relatively risky proposition – you keep a debt load on yourself and you’re putting your money in places where past performance is no indication of future results. On the other hand, you can calculate down to the penny your return on investment when prepaying your home mortgage – but that return is often not stellar.

Among the personal finance gurus, there’s not a consensus, either. Robert Kiyosaki is a huge proponent of leveraging your investments, meaning that he’d likely almost always be in favor of investing that extra money. On the other hand, Dave Ramsey strongly advocates being debt free as soon as possible, so he’d almost always encourage you to get that home loan paid off as soon as possible.

In the end, the correct decision is not one that can ever be determined by running numbers over and over. No set of numbers will ever accurately predict what will happen in the future. Perhaps you will see a bump in salary, or maybe you’ll be tempted to take a lower-paying job that’s a deeply fulfilling opportunity. Perhaps the stock market will boom and you’ll be in excellent shape – or maybe a bubble will burst and almost everything you invested will vanish, leaving you only with your mortgage debt.

If you have extra money and you’re considering what to invest it in, look at the numbers, but also don’t forget to look at your heart. If the risks inherent with investing your money elsewhere makes you uncomfortable, go the conservative route and just prepay your mortgage. On the other hand, if you’ll constantly regret not chasing the possibility of big earnings, then you should be investing that extra money.

There is no right answer for everyone, because a vital part of the equation is how you feel about risk and debt.

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  1. Adam says:

    Oddly enough, my wife and I had this conversation this morning over breakfast. Sometimes I get all “male” and want to use our extra cash to try my hand at investing.

    She, though, likes the idea of owning the house. She thinks it is smart to have everything, including the house, in our name…just in case.

    …I think she’s right, by the way.

  2. martha in mobile says:

    I have often wondered about this. I have a relative who has refinanced a few times to get the equity out of his home (the appraised value of which has increased five-fold over the past 20 years) because “it’s the cheapest money he’ll ever owe.” I, on the other hand, pay ahead on my relatively small 15 year mortgage because I want my house paid for by the time my daughter starts college. I guess it’s all about risk-tolerance.

  3. I suppose either decisions comes down to your views on debt and your risk tolerance. Personally, perhaps to my detriment, I’d lean towards investing if my rate were less than 8%.

  4. Allison says:

    I think another factor is how long you plan to stay in your house. The reason I have decided not to prepay is that we are planning on selling and moving in a few years. Since I will never totally pay off this mortgage, I don’t think it makes sense to prepay.

  5. alex says:

    Pre-paying your mortgage reminds me of the risk-averse guy who invests for his retirement by investing in savings bonds. Years later, when others have millions more than him, from having invested in a diversified portfolio of equities at least he will be able to say “it was just a conservative investment.”

    Don’t ever forget opportunity costs, sure you may be making 4 or 5% (after tax) to pay down your mortgage, but what opportunities are you giving up?

  6. Kevin in NC says:

    The opportunity costs are often too high to do it.

    Often times it just isn’t good capital allocation to pay down the debt. On some occasion it might make sense….not always.

  7. Brandon J says:

    In my personal finances we learned that there are two sides to an individual. One side is the financial side. The financial side would look at the situation and say that putting your money into stocks instead of paying down the loan would be better (unless your loan APR was higher than 10 – 12%). The other side is the personal side of finances. The personal side would rather be debt-free and have the emotional security that is involved with owning a home…the whole home.

  8. Tordr says:

    I have only read one investment book, but it had one good advise about loans. That was to view loans as negative investment in fixed (variable) interest bonds. So if you want risk or feel that the stock marked is going up, you stay with a negative investment in bonds and invest in stocks. I on the other hand have a more conservative investment strategy and I am not so bullish on the stock marked. So I will invest my money where I get the biggest risk free return, and that is to pay down my home loan.

  9. It really comes down to risk tolerance. But another good indicator is your current interest rate. If you’ve got a low rate locked in for 5+ years, you’re essentially borrowing money to invest at a low rate, and with the tax write-off benefits of the interest, your rate is lowered slightly as well. To get the maximum return you’ll have to invest in areas that minimize your tax obligations.

    It comes down to risk tolerance, desire and ultimately your values. I’m 23, motivated and aggressive. I want to retire before 40, therefore I leverage my assets and try to get a maximum return. But paying off your debt does have benefits that are psychological. You’ll alleviate the pressure of having to pay the mortgage every month and with that monkey off your back that may allow you to focus on building wealth elsewhere.

  10. MB says:

    A few years ago, on a local NJ realtor’s web site, there was a calculator into which you could input your mortgage balance, rate and years left and then enter a dollar amount in extra principal payments and it would spit out when your mortgage would would be paid off and how much total interest you saved. I cannot find a similar calculator anywhere … not even on yahoo finance. Do you happen to know where I can get this?

    PS: I just round up my mortgage payment to the nearest hundred … the amount $72 is really not enough to invest seriously, but I’m able to pay off my mortgage a little more quickly without missing the money. (I budget in round numbers too and have also rounded up all car payments, thereby paying off my cars about 6 months early.)

  11. lorax says:

    Risk tolerance is exactly right.

    I like to calculate a mortgage as a reverse bond. Think reverse GNMA!

    But it’s also something like buying stocks on margin, where the margin loan collateral is your house, not stock. The analogy isn’t perfect, for instance you won’t get marked to market with your mortgage. But you are taking out a loan so you can buy stock. Would you buy on margin after you retired your mortgage?

  12. indy says:

    MB – there is a calculator like the one you asked for at bankrate.com. Click on calculators and then click on mortgage payment calculator. There are fields to enter extra monthly principal payments, annual payments or one time payments.

    I am 2 months into a mortgage @ ~ $1360.00 a month. (30 yr fixed). I calculated the effect of paying $40 more each month towards the principal. The loan gets prepaid 25 months earlier – saving about $34000.00. Now when i calculate the cost of making the extra $40 payment for 335 months and compounded interest at 4.9%, it is going to cost me $28700.00. So, at the end of it all, I’m going to save $5300 over 30 years. Doesn’t seem like that good a deal to me (assuming int rates stay the same).

  13. plonkee says:

    To me its psychologically different to taking out a loan to buy stock, its more like renting and investing in the stockmarket.

  14. gaylej says:

    I would say that fully funding your 401k and Roth IRA before paying down a mortgage makes sense. Then pick out an amount that you feel comfortable with as extra money toward the mortgage and automate that payment. For fun and information go to a calculator site and figure out various scenarios. Then you should invest a regular amount in a good mutual fund until you have accumulated enough knowledge of whatever market you are interested in to actually make a profit. Prioritize your investments and put effort into learning as much as possible before you put money in.
    Do not ever take money (equity) out of your house for investment purposes. My now exhusband did that and that is why I own the house and he had to sell his “investments” at a 50% loss to buy stuff for wife #2. Nuf said.

  15. Bill says:

    I’m glad Trent mentioned risk – paying down a mortgage versus investing in the stock market are not even close in terms of risk level.

  16. Lisa says:

    As long as my home is the roof over my head and that of my child I prefer to have little to no risk and have no mortgage or a mortgage so low that I pay it on a very small income. Once you have a tiny mortgage or no mortgage you have alot of money to invest and risk. If you have no CC debt/school loans, you can pay your house off in about 5-7 years. With that done and the freedom it brings you will be amazed at how your investing takes off. I was able to invest 40% of our pre-tax income. It starts to add up fast and snowball into alot of money. Imagine where you would be if in 10 years you have no mortgage and for 5 of those years you had put 40% of your income into investments. Feels real good doesn’t it. I bet its alot of money.

  17. Eric says:

    Nobody has yet mentioned “The Paradox of Choice”. The reality is that the more possible investments you have the less likely you are to actually invest. Give people a simple option ( pay down all debt first ) it a risk free conservative investment that lowers your long term risk. Then placing your excess capital into the market in the form of a few, low fee investments leaves you better off that probably 50% of your peers.

    Remember that when it’s all said and done what other investment can you live in and when you sell it take the proceeds tax free?

  18. Rick says:

    Here’s Ben Stein’s take, fresh off the presses. I’m sure Trent will cover this in one of his Morning Roundups.


  19. boardmadd says:

    I’ll admit to having a bit of a Ramsey bias :), but he said something that really made sense to me. When a caller asked him about investing vs. paying off the mortgage, he asked if he would be willing to go to the bank and take out a loan to buy mutual funds or stocks. The caller said no, and when asked why, the caller replied “because that would be too risky”. Ramsey’s reply was “well, when you carry a home mortgage and invest, you’re effectively doing the same thing”. That got my attention. Mathematically, I suppose I could invest some of my money and get a better rate of return, but there was no guarantee of that. However, if I paid off my home loan, I would have our house free and clear. Seeing as I have every intention of staying here a long time, I decided that that made the most sense in my world view, so that’s exactly what we did. Now that the house is totally ours, and there is no house payment, we are taking our original house payment, plus whatever extra we can scrape together each month, and investing the entire amount. We will continue to do so each month for the next 21 years (to match our original loan schedule). I’ll let you all know then how it worked out :).

  20. deRuiter says:

    Prepaying the loan the first five years gets you the biggest bang for the buck. Prepaying after half or more of the mortgage is over nets you a smaller return. Get amortization schedule. Look at early payments, tiny amounts of principle, large amounts of interest. If you make one principle payment early, you never have to pay that large amount of interest attached to it as you would if you pay it as a regular payment.

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