This has been one of the debates that have existed though the ages. It’s right up there with “Is there life after death?” “What’s the meaning of life?” and “Should I have children?”
The questions about a mortgage are relatively easy: Should I get a 15-year or 30-year mortgage? Should I prepay my mortgage? I would have to say if you currently own a home or are looking to buy, get a 30-year fixed mortgage.
At least at this current time in history, getting a 15-year mortgage or prepaying any 30-year mortgage is foolish. I make this statement with these assumptions:
- You plan to stay in the home for at least 10 years.
- You and your spouse are younger than 50 years old.
- The monthly costs to own your home are less than 30% of your monthly income.
- You have 25% or more equity/downpayment for your home.
- Any difference in savings from prepaying or having a shorter, 15-year mortgage will go into investments.
- The home you purchase is an average–sized, 2,000-square-foot home and not some McMansion.
- You are a disciplined saver and don’t carry any consumer debt.
There are two opposing camps to the mortgage argument: Ric Edelman and Dave Ramsey.
You will not see me state, like Dave Ramsey, that all debt is the work of the devil. In our current economic environment, I tend to agree with Ric Edelman. Mortgage rates are at historic lows, and affordability is at near all-time lows. In plain English: It’s cheaper to own a home than rent in many parts of the country.
Here are the reasons you should get a 30-year fixed mortgage:
1. A Home Is an Illiquid Asset
A home is a very illiquid asset. If you are buying a home, it’s for the long haul of 10 years or more. Once you make payments into a home, it’s much harder to get cash out. Yes, you can refinance or get a HELOC but only if there is enough equity in the property and you have a job.
Let’s say you lose your job. If you followed the Dave Ramsey route, in many situations, you haven’t paid off your mortgage yet, have very little investments, and should have at least some emergency savings. You would have considerably less savings via Dave Ramsey’s method than if instead you followed Ric Edelman. The money within your home will be very hard to tap, and you could wind up foreclosing on your home anyway. This is the exact issue Dave Ramsey is suggesting you avoid by eliminating your debt. This proves my point of cash flow is more important than net worth.
The problem with putting most of your money into your home simply comes down to asset allocation. As we’ve found during the housing bubble, too many people had too much equity in their primary residence. Your home should not be a primary part of your net worth. If anything, it should be less than 1/3 of your total net worth. You should have much more liquid assets you can tap into should an emergency arise.
2. Your Primary Residence Is not an Investment
Robert Kiyosaki made this statement in his book “Rich Dad, Poor Dad“:
“As we’ve found out during the real estate bubble, your primary residence is not an asset. Your home is just a place to live. I’ll go out on limb to state it’s no different than renting, but with some advantages. Typically, it’s recommended to buy a home only if you will live at the same location for 5 years or more. I suggest an even greater period of 10 years or more. Otherwise you are usually best to rent instead. Owning a home for 5–7 years is too risky. It’s too much equity to have stored in one asset, and it can be difficult to sell when you need to move.”
3. Best to Invest Instead of a Shorter-Term Mortgage
This is perhaps the biggest fallacy from Dave Ramsey. With current mortgage rates in the sub-4% range, you are at or below the average rate of inflation. In addition, over the long haul, stocks average 8% annually. So in effect you are using leverage of a low fixed-rate loan to invest the difference in the stock market.
Let me give you an comparison: Two homeowners, both of which have a mortgage of $300,000 and both live in their home for 10 years. Let’s not take inflation into consideration for this example.
- Suze Shorterm — Suze gets a 15-year mortgage at 3.25%. Her monthly payment is $2,108.01. After 10 years she will have $116,592.72 left on the mortgage balance, or $183,407.28 in equity. She did not invest any money into the stock market, but instead used it to shorten the term of her mortgage.
- Ivan Investor — Ivan gets a 30-year fixed mortgage at 3.75%. His monthly payment is $1,389.35. After 10 years he will have $234,334.89 left on the mortgage, or $65,665.11 in equity. Ivan took the difference from the 15-year mortgage ($718.66), and invested in the stock market. Assuming an average of 8% per year for those ten years, he will have $131,476.00 in the stock market after 10 years.
So, in total, Ivan comes out ahead. In ten years he will have $197,141.11 in total equity, whereas Suze has $183,407.28. Keep in mind this is after only ten years and gets much more obvious the longer you go out.
Let’s assume both lived in their home for 15 years. Ivan comes out even farther ahead, with $357,636.18 of equity and investments versus $300,000 in home equity and no investments that Suze has. Is approximately $57k worth the difference in risk? I think so and would go with stocks instead.
If your mortgage rate was similar to the early 1980s when 8%–10% APR was not uncommon, you would be best to prepay your mortgage. This is because it would be very difficult to find fixed-rate investments or stocks that could beat that amount every year. Right now cheap credit is available, and it is best to use it to your advantage.
4. A Mortgage Is Tax Deductible
This assumes you itemize your taxes. We just refinanced our mortgage at 3.75% APR, but the real rate after the tax deduction is much lower. Bankrate.com has a great calculator to get your real mortgage rate after tax deductions. In our case our real rate is 2.59%. The higher your tax bracket, the lower your effective mortgage APR. When you live in a high-tax state, it makes even more sense. In our case it is also “free” money in terms of real dollars when compared to the average 3% rate of inflation.
In addition, even in this low interest rate environment, it is still possible to beat this rate with fixed income investments. However, since this is a 30-year time frame, you should be investing (to compare apples to apples) with a 60%/40% asset allocation. Historically, that mixture of stocks/bonds has returned 6% before inflation, or 3% annually after inflation.
Obviously if the government removes the tax deduction as some have suggested, the effective rate would go back up to 3.75%. This is still an excellent rate and still relatively easy to beat by investing.
5. You Will Always Have House Payments
One of the more common emotional reasons I hear people want to eliminate a mortgage is getting rid of the monthly nut. They state they want to own their home free and clear! Is that really true though?
The fact of the matter is even after your mortgage is completely paid for, you always have other expenses: property taxes, insurance and annual upkeep. So you will always have expenses to pay, and these aren’t cheap either. If money was tight, just try to stop making property tax payments. Do that and you can expect to see the tax man at your doorstep. So while it’s true the amount paid out each month will decrease once the mortgage is paid off, considering inflation, it will be just a small portion of your monthly expenses. Individuals, and business for that matter, get into trouble with lack of cash flow, not a huge amount of illiquid net worth.
How many readers have parents who paid $30,000 for their home in the early ’70s where their monthly payment was only $220/month? Property taxes, insurance and upkeep expenses all increased at the rate of inflation. If you have a fixed 30-year mortgage, your payment amount remained the same.
In some cases these expenses increased much more than the average rate of inflation. For example, where I currently live, Nassau County, NY, I pay almost $10,000 annually for a 2,000-square-foot residence. Let me remind readers that Nassau County is broke, and more than likely will have to raise taxes even higher to meet its budget gap. You can expect taxes to go up nationally, as most municipalities have a shortfall in revenue.
Dave Ramsey makes the assumption you do not have the willpower to invest the difference saved. If you are one of those lost souls, then more than likely you shouldn’t invest. Dave takes it one step further and suggests you pay cash for you home.
“But think how much fun that would be! No mortgage! No payments! If paying cash for a house seems too far out of reach, you can still buy a house if you make wise choices.”
Dave is all about the amount saved in mortgage interest. If we had zero percent inflation every year, Dave would be absolutely correct. Unfortunately, with inflation, the mortgage gets cheaper every year in real dollars.
Final Statement
Of course I make the assumption we will have at least the same rate of inflation we’ve seen the prior 30 years. Let’s say we experience a massive bout of deflation, what then? Doesn’t my statement make this a foolish idea? No, not really. You can start making prepayments on your mortgage at any time. My point is once the cash is within your home, it’s much harder to take it out. Assuming you have been investing, you could use your investments to prepay or pay off your mortgage at any time. Do keep in mind the Federal Reserve wants inflation at any cost. It’s been said they will drop money from helicopters, to generate inflation if they have to.
For me, the only valid reason to completely payoff your mortgage at the current interest rates is because you have retired. Even then, depending upon your investments and net worth, it still might not make sense.
Comments
Unless you are particularly well informed and somewhat mathematically inclined, it is probably best to consult a financial advisor. Perhaps a friend can recommend a good one. Do not just pick one out of the phone book (if anyone even has a phone book anymore). Taking a 30 year fixed rate loan when rates are at historic lows opens up many possible opportunities to improve you financial health. There are relatively complex relationships between income, investments, taxes, inflation rate. Speaking for myself, I have a $182,000 on my mortgage with a fixed interest rate of 3.25%. I also have that much money sitting in investment accounts, so I could easily pay of my mortgage. I am in the 25% tax bracket, and I itemize deductions. That means I am really only paying around 2.44% interest rate on my mortgage. My invested money has returned over 7% already (after taxes), just this year. Not paying extra on the mortgage allows me to direct money to tax advantaged retirement accounts. My mortgage payment will never change, no matter what inflation does. With every passing minute, the dollars I pay on it are worth less. Meanwhile, my investments exceed (by far) the inflation rate. So, back to my statement … I would be “nuts” to pay off my mortgage. It’s like having $182,000, almost “free (a mere 2.44% interest rate) to invest. Now, everyone’s situation is different, and there are other factors to consider. There are emotional factors as well. For many people, paying off a mortgage, or even paying extra, is a huge financial blunder.
At any point I see someone say “Not all debt is bad” I quickly go to the logical part of my brain which easily refutes the argument. The main crux of this article was to tell the public that they should go in to debt for a home for 30 years because of “affordability is low”. Just because something is less affordable doesnt mean it’s good advise to sign up for a mortgage that only insures that the homeowner pays the highest interest cost possible while at the same time losing 30 years of money which could have been much better invested. If affordability is an issue one needs to think about the financial aspects of the transaction on their life. Are you living beyond your means? Are you attempting to live beyond your means by extending a debt agreement out for a large part of your life to cover the costs? The interest alone between a 15 year and a 30 year fixed mortgage is an astronomical amount of money. Too many people squander away their income in monthly payments. Yes you will always have to pay for costs relative to home ownership such as taxes, water, gas, etc but those are far less trivial costs when in comparison to the cost of a P&I mortgage payment. Not only that you dont actually own your home until you make that last payment. I can easily pick apart this article further but it won’t convince someone who thinks having a debt and being a slave to the lender is an acceptable way of life.
Why does #3 above stop after only 15 years? The 30 yr person in the example ended up 57K ahead after 15 years, but what about after the following 15 years as they continue to pay 1200/mo while the other person only has property tax/insurance for those next 180 month?
Debt , especially mortgage debt end up costing you a lot of money over the years you carry them.
Simple, do the math, you’re losing money in long term loans
Hey Larry, what about the fact that after 15 yrs Ivan has paid $62k more interest than Suze? So, they’re actually even.
Hi, I see this article has been “updated” and not sure what the updates are. I enjoyed the concepts of this article until I read the part that your home is an “illiquid asset” and “is not an investment.” I mostly work with folks 62 and over (one is 95 right now) who VERY MUCH feel their home is an investment that has averaged well about most of their investments over time. I work with them to pull out that investment with a HECM loan that allows them to stay in the home the remainder of their lives, they don’t have to sell the home and their estate has no recourse to repay the loan when they pass. So you might want to not just steer to a speific audience. While I totally disagree with most of Dave Ramsey’s comments about debt when you have a good income and can invest, unfortunately most people do not do it. Just wanted to throw in my 2 cents.
On the contrary, the best investment you can do is to pay down your house – and quickly. I encourage you to take your 15/30 year amortization tables and see how much interest you will save each month if you invest $1,000 (monthly). At the beginning of the loan, it would be about 60-80% return right on the spot. I can’t see how an non guaranteed 8-10% return on the stock market would even compare.
Terrible article. Sure, you can say the stock market goes up 8% per year, but the average investor makes 2% per year due to the psychological component and volatility. In the end, 99% of people are better off paying off the mortgage and getting their risk free 3, 4, or 5%. To think that everyone can just buy stocks and make 8% is insane. If it was that easy then there would be a heck of a lot more rich people in America. It’s not the case. And to say you shouldn’t pay off the mortgage because you will always have bills like taxes anyway is like saying you shouldn’t take a shower because you are just going to get dirty the next day anyway. So insane how this writer actually believes what he writes. And I can guarantee you this writer doesn’t make 8% per year on his investments. He probably panics every time the market sells off. Release your tax returns and then I will believe you. Also, 90% of America doesn’t know to just invest in an index fund and never sell. Most are buying junk mutual funds with load fees and what not. So in the end, the return they are making even if they don’t sell and sit tight is near the same return they would make risk free from paying of their mortgage. Pathetic article.
From your statement: “with inflation, the mortgage gets cheaper every year in real dollars.”
My comment:
It gets cheaper if you assume your salary increases every year, even investments.
However, in reality, you could lose your job and may have to accept a lower salary. That’s when money gets tight and you would want the comfort of having a paid off mortgage when you had the chance.
My family are close to paying off our mortgage and would never look back and feel any regret.
The key, I believe is take a mortgage that you can pay off in a short time period. Just about the “enough” house you would need to keep a roof above your head.
Cheers!
The author uses bad math to demonstrate why a 30 year is better than a 15 in you invest. He wasn’t smart enough to calculate in taxes. I have developed an algorithm that helped me decide between a 15 and 30 year. Spreads between 15-30 range around 0.75% difference, another error of the author.
All calculations done, assuming tax write offs, PMI calculations used temporarily and not in all circumstances, you would have to average 8.1-9.0% per year with your investments to break-even vs a 15 year. With the stock market and bond market at record valuations, this was a no brainer. I chose a 15 year as the stock market and bond market will probably return 1-5% annually over the next 15. Even a typical 60% stock/40% bond portfolio over the past century hasn’t averaged 8-9%.
The author is a fool and simply cannot do math or else is a freeloader and doesn’t think anyone pays taxes.
My husband and I bought a 280,000$ home at the age of 21. We got a 10 year mortgage. Upon paying off our mortgage we listed the house for sale. House was sold for 318,000$. My husband and I have 310,000$ in savings at the age of 31:). Now we’re doing it all over again. It seemed like a simple decision to us.
There is another situation where this strategy isn’t advisable: when you plan to retire early (say, 60 years old) and use money from taxable accounts to fund your early years of retirement in order to delay taking Soc Sec until 70, while simultaneously performing tax-free IRA to Roth rollovers each year while you have no taxable income.
But let’s say you still have a mortgage that costs $1,500 per month as you enter retirement. Under the above scenario this would force you to withdraw $18K per year just to meet your mortgage payments. That’s $18K less per year that you could have shifted from your IRA to your Roth tax-free. That’s $180K over 10 years of lost tax savings. It also could kick you into a higher tax bracket, or force you to withdraw funds from your IRA to live on if your taxable savings aren’t sufficient to cover the mortgage payments in addition to your living expenses.
Finally, I’ve heard 2 different financial advisers say that Ric Edelman’s approach is really only logical if you take the extra money you save by having a longer mortgage and invest it in the stock market. And here’s the kicker: when asked how many of their clients were investing money they would have otherwise spent on a 15-year mortgage, both of them said “None”!
Ric’s advice is like a diet: it only works if you actually follow it, and few people ever really do (at least not for long). Proceed at your own risk.
60/40 allocation when carrying extra debt dos not make sense. As long as you have a good emergency fund, there is no good reason not to prepay your mortgage if the rate is above the fixed income portion of your portfolio. You can still keep the SAME $ amount of STOCKS while doing it. The only difference would be you aren’t borrowing at 4% to lend at 2%!
If you have a huge amount in BONDS, you are a fool NOT to prepay your mortgage!!!
Interesting how investors like to push the fact that in the 70’s a house payment was $220 a month for 30 years and while incomes went up the house payment stayed the same. That may have been true up until the late 90’s.
From 1970 to 1990 salaries went up 3.5 times. From 1990 to 2010 salaries failed to double.
Using your very own logic of a 30k house now being a 300k house is costing 1000% more
A quick google search shows average salary in 1970 was 6,186.24, average salary should now be $61,862.40 but another google search shows it is in fact $45,473. A bit off there.
Lets use another idea here. Cars. A 1970 Corvette cost $5,172 a 2015 Corvette costs $55,000 closer but still not close and yet in 1970 a whole years salary could cover the cost of a Corvette. And today, you come up nearly 10k short.
Stop encouraging people to risk everything they have ever worked for to be trusted to a bunch of greedy wall street investors.
Everyone seems to forget how many people lose their homes when stock market crashes and people lose their jobs. And savings disappears quite quickly. You can enjoy playing in the wall street casino and I don’t know you so maybe you risk other peoples money in the wall street casino, but me personally, I’ll keep my 15 year mortgage, prepaying as much as I can so one day when the world economy collapses, I don’t have a banker or sheriff show up on my front stoop forcing me out of my house by gun point.
This is an excellent analysis. I recently completed a somewhat simple mortgage model for a class and one of the things I did was to evaluate mortgages based on the personal rate of return for residual income (putting money into retirement or whatever). When you assume a 0% rate then a lot of the common wisdom obviously stands. Pay less interest and you win. However when assume that your savings can earn a return on their own (say at 8%) the situation shifts dramatically. You go from seeing the 10 year be the best option and the 30 year the worst to seeing the 30 year as the best and the 10 year the worst. This is mostly due to the fact that the 10 year mortgage sees a dramatic increase to net income in the later years. If you account for the time value of money though this income is worth substantially less than the increased income the 30 year mortgage sees in early years.
The crossover point seems to be around where the personal rate of return meets the APR of the mortgage.
Anyways, its interesting stuff.
If you “assume” you will earn 8% then this makes sense. It also violates basic financial principles of risk-adjust returns. If I “assume” I can get 8% on an invesetment, then I should take a 40 year mortgage, a 2nd mortgage, a car loan, a personal loan, and every other loan under the sun at under 8%. Does anyone actually recommend this?
I don’t believe I can get a risk-free 4% today, matching the risk-adjusted return of a mortgage payment.
I’ve heard the argument you shouldn’t pay off a fixed mortgage because as inflation increases the money you spend on your monthly payments will actually be lower (less costly) over time in relation to previous years… but that doesn’t take into account the fact that salaries (personal employment income) don’t rise equally. So while my mortgage is the same in 2015 as it was in 2010, I’m still making the same salary while my milk and eggs and heat and stamps etc. increase in cost year over year. So sure I can keep paying 60% interest on my mortgage while all my other common expenses rise while my salary stays stagnant. Or I could pay my principal down so I pay less interest year over year and contribute to an investment that I could turn into an income property or liquidate accordingly.
You bring up an interesting point. Though historically the price of labor rises at some point with the cost of everything else.
Its all about moderation, I’m 36 yoa and just paid off the house, its a great liberating feeling First we always maintained a years salary in a money market in case of trouble, continued to invest in 401(k), IRA, and kids college savings. Then sent all extra money over to principal. It helped that we bought a modest home, and had paid down all our other debts, including student loans and had no car payments. Frugal living was definitely key, now the freedom we enjoy to change careers, take risks, and nice vacations was worth the seven years it took to pay it off. Now we have an extra 35k annually to invest.
After losing money in the corporate bonds in the late 1980’s, then on Black Friday in 1987, then again in 01 and 2008…between corporate corruption and all the emotional investors, and bad investment advice, I’m pretty much done with investing. I’m stuck at a 6.275% 40 year bullshit modification…I am pre-paying my mortgage. Although not liquid until sale, it’s there. These young investment advisors always say “you have time to make it up” no you don’t. They are just pushing people so they can make money. I have lost faith in all advisors, insurance companies, the government, lawyers and bankers. Your best investment? I don’t know anymore. I just want to sleep well. My idea is to pre-pay my mortgage, invest somewhere so my property taxes and homeowners insurance are paid when I pay it off.
Amazing how our country pushes everyone to the stock market. “But imagine how much you could be making in investments!”
Your home and payments are tangible things you can measure. The stock market is all about ifs and buts and is pretty much a casino. “Let’s all take our money and play the stock market!!!”
People – please learn math and stay away from financial advisers who push you to invest I stocks. Win or lose at that game, the advisors and brokers and banks are the only ones making money. They live off other people’s money.
Be smart – make your own investments wisely.
DJ,
on average a home gains 2% a year, or slightly less than the rate of inflation. Stocks on the other hand gain 7-8% on average.
If you put all your money into your home, how well diversified are you?
3, 6 and 7 are extremely bold assumptions. In fact, most of the people that are against paying off a mortgage early do not have these in check. My main problem with this way of thinking is number 7. In theory, using the money you save is wise. Most do not save or invest this properly. So, I think most people jump on this bandwagon so they do not have to commit with extreme discipline while while telling themselves, their spouse and all others, “it’s just stupid to pay a mortgage off early.” This way, they can continue their spending ways without ridicule.
This is a good discussion as I listen to Dave Ramsey all the time. I am retired (61yo) who has chosen to not payoff my mortgage. My rate is about 4 percent and I earn several times that on my investments over my 30 years of investing Needless to say I am not heavy in stocks or bonds. I consider my house even with 600K equity a cost not an investment and I would rather put the money in compounding investments.
The 4 percent is a risk free return but there are other investments outside of the stock markets that provide a better risk adjusted return.
Ivan investor has to pay taxes on his earnings he pulls out, to put on his mortgage! You must think people are disciplined enough to put the extra on the market, are u kidding me! I personally sleep better at night knowing my house is paid for and not worrying about the market crashing! Of course if I was a CFP I wouldn’t want people to pay the house off either….
If I may- For me to consider a property to be an investment it has to earn me an income. For instance a property that i use as a rental which earns me rental income each and every month. I do not consider my personal residence, the place I live with my family an investment. If it costs me money I consider it an expense. Yes it grows in value but still cost me money each and every month.
I do agree with the idea of not paying the home off early and investing the money instead. I find it makes no difference if you are paying a mortgage or a rent payment. Either way you must pay to live somewhere. I own my own place and my mortgage payment is actually less than what it would cost me to rent an apartment today so the risk would be the same as renting for me. I have no desire to pay off a home that does not earn me money.
My desire is to build my various investments to the point where I will earn enough to replace my income and lower my tax rate cause we all know investments are taxed at lower rates.
Since I have been investing in the stock market and bonds I have earned on average 10% or more and during the last 5 or so years lest just say I have been killing it. Something I would never been able to do if I was sending the bank all of my money to pay off my mortgage on a property that earns me no income.
Larry I loved the article!
It is costing you more when you are paying interest.
Mortgage prepayment vs. stock investment is apples to oranges since the mortgage prepayment is a guaranteed return, while the stock is not.
The proper comparison is scheduled payment only and stock/bond mix, or throw bond allocation money at the mortgage and keep stocks the same. This is apples to apples. Of course I am assuming the bonds are held to maturity.
The value of the house is irrelevant because it is not impacted by financing. Appreciation or lack thereof will occur regardless of how much is owed on that house.
The amount invested in the house is the ENTIRE market value, NOT just the equity. You must pay the lender back regardless of the value. The amount you risk is thus the WHOLE THING, not just the equity.
Sorry, you are the fools.
Either way, the big banks get to play around with your money. They make huge profits and let a few coins slip through to us. The convicted criminal banks destroy everything of value and they do not care about you or me. The builder of your house gets paid less than the banks.
Best to pay cash for a small house, plant a food forest, become energy neutral and never buy anything on credit again.
Working your whole life for some carrot on a stick is insane. Your life is passing you by right NOW. Stop consuming useless junk, protect your health by understanding where your food comes from, stop supporting things that are wrecking our future, get back in touch with your family and with nature. You don’t need many things. You get only one life, don’t put it off for later.
Right…while we’re at it, let’s all quit working since it just benefits our employers. Hell, let’s quit paying taxes while we’re at it!
*facepalm*
I get the philosophy behind your comment, but to say that only one person benefits (the bank) in a cheap leveraged mortgage is just plain blasphemy. The only way this is true is if you just keep making bad financial decisions over and over again.
Awesome. Well said.
I’m always surprised at how few calculations on this subject consider present value. It doesn’t always mean 30 is the way to go, but much of that extra money is paid out well in the future. A small 2% inflation assumption mutes bite of those payments due 20+ years down the road.
Good discussion and I’m glad this is still getting comments and looked at it. I can appreciate both sides and think about this often as I approach the time where I will be getting a mortgage. On a purely philosophical basis – Ivan has slightly more flexibility than Suzie in years 1-15 (lower monthly payment), but I believe Suzie has a significant amount more of flex after that. She has a paid for house and can move onto bigger & better things. I think if you look at wealthy people, on average, they are not going to say they built wealth because they ran a 30-year mortgage to maximize the amount of money they could invest. Instead, they’ll probably say they have a paid for home and can now put that housing cost towards investments, etc. Otherwise, why ever even pay off your mortgage? Just keep cashing out your equity to invest…. You’re damn right it’s emotional, I’m not willing to take that amount of risk on my family’s future life. At the end of the day, everyone has a different risk meter, that doesn’t have anything to do with being ignorant.
@Jacob – “Ivan has slightly more flexibility than Suzie in years 1-15 (lower monthly payment), but I believe Suzie has a significant amount more of flex after that. She has a paid for house and can move onto bigger & better things.”
Not until she too accumulates the kind of liquidity that Ivan has. If Ivan’s investment strategy has been stupid, maybe Suzie can catch up by year 20 or so once she has built up a few years of pouring money into investments, but certainly not by year 15. Also, as I noted above, it isn’t just flexibility of monthly payment for Ivan — it’s having a huge chunk of liquid capital, instead of money buried in an illiquid asset. There are many types of situations where having money that can be moved easily if needed is much more important than having illiquid assets. Frankly, I’d say that that kind of flexibility alone might justify a situation even if Ivan weren’t quite able to come out ahead in the end — but it depends on overall portfolio and individual situation.
“I think if you look at wealthy people, on average, they are not going to say they built wealth because they ran a 30-year mortgage to maximize the amount of money they could invest.”
That is demonstrably not true, at least not in the general case. Whether a particular rich person buys a house outright or takes a mortgage probably has to do with what sort of real-estate speculation he is into, tax benefits, overall portfolio, etc. But the more general thing to consider is that the people who accumulate the most wealth are really good at balancing SAFE return investments vs. RISKY ones. People who do too much risky stuff can get very rich, but they can also go bust. Those who only so “safe” things will never get quite as wealthy as their peers.
The mortgage overpayment is the “safe” investment here — it’s effectively a guaranteed return. A reasonably wealthy person with a large portfolio will balance possible greater returns (with more risk) against the safe mortgage, and make a decision based on overall portfolio. Just like he might judge what mix of stocks vs. bonds vs. other types of investments. If he already has a lot of risky stocks, paying down the mortgage may be a reasonable decision, because it represents a safe investment as part of his portfolio balance.
“Otherwise, why ever even pay off your mortgage?”
I know you meant this as rhetorical, but it is actually a serious question to consider. Any type of investment usually involves giving up some of your money with the promise of future returns. People who are wealthy enough usually also find it necessary at times to “leverage” themselves by borrowing money to invest (the same thing a person starting a small business might do on a smaller scale). This is only a good idea if the investment is very likely to pay off and the risk in borrowing is relatively low.
So, from a simple mathematical perspective, say you had a loan at 3%, but by investing that money elsewhere, you knew you could make a minimum of 4% in a relatively bad market, but maybe 10% or more in a good market. Why the heck would you ever pay off the loan? This is precisely how banks make money — they take someone else’s money, pay only a tiny amount of interest, and lend it out to earn more interest. Truly wealthy people do this sort of thing themselves in various ways.
Of course, the trick with all of this is always to maintain enough liquid money to be able to settle your loans if necessary. Otherwise, you risk bankruptcy if things turn bad. In the situation above, Ivan will be able to settle his mortgage around year 15 if he wanted to, the same time Suzie does. Keeping his money liquid and in various investments that will earn more money than the mortgage after that point is simply using the bank’s money to make more for himself. As long as he can “get back” to approximately the same equity that Suzie has at any point, why should he bother to pay off the loan if he’s making more money by not doing so? (Also, keep in mind the role of inflation in all of this — the loan principal will continue to decrease in value over time, even if Ivan doesn’t pay down a lot, so his returns can accumulate even more by waiting to pay off a balance further in the future when it is effectively less valuable due to inflation.)
Obviously there is risk involved in these sorts of things, but people who actually accumulate wealth will use this kind of strategy in one way or another. If you want to play it absolutely safe, sure, pay off your mortgage, and keep all of your money in a savings account earning 0.5%. But building wealth involves assuming some risks — and if you weren’t willing to assume ANY risk, you shouldn’t be taking out a mortgage in the first place, but instead waiting to purchase with cash.
Actually, I think Suzie has somewhat less flexibility in the first 15 years and then at year 15 Suzie has way MORE flexibility than Ivan will. It is really about trading one kind of risk for another…the riskiest time for Suzie are those first 15 years. After year 15, that changes. I do believe in a strong emergency fund, which is sometimes difficult to achieve, but assuming the emergency fund, Suzie has it made compared to Ivan in years 15-30. Also, I’d like to see actual statistics on those who have a 30 yr vs 15 yr mortgage – which group are statistically better off in years 30 and greater? Math projections don’t automagically equal reality as another poster mentioned…
@JohnG – “Actually, I think Suzie has somewhat less flexibility in the first 15 years and then at year 15 Suzie has way MORE flexibility than Ivan will.”
How is that? At 15 years, Suzie has no flexibility — she has a huge asset that she’s sunk a lot of money into, and it’s hard to get it out. (Even if she wants to take out a home equity loan, chances are the interest rate will be higher than what she had on the mortgage.) She has no savings.
Meanwhile, Ivan could actually sink a huge amount of his savings INTO the house at 15 years, if he wanted to. If his investments did well, he probably could even pay it off outright, and thereby be in the same position as Suzie. Or, he could hold onto liquid assets and make use of them as he sees fit at that time. Unless Ivan sunk his money into really bad investments and lost a lot of it, there’s no way he has less flexibility than Suzie at year 15.
Now, after maybe 5 more years, Suzie could build up a significant chunk of investments, and if Ivan did poorly for the first 15 years, she might be able to catch up in terms of liquid assets and flexibility. But that doesn’t happen magically at year 15 when she pays off the mortage: it happens when she approaches the kind of liquid asset situation Ivan has. (And if Ivan has consistently done well, as I pointed out above, Suzie will NEVER catch up — hence, it would be ridiculous to claim that Suzie somehow has more flexibility than someone who always has more liquidity and ends up with a higher net worth.)
“assuming the emergency fund, Suzie has it made compared to Ivan in years 15-30.”
Why? Just because she doesn’t have to write out a check every month? If Ivan has been investing reasonably, he will have the money in the bank to pay off the mortgage and be in the same position as Suzie whenever he wants. Or, he can have extra money in the bank in case he loses his job for a couple years or if he needs to relocate quickly or for whatever. He can make a choice to throw that money into the house or not, as he pleases — Suzie can’t, because she’s already locked in. The only situation in which this is not true is Ivan invests very irresponsibly and his accounts tank — which could happen, but is unlikely in the case of a rational investment strategy.
Here’s a final important point that I think people miss here. After 15 years, Suzie has a better net worth, but Ivan has more investments to speak for. So we might say there are trade-offs.
Yet another important consideration is that Ivan has more FLEXIBILITY. He has almost $250,000 in investments, which might be liquidated easier if need be than selling a house. Sure, you might be able to get a home equity loan, but not if you’re out of a job. Ivan has a fantastic emergency fund for a rainy day. Suzie, in this example, has nothing but a house to live in… and if the “rainy day” comes before year 15, she also still has a mortgage payment to make.
If Ivan loses his job in year 13, he has a huge boat of cash he can use to pay off the mortgage for a while until he gets back on track. Or, even let’s assume he doesn’t have a disaster but he has to move in year 13, but has trouble unloading his house at a good price. Ivan can afford to sit on it and continue paying the mortgage for a while, even when he moves and perhaps buys a new place.
Suzie?? Well, she’s stuck. She has no savings, and she can’t move until she gets that equity out of her house.
There are loads of reasons not to put all your money into your house, and it’s amazing that so many people here are even quoting numbers that are wrong to justify their ignorance.
For a more detailed (and balanced) piece, you might have a look here, at a series of articles I found some time ago:
http://www.heracliteanriver.com/?p=621
Interesting discussion. Larry you are right, a lot of people do not stay in a home for 30 years. 30 year mortgages follow a 10 year note due to more than just sales. Usually the biggest other reason than sale is refinance. However, when people move or refi they do not just magically quit paying a mortgage. In a perfect world you would roll into a similar house and pay on the same schedule. In your scenario would you suggest going back out to a 30? The problem is the world is not perfect. People usually either plan to stay in their house longer than they do and refi more often than originally planned. The problem with a 30 year is that you are practically a renter for many years. By this I mean you pay almost all interest and do not build much equity unless the house appreciates. If it does not appreciate and life put you in a position you need to refi or sell you can ride this decision to the poorhouse (assuming the market has had a dip also). We do not have to look back too far to see this model. I will agree you can get way to conservative on investment and mortgage pay down but 30 year mortgages can be fire. I have been in the banking business for many years. People that refi large balances that they never pay down are profitable. However, it has been my experience you can usually almost tell what the rest of the balance sheet is going to look like just by looking at equity value of the home and credit score. No matter what income class people that build equity usually end up wealthier and also seem to end up with more assets later in life. I have heard your argument many times before but I have seen very few make it work. At some point they get stuck when that hard to get to equity was important. They also tend to chase returns and do so till they get burned. Your argument sounds great but in the real world I have seen Suzi win time after time. Ivan will tell me what he was going to do only to make a mistake along the way and have to start all over again. Thirty year mortgages in this country quite often just let people buy houses they could not afford long term anyway.
So much depends on your personal situation–income, health, kids, debts, etc. It’s a personal choice, you are not a fool to pay off your mortgage.
The stock market has not been a winning strategy for the past 10 years. Historical performance means nothing, as banks must tell you by law. Stocks may not pay much for a long time.
Why? Boomers will, by law, have to make withdrawls from retirement accounts, and sell stocks. I am curious to see how this will play out. Market glut? Cheap stocks? Devaluation? I’m not the expert here, but we are in for changes.
Nothing in life is guaranteed, and paying off your house when you might need cash later is not wise. But if you have a big cash cushion, you might do better to pay off your house (if you can within a few years) and then invest more heavily in stocks for retirement. But make sure you have cash, no matter what. Cash by itself is not an investment strategy–it is a life strategy. It’s there when you need it. Inflation or no, cash is king.
Anon,
If you did DCA (Dollar Cost Average) in the past 10 years you actually did OK. Money Mag had an article a few years ago and with dividends included you did ok (like 5% return). So hogwash to that myth about the past 10 years. Unless you put all your money at the peak (which most don’t and DCA), you did ok because you invested every month.
Devaluation – unless we get very high inflation stocks and housing are good with moderate inflation. Though if you are expecting inflation why prepay your mortgage and then goes back to the purpose of this post. Housing typically only matches inflation (barely). Investments match inflation and 2-3%+ that. Where you come out ahead with housing is because of the mortgage. You are leveraging your housing.
Let me finally state this article might not always be true. There comes a point with fixed income investment and the overall valuation of the stock market it might be a safer bet to pre-pay your mortgage. When I originally wrote this article (in 2012) there was no question. Today might be slightly different, but overall I stand by my statement.
Jacob and john g. Have a really good point that Suze Short-term comes out way ahead in the 30-yr time frame. Ludwig says we only live in our homes 10 to 15 years. Where does that stat come from? Seems self-serving to support your point, but isn’t Suze still ahead when she sells and uses the equity toward her new home?
Ludwig stopping at 15 years for his point #3 comparison is non-sensical for comparing a 15-yr to a 30-yr. Why the bias in favor of a long, interest heavy mortgage?
See this latest discussion from Robert Shiller about is your home an investment.
http://www.businessinsider.com/robert-shiller-home-investment-a-fad-2013-2
Regarding the average timeframe you live in your home, I read that stat years ago and will see if I can find an online reference. Let me add there is a reason why 30 year mortgages are based around 10 year US Treasuries.
Thanks for the interesting article. The ideas do deserve some thought. Though comparing a home one lives in to a “mothballed” car is a false analogy.
I guess from a 100 percent clinical view, one could make a little more in the market than in paying off a house, but I guess I like the idea of owning my house as opposed to renting: I can stay here even if I loose my job (without depleting my portfolio), I can pass it on to my kids, and I’d rather own something than rent it from a landlord.
I guess that peace of mind will cost me a few grand.
After 15 years Ivan still owes 190,000 on the house. His equity and investments of 357000 minus what he owes gives him a net worth of 167000. At the same point suze has a net worth of 300000. Because houses go up in value long term they will both have a bit more than that but Suze wins hands down due to the extra risk she took over the first 15 years. If she invests 711 or 2100 per month from that point forward she gains even more ground and leaves Ivan behind.
This is absolutely false. Run the numbers. It’s true that Suzie has a better net worth at 15 years, taking into account the mortgage. But Ivan has HUNDREDS OF THOUSANDS of dollars in investments that are ready to grow, while Suzie only has the house.
Ivan’s net worth surpasses Suzie’s around year 21. Run the numbers.
What’s the risk differential, though? What’s the beta on, say, the S&P 500 vs the risk of a house declining in value?
Good point. I put my money into Real Estate investment property which gave me more flexibility than simply paying cash for my home. Some years the value has gone down but over the 19yrs that I have done it rather than pay cash for my house in 1996 I am 2 Million bucks ahead plus I get cash flow from rents (each year) more than what I paid for my house in 1996.
Why is it that most people assume that the stock market is the only alternative that’s very limited thinking.
Volatility is a good thing if you know how to utilize it and buy when prices are low or know how to buy housing at a discounted price.
Hello, just found your blog and I thought I should add to the discussion. I definitely appreciate some of your points, but I have to agree with Derek that you aren’t necessarily looking at both sides of the pros vs. cons fairly.
In the Suze vs. Ivan example, if you assume both live in the house for 30 years: “short term thinking” Suze has a paid for house after 15 years and now has the cash flow from her no longer in existence house payment. If she invests the $2100 and Ivan continues to invest the difference ($710), she now has an extra $1390 of investments every month for 15 years… assuming your 8% assumption, she now has over $400k more than Ivan after 30 years and they both have the same paid for house.
Essentially instead of paying the bank like Ivan, Suze has paid herself.
She’s taken less perceived risk and she’s still out far far ahead.
@Jacob — sorry, but your numbers are way off. Suzie won’t catch up.
My numbers are a little different from Larry’s, because I think he may be calculating APY on investment returns the same way as mortgage interest rates, so I get the following:
After 10 years:
Suzie — $0 in investments, $183.4k in house, total = $183.4k
Ivan — $129.4k in investments, $65.7k in house, total = $195k
After 15 years:
Suze — $0 in investments, $300k in house, total = $300k
Ivan — $242.6k in investments, $109k in house, total = $351.6k
After this, Suzie invests like mad, throwing the $2100 into investments, while Ivan keeps his $242.6k of investments growing AND continues to add more as he has always been. (I think you may have forgotten to include Ivan’s previous huge amount of investments he’s accumulated over 15 years.)
Now, after 30 years:
Suzie: $711.7k in investments, $300k in house, TOTAL $1.01 MILLION
Ivan: $1.01 million in investments, $300k in house, TOTAL $1.31 MILLION
In effect, Ivan could BUY AN EXTRA HOUSE for $300k for all the extra money he has!!! (That is, if housing prices didn’t go up over 30 years, which of course they would….)
In fact, Ivan doesn’t need to get an 8% average return to come out ahead. He doesn’t even need to make 6% or 5%. In fact, as long as Ivan makes a little more than 4.5% return on his investments over the 30 years, he’ll come out ahead of Suzie. So, he doesn’t need to invest in crazy risky stocks — just in things that will get him a more modest return on the long term (but a little more than the interest rate on his mortgage).
Granted, Suzie’s return at 3.25% was guaranteed, but Ivan’s risk pays off huge. Those arguing in favor of Suzie are simply arguing out of ignorance.
Hi Bob,
Thanks for your comment. It’s possible my math was slightly off as I use an online calculator but the numbers looked close to what I was expecting. Though the end result is still correct, not prepaying is a better deal. The only reason to prepay is for emotional reasons and that’s not a valid reason for any investment.
Hi Jacob,
Most individuals don’t live in the same house for 30 years. On average for most it’s 10-15. Also as I mentioned you would have way too much equity into just one asset – your home. That’s an illiquid asset to boot!
In addition, you’ve lost all of the possible gains during the 15 year period. Could you come out ahead in your situation? Yes it’s possible. I don’t deny that.
Next up should be the article about how awesome investing with margin is, because that is what you are doing here. While it is certainly possible to beat the normal home mortgage rate, it is also has more risks. Considering the stock market has gone absolutely nowhere for about 12 years, it’s hard to argue that you are going to have 8% compounded returns guaranteed.
Another thing to note is that you include tax deductions in your calculation, but not the taxes you have to pay on the gains. I assume since you are wanting things to be liquid you aren’t putting the difference in an IRA. Also, many people don’t itemize, and even if you itemize only the amount over the standard deduction is useful to this discussion so it is a much more complicated calculation than just saying you save money on all the interest paid (you may be doing this calculation in your numbers, but it isn’t mentioned for other people reading).
As far as I know, the first $250,000 in profits is tax free if you live in it for at least 2 years. I think there are some changes though.
Hi Sam, I wasn’t even discussing the possible increase in value of owning a home. So I’m not sure I understand your statement. In the Suze example I mentioned she has $300,000 in equity, not in gains. So that would not not be taxed. Only if the house say increased in value to $400,000 in the 15 years she owned the property. She would have a $100,000 in capital gains and would be under the $250k limit you mentioned.
Don’t forget about depreciation…after 10 years you’d have depreciated 36% of the purchase price of the home (approximately $100,000 of the $300,000 home, so a $200,000 gain on the $400,000 sale price). But Sam is right, if it’s your primary residence and you’ve been there at least 2 of the past 5 years you can exclude up to $250,000 of gain.
How many 10 year periods have we had little gains in the stock market? Not many, and there were many good asset allocations and dollar cost averaging situations (since it’s not all at once savings) you most definitely came out ahead. I can reference a Money Mag article if you want for the calculations to prove my point. You are fixated on recency bias.
Life has risk in anything you do, and so does paying down your home. Traditionally home prices only increase an average of 2-3% annually. If you follow the Dave Ramsey way you are putting all of your eggs into one basket – your home. If anything it’s risker than an asset allocation of stocks AND home mixture I suggest.
You can invest in an Roth IRA and take the principal out without penalty, so that statement is false. Roth IRAs are just as liquid as taxable accounts. So in the example I cite, a married couple could easy fit the annual $8,623.92 savings into 2 Roth IRA accounts.
So the savings should most definitely go into tax deferred accounts first. See my previous post for the order to invest tax efficiently.
I assume you itemize if you are if a high income tax bracket (most readers here are). Even if you don’t, it’s still a good deal at current mortgage rates.
Again, missing key points. A Roth IRA is absolutely not as liquid as a taxable account. You can only withdraw the principal penalty free after 5 years.
The only 10 year period where the market didn’t go up is the current one. That being said, there are plenty of 10 year periods where the market gains weren’t 8% compounded. 8% compounded is a 115% gain. There are lots of 10 year periods that don’t meet that assumption.
I’m not here to defend Dave Ramsey, but I will note that his plan includes investing 15% of your income in retirement accounts before paying off your mortgage, so I’d hardly call that all of your eggs in 1 basket.
I definitely itemize, but I’m just pointing out that there is a standard deduction. Example:
2012 standard deduction – $5,950
mortgage interest – $10,000
(no other deductions for simplicity)
Not all $10,000 lowers your tax rate which means that it isn’t necessarily lowering your effective mortgage rate by your tax rate. In this case only 4,050 of it helps meaning you would only lower your interest rate by 40.5% of the stated tax advantage.
Please note that I’m not suggesting there is no way investing and keeping a mortgage can work. It is a valid idea. It is not however nearly as cut and dried as you suggest, and you are not a “fool” to prepay your mortgage. You are posting the advantages and completely ignoring and disregarding the disadvantages. To me that is not nearly as useful as stating all the facts and drawing the reasonable conclusion that investing might be better.
Just to play Devil’s Advocate, it should be made clear that the mortgage tax deduction is an adjustment on your W-2 income. As in, the expensive kind of income as it relates to tax policy.
Capital gains taxes are extremely low at 15% for the long-term outside of retirement accounts.
So, even if you don’t get a complete write-off of your mortgage interest, it cannot be ignored that you’re also trading highly-taxed income for capital gains taxed at a lower rate.
Good point, but for how long this is true who knows?
For the first 5 years you are correct Roth IRAs are not as liquid.
I am suggesting you’re a “fool” because of the current interest rates, the average rate of inflation and average returns for investing. The advantages are pretty clear IMHO. The disadvantages, while exist, are pretty minimal at this point in time. The only risk I see at this point is renting vs. owning, which isn’t part of this equation.
If you can pay for it why not go for it? A borrower is servant to the lender.
The only reason we get into mortgage is that people did not have money to pay outright.
It is better to be debt free and invest without any debt.
Invest whatever you would have to pay in interest and you would be safer.
You assume having a mortgage is bad? Having a mortgage in real terms (especially at today’s rate) means you are basically paying zero percent interest on your house. See my article: https://investorjunkie.com/13979/fool-prepay-mortgage/