Investment Risk and Paying off the Mortgage Early

Hi Dan,

I was reading your article on "should you pay off your mortgage faster?" (DM: link here DELETED It'll be a fresh 30 year loan and I'm 44 years old so this discussion has interest, I don't really want to be making a mortgage payment at 74 ;).

I must be really dense but A: I don't get it and B: the table looks like it has an error in it to me.

Start with B: first - the investment column can't possible be correct. The assumption is you save or pre-pay $100 per month and invest at 8%. The amount for year 1 is $1,353.29, if you saved $100 per month at the end of a year you'd have $1,200 in principal + $100 * 12 months @ 8% + $200 * 11 months @ 8% + $300 * 10 months @ 8% etc. Even if you socked away the whole $1,200 on day 1 you'd only have $1,296 and have to pay taxes on $96.

What I don't get is this - by prepaying $100 on my mortgage I get a guaranteed return of 6% or 6.5%, whatever the mortgage rate is. I do not ever have to pay interest on that piece of principal again, it keeps on giving. Yes my payment stays the same but the amount going to principal increases by the amount of interest I am not paying due to the previous principal payment.

Now, the valid comparison to that is a risk free investment alternative no? I've got savings accounts currently yielding 4.5%, 5.3% and 5.4% APY, you might find 6% - might and it probably is an intro rate. Let's be generous and assume I can get the same rate of return on the savings as I pay on the mortgage and put that at 6%. If I pay $1,200 extra in principal on day 1 of the year I don't pay $72 in interest and can't deduct it. If instead I put $1,200 in a savings account on day 1 I earn that $72 in interest. It is a wash, The tax issue is a red herring since not paying the principal gives me a $72 interest deduction but the equal investment return is added to income so (72) + 72 = 0 Could it work out if you put the investment dollars at risk? Sure, but that is a gamble and an apples to oranges comparison.

I have different mental pots of money.

Pot 1 is investment dollars for retirement, 10% or so of income goes to a tax deferred account invested at various risk levels and doesn't get touched - ever. Until I retire at least!

Pot #2 home equity + the carrying cost on the mortgage which is the 25% or so of income that pays the PITI on the house.

Pot #3 is liquid reserves, currently about a years worth of #2's income requirements.

My goal is absolutely to eliminate the P&I part of PITI over time. With enough in pot #3 I'll be plowing as much as possible into principle reduction over the next few years once we get moved in and clear the costs associated with a new house such as drapes and furniture. I make a pretty decent salary but who knows how long that will last? As long as the job is secure I'll keep the current mortgage and pre-pay as much as possible. If a few years down the road I felt a little vulnerable to layoff or whatever I'd seriously consider refinancing the then smaller principle balance for a smaller required monthly nut and keep making the higher payments as long as the income stayed intact. Alternatively I may need to do that in 10 years anyway when my kid goes to College. What we are currently paying in private tuition from current income + available cash flow might be a bit short, or we may be ok - depends on where he goes. I'm a College administrator so if he goes here he gets a 100% tuition waiver, 50% at other state schools. And I did look at saving for College in one of the tax deferred accounts, we don't qualify for all the juicy ones based on family AGI. We could do a 529 but I've made the personal choice that we're better off driving the retirement savings and paying off the mortgage rather than killing ourselves to give the kid a free ride .

I like a guaranteed 6.5% return. With any luck the house will get worth more over time as well making the return even better. I played leverage to the max in 1999 when I bought a townhouse for 78K by assuming a mortgage, I just sold it 2 months ago and cleared $112K cash in my pocket, principle balance was 64K so 14K of the 112K was return of my principle payments. That was great but now we're in a little better position financially and I'd like to preserve it over time. I've owed huge piles of money to CC companies and auto loans in the past - don't ever want to go there again!

One other thought. Despite the current turmoil in the market houses do tend to be worth more over time. Probably not as good as the stock market if the time horizon is long enough but they do go up. In my case 60% of the asset value is borrowed so there is a leverage factor on the return. Here is the thought - under current tax rules that return is tax free where as the stock market return is not. It's all about risk tolerance I guess.

Upon examination, I think you're probably right, although I have assumed "a start of the month/year" program where the question was academic until you actually had some money to put to one place or the other; i.e. an initial $100 today and $100 every month, so a year from today you've got $1300 without interest. Kind of like the old problem where if you've got an eighty one foot wall and beams every nine feet, you need ten beams to have a real structure. One to start (at the zero point), and then another one every nine feet.

The pots of money idea is a good one, but most people shouldn't be limited themselves to theoretically risk free investments, especially once you've got your reserves. 1) They're not risk free 2) The big certainty if you don't take any risk is that you will make less than someone who did. Kind of like being chased by headhunters, and having a choice to sit there and be killed an eaten immediately or jump off a cliff into a river with crocodiles. Sure, the crocodiles might get you, or you might hit the rocks when you land and you might even drown. But if you do nothing, you're going in the stew-pot for certain.

Question: How do you think the bank or insurance company can afford to pay a return on the money? It doesn't come out of some hyperspatial vortex! They take this money and invest it in basically the same places you would. The difference is: They take the risk, they get the reward. This reward is plenty to pay their employee salaries, all the expenses of operating, plus your little pittance, and have plenty left over for the stockholders. If their results are adverse, what's going to happen to your money?

Question: If you never refinance, how hard do you think it's going to be to make a $1500 payment in thirty years? Assuming a 3.5% rate of inflation, about like paying $530 per month now. Shouldn't be difficult at all. If you do refinance, you are making a conscious choice that the other loan is, in total, a better deal for you. Sure you might not have a lot of income. My point is that with time and diversification, the assets you would accumulate from alternative investments will be more able to pay your loan out of interest than any money you saved.

Question: If you can't make the low payment, what will your equity situation be like? Once again, this is assuming you never refinance, but 29 years out, you'll owe roughly $15,000, and the property, assuming average 5% appreciation, while the property will be worth about 4.3 times as much. Even if you never paid a penny of principal down, that's well over a million in equity. This gives you options such as selling (take the money and run), a RAM (take the money and stay), etcetera. Stop thinking of money as something that pays the rent and other expenses, and start thinking in terms of what it can do.

Furthermore, it's not a risk free 6.5%. For most people, it's more like an effective margin of 4.7% or less. I'm not advising anyone to go out and strip equity without a very strong reason to do so so and a clear eye on potential consequences, but which after tax return sounds better to you: 4.7% or 7.2%? I agree with the NASD rule that prohibits member firms from accepting borrowed money for investments, but I have admit that it does work, at least for the numbers in theory. The 7.2% assumes investment income is all ordinary income, fully taxed every year. In point of fact, at least some is likely to be capital gains and some is likely to be deferred. The downside is that any investment return is purely speculative and you could lose your principal. You don't ever gamble with money you can't afford to lose, no matter what the long term odds. Nor do you put it all on the same bet, no matter how you split it up. On the other hand, the biggest risk is not taking any. Instead of paying off your mortgage, diversifying your money amongst a sufficient number of stock and bond investments is so likely to leave you with so much more in total net assets over the next twenty years that the expected exceptions are a statistical non-event.

Caveat Emptor