Pay down mortgage or invest?

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Pay down mortgage or invest?

Postby nepenthegu » Sun Sep 01, 2013 3:04 pm

Hi, Everyone:
I have a question that probably has been asked zillion times. We are in our early 30s and have a 30-year fixed mortgage at 4%. We have maxed 401K contribution and do not quality for Roth IRA. Beyond retirement contribution, we have some additional savings which, if all used to pay down mortgage, we will own our house free and clear in 15 years. Effectively, however, the annual return from paying down mortgage is merely 4%. And if we buy and hold index fund in taxable account, the annual return could be much higher. Did I miss any advantage of paying down mortgage as opposed to invest?

Thank you very much for your inputs!

**************************
Updates:

Thanks everything for their invaluable advice!

Backdoor Roth IRA conversion is a new idea to me. I did some research but I am not sure if my understanding is right.
The basic steps are straightforward. Make non-deductible contribution to Traditional IRA and sell the share in Traditional IRA to fund Roth IRA. However, the tax consequence on my traditional IRA balance is unclear to me. Let's say I make a $5,000 non-deductible contribution to Traditional IRA. And I have an existing Traditional IRA with a balance of $100K (mostly from 401k rollover). According to the Backdoor Conversion to Roth IRA piece on Boglehead wiki, tax will be assessed on my total balance across all IRA accounts. In my case, only 4.7% ($5K/($100K+$5K) of total IRA balance is tax-free and the rest are taxable. So effectively, backdoor roth IRA only makes sense for someone with no other IRA account. Is that right? Help?

Thanks again!
Last edited by nepenthegu on Mon Sep 02, 2013 3:07 pm, edited 1 time in total.
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Re: Pay down mortgage or invest?

Postby Grt2bOutdoors » Sun Sep 01, 2013 3:27 pm

What is your federal and state tax rate? Do you live in a state that allows you to deduct your mortgage interest? Let's say hypothetically you are in the 25% tax bracket (it's likely you are higher than that) - that 4% interest rate may be only costing you 3% (4% * .25 = 1%). The argument is by investing, if you can realize a return higher than 3% over time, you will come out ahead. Others may have more cashflow and say, by paying down the mortgage, I will reduce my liabilities, earn more than I can earn in fixed income investments and own my home free and clear even sooner. They don't care about investing in other accounts, simply because they are seeking to reduce risk that a volatile investment can not satisfy.
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Re: Pay down mortgage or invest?

Postby sambb » Sun Sep 01, 2013 3:57 pm

By paying down your mortgage, it is a RISK FREE return. It is NOT the same as investing the money in the stock market. It is sort of like putting money into a money market fund in my opinion. It has no risk to you to put the money into the mortgage.

I dont favor using it as a replacement for equity investments... But it is a risk free return, and that is a key component.
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Re: Pay down mortgage or invest?

Postby stan1 » Sun Sep 01, 2013 4:06 pm

Personally I would make extra payments to get the loan paid off in 15 years, and invest the rest in a taxable account. Having a taxable account gives you a lot of flexibility/liquidity in case you ever need it for home remodeling or to start a business, without the cost/approval process/risk of a home equity loan. A 15 year paydown plan gives you the flexibility to revert back to 30 year payment amount if you ever need to while saving a significant amount of interest paid.

Can you do Backdoor Roth IRA contributions (contribute to Traditional IRA, convert to Roth)?
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Re: Pay down mortgage or invest?

Postby grabiner » Sun Sep 01, 2013 4:49 pm

nepenthegu wrote:I have a question that probably has been asked zillion times. We are in our early 30s and have a 30-year fixed mortgage at 4%. We have maxed 401K contribution and do not quality for Roth IRA. Beyond retirement contribution, we have some additional savings which, if all used to pay down mortgage, we will own our house free and clear in 15 years. Effectively, however, the annual return from paying down mortgage is merely 4%. And if we buy and hold index fund in taxable account, the annual return could be much higher. Did I miss any advantage of paying down mortgage as opposed to invest?


Wiki article link: Paying down loans versus investing

You missed the fact that the mortgage payment is risk free, while the stock market is risky.

However, if you pay down the mortgage, you won't be getting the benefit for at least 15 years. You will be committing to investing at a 4% taxable risk-free return, but with a duration of 15 years or more. If you don't qualify for direct contributions to a Roth IRA, you must be in at least a 28% tax bracket, so your return from paying down the mortgage is 2.88%.

And 2.88% is not a very good return on a long-term commitment. If you aren't maxing out your backdoor Roth IRA, you can earn 3.31% risk-free by buying Vanguard Long-Term Treasury there, which also has a duration of 15 years; the interest-rate risk of the Treasury bonds to you is equal to the interest-rate risk of your mortgage to the bank. And if you are maxing out your backdoor Roth IRA, you can earn 3.58% by buying Vanguard Long-Term Tax-Exempt in your taxable account; this fund has a small amount of credit risk, but much less interest-rate risk than your mortgage.

You don't need to make either of these investments, but they give a fair comparison. You could first decide that you would rather invest in Treasury bonds than in mortgage payments because that gives a better risk-free return, and then decide that you would rather invest in stocks because the extra return is worth the risk.
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Re: Pay down mortgage or invest?

Postby Bubbagump » Sun Sep 01, 2013 5:53 pm

This is interesting to me:

http://www.hughchou.org/calc/payoff_v_borrow.cgi

At least in my case, it was practically a wash. The real question is over the long haul, what can you expect your investment returns to realistically be as well as tax bracket? You really hope (assuming you are a wage earner) you go up in the tax bracket as well as your interest on investments going up. Realistically and perhaps conservatively, we can say a 6% return on investments is realistic. (Buffet says 7%, but that's on stocks alone and hopefully we invest a little more diverse than that.) Then, look at your bracket. Are you $2k from going to the next level or $30k? In all likelihood, you could get a raise for $2k, $30k not so much unless you just finished some sort of schooling or were totally underpaid in your field. All that to say, it can be a tough call unless you have a good handle on what the future holds. Note, a percentage point one way or the other can completely tip the scales.
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Re: Pay down mortgage or invest?

Postby stan1 » Sun Sep 01, 2013 6:04 pm

Bubbagump wrote:Note, a percentage point one way or the other can completely tip the scales.


Absolutely, and this is a point that's often lost when people want to grind away on spreadsheets and formulas to determine an optimal outcome. All these models have a high degree of sensitivity to future market returns, future inflation rates, and future tax rates/laws. In the end the mortgage payoff question comes down to three choices: debt aversion (not wanting to carry debt); debt as a nuisance (mortgage balance becomes a small percentage of net worth so just pay it off to simplify life); and liquidity (keeping assets in a taxable investing account rather than home equity).
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Re: Pay down mortgage or invest?

Postby dhodson » Sun Sep 01, 2013 6:30 pm

As mentioned above you can back door Roth

2nd depends on what you would invest in and over what time period. If you have 30 years of mortgage left, can get the housing deduction, and are comparing to stocks then I'd invest. If a short duration, plan to move in a few years, then I'd pay down.
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Re: Pay down mortgage or invest?

Postby larmewar » Mon Sep 02, 2013 1:29 pm

If your itemized deductions, excluding mortgage interest, are less than your standard deduction ($11,900 for married 2012), then you are not getting the full benefit of the mortgage interest deduction. So there may be a small income tax benefit from paying off the mortgage.

Peace of mind of not having the expense is a non-monetary benefit of paying off a home mortgage.

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Re: Pay down mortgage or invest?

Postby mephistophles » Mon Sep 02, 2013 2:48 pm

Just my opinion, but paying down a mortgage has some disadvantages. First, a home/house is a place to live in, not an investment. Secondly, money ties up in the house is not directly available should you need it for whatever, You have to take a second mortgage, line of credit or sell it. Third, as the housing bubble illustrates, you can dump money into a house and drop in house prices can wipe out all or part of your equity. Fourth, we are still dealing with the lowest mortgage rates in many decades, so why not use their cheap money. Over the long haul, I would think, you will be able to do much better than the 4% or so current mortgage rates.
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Re: Pay down mortgage or invest?

Postby Watty » Mon Sep 02, 2013 9:23 pm

Did I miss any advantage of paying down mortgage as opposed to invest?



One option to consider is to save up a significant amount then see if the lender will allow you to pay off part of your mortgage and have the "mortgage recast" (Google this). If they allow this then if you pay down 25% of your mortgage in a recast then your monthly mortgage payment would be reduced by 25%. The interest rate an length of the mortgage would be the same which could be to your advantage if interest rates go up later on.
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Re: Pay down mortgage or invest?

Postby Clivus1 » Tue Sep 03, 2013 9:53 am

A few thoughts:

1 Mortgage rate are at generational lows. As others have mentioned your effective return on paying down the mortgage is well south of 4% If it ever makes sense to invest rather than pay down the mortgage the time is now.

2 Inflation will dramatically shrink your mortgage payment as a fraction of income over 30 years.

3 Early savings rate plays a large role in portfolio success. It will be mathematically very challenging to "catch up" later with a more aggressive savings rate.

4 Ask yourself which is a stronger position in 15 years: Mortgage paid off or funds in the bank able to pay off the mortgage + residual balance.

I find the fourth argument very compelling and have decided to keep my mortgage and divert more cash to investments.
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Re: Pay down mortgage or invest?

Postby Harold » Tue Sep 03, 2013 10:22 am

Since these thoughts represent a well-organized summary of the thinking of many considering this question, and since each offered easy clarifying counters -- I thought I should respond:

Clivus1 wrote:1 Mortgage rate are at generational lows. As others have mentioned your effective return on paying down the mortgage is well south of 4% If it ever makes sense to invest rather than pay down the mortgage the time is now.

The prices for cash flows are what they are. It's not as if one can borrow at "well south of 4%" and get returns "well north of 4%" without taking on more risk. People can (and do) make the same arguments when rates are X% and other investments can be seen as making more than X%. Nothing special about 4%, except psychologically it feels safely low by historical standards.

Clivus1 wrote:2 Inflation will dramatically shrink your mortgage payment as a fraction of income over 30 years.

This is a true statement. However, inflation expectations are built into the discounted prices of all cash flows the mortgage is being compared to. This works in the investor's favor only if inflation exceeds expectations -- if inflation meets expectations, it's a wash; and if inflation is lower than expectations, the investor making a decision on this basis loses.

Clivus1 wrote:3 Early savings rate plays a large role in portfolio success. It will be mathematically very challenging to "catch up" later with a more aggressive savings rate.

Paying down a mortgage is savings. One is deferring consumption and getting a return equal to the mortgage rate. The mathematics of compounding works precisely the same for paying down debt as it does for investing.

Clivus1 wrote:4 Ask yourself which is a stronger position in 15 years: Mortgage paid off or funds in the bank able to pay off the mortgage + residual balance.

Part of your equation is missing. Since more risk is being taken, there could be a "- residual losses", which could quite obviously lead to a weaker position than a paid off mortgage.

For an investor with a well-thought out plan, this question is simple:

- If one doesn't want to take on more risk, he invests in a higher returning investment of equivalent risk if available, otherwise pays down the mortgage.
- If one wants to borrow to invest at higher risk, he does so.
(if one invests while maintaining a mortgage, he is doing one of these two)

Neither of these really has to do with having a mortgage, except that many people have mortgages, and that tax-advantages and the collateral of their homes make them a lower cost method of borrowing for many.
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Re: Pay down mortgage or invest?

Postby grabiner » Tue Sep 03, 2013 7:10 pm

Harold wrote:
Clivus1 wrote:3 Early savings rate plays a large role in portfolio success. It will be mathematically very challenging to "catch up" later with a more aggressive savings rate.

Paying down a mortgage is savings. One is deferring consumption and getting a return equal to the mortgage rate. The mathematics of compounding works precisely the same for paying down debt as it does for investing.


And you have to make this a psychological decision. If you consider your mortgage payment as "savings", then you should plan to increase your retirement contributions by the amount of the mortgage payments once the mortgage is gone.

Clivus1 wrote:4 Ask yourself which is a stronger position in 15 years: Mortgage paid off or funds in the bank able to pay off the mortgage + residual balance.

Part of your equation is missing. Since more risk is being taken, there could be a "- residual losses", which could quite obviously lead to a weaker position than a paid off mortgage.


And the time not to pay off the mortgage (except for psychological issues) is when there isn't a significant extra risk. The OP could get a better return from Treasury bonds in a backdoor Roth IRA (or with a slight risk, from municipal bonds in a taxable account if his IRA is full) than from paying down the mortgage, because the mortgage is now at a below-market rate.
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Re: Pay down mortgage or invest?

Postby RyanKaleb » Tue Sep 03, 2013 10:09 pm

Here are a few things to consider:

-Mortgages are excellent ways to borrow money, thanks to all of the government subsidies (assuming you take the deduction(s) that come from owning a home).

-Having a mortgage is a great way to short the US dollar because of the long maturity and low rates you can borrow at. If there was some way to borrow hundreds of thousands of dollars at today's rates for 30 years and buy stocks with the money w/ a tax deduction and all of the benefits that come with a mortgage, I would...In a heartbeat.

-I would never even consider buying a home with my own money, but hey, if the US taxpayer and a bank is dumb enough to loan me several hundred grand a 3-4% for 30 years and give me a tax deduction sure why the hell not.

Check out this short clip from not too long ago and consider your options carefully:
http://www.youtube.com/watch?v=KMvQPeBAesw
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Re: Pay down mortgage or invest?

Postby sls239 » Wed Sep 04, 2013 9:48 am

What is your current asset allocation?

I might consider using extra money to pay down the mortgage, but in concert with that having a more aggressive asset allocation.

Especially if I thought there was any chance I may be moving in the next 10 years.

And there's nothing that says you have to continue to pay down the mortgage. You can change your mind the next time interest rates rise, when you get "tenure," or any number of other events happen.

As for the backdoor roth - if your employer allows, it may be possible to put your current rollover-IRA into your current 401K plan, and then there would be no complication with the backdoor roth.
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