Pay Off Mortgage Sooner, Invest, Or Save? The Math Analysis

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I’ve previously written about this topic – should you pay off the mortgage early or invest – but I realize that post was sorely lacking the math.  Today, I want to take a deeper look at the discussion to give a more thorough answer to the question – should you pay off the mortgage or invest? Watch out! I’m about to unleash the geek inside and let him run some math with the calculator.

This post is the first in a series that deals with home ownership questions.  The series will cover the following topics:

  1. Is a house an investment or a home?
  2. How to know when you’re ready to buy a home
  3. How to pay off the mortgage early

Pay Off Mortgage Or Invest – Points To Ponder

I was recently talking with someone who wants a home loan.  He likes where the average home mortgage rates are and he thinks you’d be crazy not to have one.  At the time of this article, the national average for a 30 year fixed rate is 5.13 and for a 15 year it is 4.38 – wow those are some great rates!

However, we should keep in mind that over the last 10 years, the Wilshire 5000 index has basically been flat.  In other words, if the next 10 years are just like the last 10 years, you could have paid around 5% to invest the money and get 0% return.

Canada Vs. United States

Your country of residence also influences this decision.  In the United States, interest paid on a mortgage is tax deductible, while in Canada you do not get this deduction.  If you are a Canadian, your numbers and calculations will need to reflect the proper Canadian taxation.  It is better to pay off your balance in Canada than in the States.

Occupation

Ministers are eligible to receive lodging from the church free of income tax.  In addition, ministers can receive a tax deduction for interest payments.  This means that if you are a minister, your full house payments are tax deductible (along with the cost to maintain a home – called a housing allowance).  While the IRS does allow a minister to deduct fair rental value of the home, there does seem to be some discussion on how ministers are impacted if they pay off the home early.  Consult your local tax professional for guidance.

Personal preference, personal comfort, and personal security

A home is not just a place where the heart is, but it is also the place you feel most safe and secure.  When you completely own your home, you reduce the possibility that someone will come and take it from you.

The “I-just-feel-better-having-the-house-paid-off” feeling is certainly worth something.

What if we change the formula – pay off the mortgage or spend it?

For most people, it is extremely hard to continue to be financially focused when they are already doing very well.  Compared to national averages, anyone who only owes on the house is in a good financial position.  Thus, the question is if you had an extra $150 per month, would you really invest it or would you blow it?  Sometimes we have great intentions, but we don’t follow through on our intention to invest the money.

Your debt definition

Some people think that if they pay off everything but the house they are debt free.  Dave Ramsey set that standard.  However, you are still in debt, all be it a good debt on the account of many.  Some people want to be REALLY debt free, and if that is your personal goal, you will be better off paying off the mortgage and then get to your investing.

Mortgage Interest Rates

If you have any other debts, there is a good chance that your mortgage interest rate is the lowest.  With the exception of student loans, you are probably not going to get a lower interest rate for borrowed money.  In addition, those who have borrowed on the house make the assumption that their property will increase in value.  This may or may not be true.

Upon purchasing a new home, it is smart to use a mortgage loan calculator to make sure your new investment is within your budget.

It your mortgage a fixed rate or variable?  What is the length of your term?

Guaranteed return vs. possible return

Paying off the mortgage guarantees that you will save yourself the interest.  Investing the money means you are assuming the investment will make a larger return than your borrowed money.  Anyone who has been alive more than three years knows the investment market can be quite volatile.

Inflation

When the dollar becomes less valuable in terms of the value of your payments, they actually decrease over time.  If, like many think we are, we are on the verge of seeing a time of inflation, then you will be getting more of tomorrow’s dollars, but will still be required to pay the same dollar amount in the future.  In other words, there is not inflation increase on mortgages (assuming it is a fixed rate).

Asset allocation and risk

There is really only one way to increase your investing return potential.  Increase your risk.  When you say pay off the mortgage or invest, you need to compare paying it off to different levels of investing risk.  The more conservative you are, the less likely you are to make any sort of significant gains over and above your mortgage.  However, the more risk you take, the more likely you are to do much better or much worse.

Thus, you need to find a way to take enough risk to make the investment worth it, but not to take too much risk to be in a worse financial position.

Igor the Intense Investor Vs. Matt the Mortgage Manic

Igor the Intense Investor Matt the Mortgage Manic
Both start off with a $150,000 mortgage for a 15 year 5% fixed rate mortgage. Both start off with a $150,000 mortgage for a 15 year 5% fixed rate mortgage.
Igor pays only his minimum payments ($1286.19) and uses a $100 per month to invest.  At the end of 15 years, his house is paid off and his investments (at 8%) are now worth $34,603.82. Matt pays his regular payments ($1286.19) plus adds $100 each month to the principle.  When the house is paid off, he invests his regular house payment plus the extra $100.  He gains 8%.  He does this for 19 months.  At the end of 15 years, his house is paid off and the total value of his investments would be $32,728.87.
However, if Igor were paying 25% taxes, he would have also have deducted 25% of $63,514.28.  Along the way, he deducted and saved $15,878.57 in taxes. If Matt were paying 25% taxes, he would have deducted 25% of $55,826.56.  Along the way, he deducted and saved $13,956.64 in taxes.
Igor cashes out his investment and pays 15% long term gains tax and he has $29,413.25.  Plus his tax savings equals $45,291.82 Matt cashes out his investment and pays 15% long term gains tax and he has $24,546.65 plus his tax savings equals $38,503.29.
At the end of the day, Igor ends up with $6788.53 (account value plus tax savings) more by focusing on investing.  Over a 15 year period, that means he saved on average about $450 each year.  If, however, Igor’s investments returned anywhere less than 6%, he would have lost money in the process of taking an increased risk over a 15 year period.

Important Observations and Notes about Paying off the Mortgage:

  • Since the Wilshire 5000 is flat over the last 10 years, it is hard to know if you will be able to find a relatively safe 8% rate of return over the next 15 years.
  • Home loan rates are extremely low right now.
  • During that 15 years, there was probably at least one period where Igor’s investments were down 30% or more.  Would he have had the stomach to keep investing?  Would he have bailed?
  • As a side note, if Igor was investing in a tax deferred account (like a Traditional IRA or a 401K), then the numbers would be much more in favor of investing.  Again, assuming an 8% rate of return.
  • If you pay it off you will know that you will be better off financially in 15 years time.  If, however, you invest, you may be better off – or you may be worse off.
  • If you are in Canada, the difference is more like only $2,000 difference or $133 per year by taking the investment risk.
  • Before paying off your mortgage early, even the most conservative financial advisers suggest you should first be putting 15% of your income into retirement.  Thus, I’ve ignored the tax deferred accounts in this equation because you should already be putting 10-15% into retirement before considering paying off the mortgage early.

Here is a great downloadable excel document (and free) that will help you calculate your own mortgage prepayment options.

Summary

When comparing paying off the mortgage early or investing at 8% in a taxable account, the numbers reveal little overall difference.  Neither one is a terrible math decision.  Neither is the deal breaker.

So, what should influence the ultimate decision?

Thus, ultimately it comes down to the non-math factors to help you make the right decision. I’m sticking to my guns that paying it off or investing is not a math decision, it is a highly personal choice based on the preferences of each family.

Personally, the emotional roller coaster to come away with a possible $450 per year is not worth the risk.

Consider doing both.  I’m a proponent of financial plans that make room for you to be both right and wrong.  In that case, when the future unfolds you are never completely right or completely wrong.  You could consider 1/2 of your extra money towards the house debt and 1/2 invested.

How To Determine if the Investing Risk is Worth It?

Questions to ask:

  1. Do both husband and wife completely agree about the decision to invest?  If not, it is not worth the extra strain on your marriage.
  2. Are you already saving 15% for retirement?  If not, pay minimum house payments and invest into your retirement account.
  3. How certain is the investment?  If you can get an 8% CD, then you are completely removing risk from the equation.  However, if you need to invest in aggressive funds to hope to get 8%, then just pay off the mortgage.
  4. Is greed driving your decision?  Are you taking a financial risk with something that will provide a decent stable return?

Be sure also to read the following posts (by fellow Money Maven Network members):

Pay off mortgage or save?

Free Calculator: Pay off the mortgage or invest

Pay off your mortgage or invest your money?

12 Good Reasons Why You Should (and Should Not) Pay Off the Mortgage

Should You Grow Your Nest Egg Or Pay Off Your Mortgage?

What are your thoughts?  How is my math?  Did I miss any important considerations?

Comments

  1. says

    Wow, clear as mud, eh? Thanks for running the numbers and making them so presentable. Like so many financial decisions, it comes down to psychology. A house you can touch and feel, or investments that are flexible but elusive.

  2. says

    WOW….a really thorough job. I believe it’s all about priorities like you wrote. I personally feel much better with my mortgage gone. I could have made more money doing other things with it but..

    a. I didn’t know that at the time.
    b . I don’t care. It’s worth it to me.

  3. says

    Great summary, Craig!

    While the US does give a tax deduction for mortgage interest to those who itemize their deductions, that deduction naturally decreases over time as the amount of interest one pays is reduced.

    My mortgage interest deduction is now almost so low it hardly matters anymore!

    All the best,

    Len
    Len Penzo dot Com

  4. says

    Interesting. 2 & 3 seem to contradict. If a mortgage is 6%, but risk free investments are 1%, then (absent a match) paying the mortgage may be the better choice over the 401(k) choices. It all depends, I suppose.

  5. says

    @Joyln
    Yes, once again psychology becomes the deciding factor.
    @Neal
    I’m in the same camp as you. Even if it was a greater math difference I feel a lot better paying off the house.
    @Len
    Good point! The closer you get to paying off the mortgage the less the difference the deduction makes.
    @Karen
    That is of course the biggest unknown factor – will we see 8% returns. I honestly don’t know. It could be 15 or it could be 3. It is hard to do the math with the biggest variable is still unknown.
    @Lencib
    Your right. It is a very important decision.
    @Joe
    They do contradict. I figured if I didn’t write that someone would have thought I fixed the numbers buy running the math outside of a 401K account.

  6. says

    Very nice post Craig!

    I agree with you that there are several risks involved when you are investing vs life is quite simple when you just have your mortgage to pay ;-)

    Have you done the calculation considering a Smith Manoeuvre for Canadians? This would be a great advantage to consider since mortgage can’t be tax deductible unless you apply the Smith Manoeuvre..

  7. David says

    It is better to use the extra money to pay back the loan instead of investing it. You can get a 5 year CD at 4 percent if you’re lucky before taxes. Getting a guaranteed 5 percent return from paying off loan is much better than getting a return of 4 percent.

    Stocks are riskier than CDs. In 2008 the S&P 500 went down 37.22 percent which will take many years to recover from. So paying off your loan is the safest bet unless you are the Oracle of Omaha.

    • says

      @David
      I’m with you. Stocks can be dangerous – hence the extra risk factor. However, in my case my bank (overseas) is offering an 8.05% one year CD. My mortgage is 5%. Everyone needs to work the math based on their own situation. There is no open and shut case.

  8. Matt says

    Thanks for providing these very equal terms. The good news in both of these scenarios is that they both are purchasing a home. They will both benefit from the property value increase if they were smart and invested in a property that will increase in value.
    Other scenarios I have seen have said that renting and investing your money would be a better option but I totally disagree; unless you move often.
    Another factor you could add to this equation is the brokerage fee’s that you typically pay when purchasing and selling stocks and bonds. Those can really make a difference and makes you understand why a financial planner would like you to rather invest in stock than pay off your mortgage early.

  9. Diane S says

    You have made 2 all too typical oversights in your calculation.

    1. Mortgage interest is only tax deductible when a person, or married couple can itemize their taxes. Then it only is worth a deduction over and above the standard deduction, which nowadays is around $11,000 for a married couple. Unless a person is single, or makes significant charitable contributions, or pays really high property taxes, if their interest is less than $8,000 a year, for example, then they will not benefit from the tax deduction beyond what they would have gotten from the standard deduction. I fall in the higher end of middle class for income, am married, and will have paid around $8,000 in interest this year on my around $172,000 principal. Add to that about $2500 in taxes that I can deduct, and about $500 in charitable contributions and it is unlikely that I will be able to itemize this year. If I do benefit from itemizing, it will only result in very small tax savings.
    2. Further, unless I missed this point in your analysis, you didn’t consider how much total money Igor and Matt will pay in interest (i.e. rent to a absentee landlord!). According to your setup, Igor will pay $63,514.28 in interest over 15 years, while Matt will pay a total of $55,826.56. This is the simplest, most straightforward way to observe monetary gains from paying off your mortgage early – Matt will save $7,687.72 by simply paying a measly $100 extra each month. If Matt were to be more daring and pay $200 extra each month, he only lose a total of $49,837.69 in interest, and save $13,676.59 over Igor. Imagine the savings if he were even more daring each month! Now, how this ties into the rest of your analysis, I will leave up to you. But I urge you to not forget the Basics in your analysis –the overall savings gained by paying less interest, and the complication of weighing the use of the standard deduction to the itemized deduction.

  10. Dave says

    Am retired, wife drawing Soc Sec., health insurance paid til just 6 months shy of me applying for Medicare, wife under Medicare and under my insurance, no debt other than house, drawing retirement from State retirement plan which will reduce when I turn 62, will apply for early Soc. Sec. to offset difference in income. Could pay off house from my 401K and have 25,000 left. Have been able to itemize and take advantage of mortgage tax credit. 401 K making slightly higher interest than mortgage interest. Would religiously invest back into 401K equivalent of house payments til 62 (am 60 now). Interest is 5% guaranteed not to fall below 4%. Should I pay off the house and lose tax deduction? Would pay half in this tax year and other half right away in the next tax year to accumulate into 401K. Would this be the wisest decision to get out of debt?

    • says

      @David
      For such specific questions you would need to seek the professional advice of a certified advisor. Here are some of my general considerations:
      • The “risk” question needs to be explored. Are the contents of your 401k more or less risky than a paid for home?
      • Retirement cash flow. Will there be enough cash flow if the mortgage is paid off?
      • The amount of tax savings lost. How valuable is that?

  11. Robyn says

    I think there may be something a bit off in your numbers. If you reduce Matt’s investment value by the 15% tax rate, wouldn’t Matt be left with $27,819.54 of the original $32,728.87, not $24,546.65? That would make the difference between Matt’s and Igor’s strategies even smaller.

  12. Brad says

    What about the $7,687.72 in interest that Matt saved by paying off the mortgage almost 20 months earlier than Igor?

  13. Rick Flerry says

    Overall a pretty poor analysis, Craig. You didn’t even factor in the interest saved by paying off early. In other words, you got all dressed up for dinner and didn’t bother to put in your dentures.

  14. Alvin says

    Hi Craig,
    I do have a question:
    “Are you already saving 15% for retirement? If not, pay minimum house payments and invest into your retirement account.”
    In my case, I have my State Gov. retirement (Calpers). beside that, I have a 457k account ( but not match). Do you think if it is still a good idea to max out my 457k account first; then put extra money to my house mortgage?
    Thank you for your help

    • says

      Alvin,
      The premise is that you should be sure that your saving an appropriate amount for retirement while paying off your house. If you have an opportunity for a match I would be sure that I was investing there first, but it is a very personal decision.

      • Alvin says

        Hi First thank you for your help David and Craig.
        Craig,
        my 457k retirement account is not matched from employer, so you mean I should pay extra on my mortgage first. right?
        By the way, I lose a lot of money from 457k within this couple years.

        • says

          Alvin,
          Sorry I misunderstood. I’m assuming you’re completely debt free other than the home, right? In that case either choice would be good (invest or pay off mortgage). You may feel better about paying off the mortgage because it is a more sure return. That’s find. I wouldn’t pull money out o the market to pay off the house.
          This is not professional, legal, or accounting advice. Simply my thoughts on what I would do.

    • David says

      @ Alvin, Paying off your home is saving for retirement because when you retire your mortgage will be zero dollars every year, take out all your money from all accounts to pay off your home first.

      • says

        Alvin & David,
        I would not “take out all your money from all account” if you are referring to retirement funds as you will (in most cases) pay taxes and fees to do so. Furthermore, I prefer diversification so I’d try and do a little of both.

  15. Jennifer S. says

    Thanks for this article Craig! I’ve been asking myself these same questions and have been looking for the answers. I do fee like paying off the house first would be the best decision for me. However, does this still work out the same if you were to sell your house before the mortgage is paid in full? That’s where I keep stumbling. And I assume it would make a difference in this economy if your house isn’t worth what it was when you bought it. Thanks again for your helpful article!

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