### Sunday, October 15, 2006

## Extra mortgage payments versus taxable investing

One question I've often had: does making extra mortgage payments make sense, versus saving the money for (taxable) investing? On the one hand, mortgage paydown has a guaranteed gain - the interest rate of the mortgage - that is typically higher than money market returns, and is a reasonable strategy if someone would otherwise spend the money. Also, many people are "debt haters" who can't abide debt and feel better if they're working the debt off rather than "juggling" both debt and investments.

On the other hand, mortgage interest rates are typically lower than longer-term interest yields on even fairly conservative investments, and since mortgage interest is tax deductible** and is being "eaten" by inflation, its real rate is typically even lower.

Let's run some numbers: consider a $100,000 30 year fixed mortgage at 6%, and an investment plan that yields 8% over time. For simplicity, we'll ignore tax deductibility and inflation, and assume the investment plan behaves like a savings account, even though most plans paying this much would likely involve investments that vary over time, like stocks.

Now, let's say we have a spare $100/month to use for either extra mortgage paydown or for deposit into our investment plan.

The $100K 30 year fixed mortgage's payment is $599.35, according to calculators on bankrate.com. If the loan is paid down over the course of 30 years, a total of $215,833 will be paid.

Paying the extra $100/month will cause a total of $175,937 to be paid, and the loan will be paid 9 years earlier. This will save $39,896 over the life of the loan, and will be paid off 9 years earlier.

Now, let's see what would happen if we put the $100 into the investment plan.

As mentioned above, we save $100/month into the investment plan that pays 8%. If we do this for 30 years (here's the calculator I used) - instead of paying down the mortgage with it - we will have $149,035 saved.

Now, let's say you did the early paydown and paid the mortgage off in 21 years, and then saved the mortgage payment and the $100 into the investment plan, for a total of $699.35/month for 9 more years. After 30 years, you'd have paid off your house and saved $110,098.

One more scenario: Let's say you chose to save the $100 into the investment plan, and paid the mortgage down on schedule. Now, at some point, you have enough money in the investment to pay the mortgage off, and decide to do so, and after this, you save . A bit more calculator work indicates that this point is reached 19 years and six months (234 months) into the mortgage, when you have a balance of $55,946 on the mortgage and have saved $56,013. Now, let's save $699.35/month for 10 years and six months into the investment account. After the 30th year, we've saved $137,413.

So, to summarize (sorry, my HTML table skills are nonexistent):

As mentioned, this example simplifies things in that taxes and inflation are ignored, but since ignoring them is the pessimal case for the investment plan versus the mortgage, it should be clear that paying the mortgage to term and investing the savings at the same time is the strategy that maximizes net worth.

**The tax deductibility of mortgage interest is much less useful than it once was, especially if you live in a state with no state income tax, because the personal exemptions are much higher nowadays than they once were. But for us at least, state income tax and property tax are high enough by themselves to make it worthwhile to itemize, so we consider the full mortgage interest to be tax deductible.

On the other hand, mortgage interest rates are typically lower than longer-term interest yields on even fairly conservative investments, and since mortgage interest is tax deductible** and is being "eaten" by inflation, its real rate is typically even lower.

Let's run some numbers: consider a $100,000 30 year fixed mortgage at 6%, and an investment plan that yields 8% over time. For simplicity, we'll ignore tax deductibility and inflation, and assume the investment plan behaves like a savings account, even though most plans paying this much would likely involve investments that vary over time, like stocks.

Now, let's say we have a spare $100/month to use for either extra mortgage paydown or for deposit into our investment plan.

The $100K 30 year fixed mortgage's payment is $599.35, according to calculators on bankrate.com. If the loan is paid down over the course of 30 years, a total of $215,833 will be paid.

Paying the extra $100/month will cause a total of $175,937 to be paid, and the loan will be paid 9 years earlier. This will save $39,896 over the life of the loan, and will be paid off 9 years earlier.

Now, let's see what would happen if we put the $100 into the investment plan.

As mentioned above, we save $100/month into the investment plan that pays 8%. If we do this for 30 years (here's the calculator I used) - instead of paying down the mortgage with it - we will have $149,035 saved.

Now, let's say you did the early paydown and paid the mortgage off in 21 years, and then saved the mortgage payment and the $100 into the investment plan, for a total of $699.35/month for 9 more years. After 30 years, you'd have paid off your house and saved $110,098.

One more scenario: Let's say you chose to save the $100 into the investment plan, and paid the mortgage down on schedule. Now, at some point, you have enough money in the investment to pay the mortgage off, and decide to do so, and after this, you save . A bit more calculator work indicates that this point is reached 19 years and six months (234 months) into the mortgage, when you have a balance of $55,946 on the mortgage and have saved $56,013. Now, let's save $699.35/month for 10 years and six months into the investment account. After the 30th year, we've saved $137,413.

So, to summarize (sorry, my HTML table skills are nonexistent):

Option Month mtg is paid off $ in 8% after 30 yrs

Pay extra $100 to mtg 252 (9 years early) $110,098

Save $100 to plan, 234 (10 yrs 6 mos early) $137,413

prepay mtg when ready

Pay mtg to term, save 360 (paid to term) $149,035

$100 to plan every mon

As mentioned, this example simplifies things in that taxes and inflation are ignored, but since ignoring them is the pessimal case for the investment plan versus the mortgage, it should be clear that paying the mortgage to term and investing the savings at the same time is the strategy that maximizes net worth.

**The tax deductibility of mortgage interest is much less useful than it once was, especially if you live in a state with no state income tax, because the personal exemptions are much higher nowadays than they once were. But for us at least, state income tax and property tax are high enough by themselves to make it worthwhile to itemize, so we consider the full mortgage interest to be tax deductible.

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Interesting post, I wish mortgage interest was tax-deductable in Canada!

See my blog: ngifford.wordpress.com for more information on real estate investments and repayment.

NG

See my blog: ngifford.wordpress.com for more information on real estate investments and repayment.

NG

It's worth noting also that the numbers change somewhat when one is looking to cut down on obligations in preparation for pseudo- (or, for that matter, actual) retirement.

For example, my fiancee and I ran the numbers on prepayment of our mortgage in preparation for me to quit W2 work in order to focus full-time on family and my new businesses (at which I expect, eventually, to make a profit, but which will probably lose money for at least a year, and whose profit will be uncertain for a while when it does come), and it turned out that the best solution was to put about 20% of the cash-on-hand into an immediate refinance, and then invest the rest, paying most of the remaining mortgage out of the interest on the investments.

I'm not disputing your numbers about the end point, but for some situations, it's actually the middle points that matter more. (What my net worth will be in 25 years has a lot more to do with whether I can make the business succeed than with how much I prepay the mortgage, but whether I can make the business succeed has a LOT to do with whether, at some point in the future, I need to quit working on it in order to take a W2 job in order to meet the mortgage payment every month.)

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For example, my fiancee and I ran the numbers on prepayment of our mortgage in preparation for me to quit W2 work in order to focus full-time on family and my new businesses (at which I expect, eventually, to make a profit, but which will probably lose money for at least a year, and whose profit will be uncertain for a while when it does come), and it turned out that the best solution was to put about 20% of the cash-on-hand into an immediate refinance, and then invest the rest, paying most of the remaining mortgage out of the interest on the investments.

I'm not disputing your numbers about the end point, but for some situations, it's actually the middle points that matter more. (What my net worth will be in 25 years has a lot more to do with whether I can make the business succeed than with how much I prepay the mortgage, but whether I can make the business succeed has a LOT to do with whether, at some point in the future, I need to quit working on it in order to take a W2 job in order to meet the mortgage payment every month.)

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