Extra Principal vs. Investing

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MarquisMark
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Extra Principal vs. Investing

Post by MarquisMark »

Hi folks,

I would like to ask the very wise minds here in the community whether it is better to pay extra principal on a mortgage or take that money and invest in mutual funds. I know this topic has been done before but I wanted to see what would be best based on my situation here...

I recently paid off my auto loan and this leaves me with some extra cash every month. I was planning on paying an extra $200 a month on my mortgage. I did an FHA streamline a few months ago…the payment is currently about $700. Currently I see three options:

1: Pay the $200 extra principal on mortgage every month
2: Invest the $200 in a Trad IRA

I don't know how long I plan on holding this house…at least another 5 years or until I can at least break even. My gf and I were planning on finding a place together down the road, but will depend on housing market. So hence the third option:

3: Invest the $200 in a tax free muni bond to accumulate downpayment for the house we want to get together down the road.

This way I could keep my own as a rental as well (my HOA doesn't currently allow rentals in this neighborhood but I think I can get around that and is possible that rule will change). My gf owns a house as well, which we will also use as a rental when that time comes.

As you can see, I got a lot of ideas swimming through my head. I'm eager to hear what the folks here think.

Here is my pertinent info:

Emergency Fund: 6 months

Mortgage: ~ 104K @ 3.75% (Purchase price of 120K, market value now about $110K)
No other large consumer debt

Tax Filing: Single

Tax Rate: 25% in NV (no state tax)

Age: 37

Desired Asset Allocation: approximately 70/30

Desired Int'l Allocation: 20%

Current Investments: low 5 figures

Roth IRA:

100% Vanguard 2045 Target Retirement Fund (VTIVX) .19%

401(k):

100% MFS Bond R4 (MFBJX) .60%

Annual Contributions

Roth: $5000 DCA over the year

401(k): Approximately $2,000 (there is a limit to the employer match and I only contribute until I receive the match).

Thank you!
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bUU
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Re: Extra Principal vs. Investing

Post by bUU »

Can someone please let me know how to "Notify me when a reply is posted" without posting a reply?
STC
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Re: Extra Principal vs. Investing

Post by STC »

Its a pretty simple decision point. If the effective rate (rate on mortgage * (1-marginal tax rate)) is higher then the "risk free rate of return" (i.e. treasuries) for the same duration (i.e. if you have 15 years left on your mortgage, compare against the 15y tres), then pay down the mortgage. Else invest.

If it is a few basis point difference then do whatever makes you feel the most warm and fuzzy
livesoft
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Re: Extra Principal vs. Investing

Post by livesoft »

With the amounts the OP quoted in savings and investing ("low 5 figures"), I would not be paying extra on the mortgage. I would want more of a cushion to pay for home maintenance, perhaps a vehicle in case my car is totaled by an uninsured motorist, travel in case my mom died, and things like that. This is all regardless of interest rates on mortgage.
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The Wizard
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Re: Extra Principal vs. Investing

Post by The Wizard »

Perhaps split the extra money in half and do both an IRA and principal pay-down.
Over coming years, you might expect pay raises and additional extra income such that you can top out your IRA ($5500) and then throw the remainder at your mortgage!
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keq1381
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Re: Extra Principal vs. Investing

Post by keq1381 »

The Wizard wrote:Perhaps split the extra money in half and do both an IRA and principal pay-down.
Over coming years, you might expect pay raises and additional extra income such that you can top out your IRA ($5500) and then throw the remainder at your mortgage!
+1
phish_indexer
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Re: Extra Principal vs. Investing

Post by phish_indexer »

MarquisMark wrote: 2: Invest the $200 in a Trad IRA

Annual Contributions

Roth: $5000 DCA over the year
If you plan on maxing out a Roth each and every year, you can't put additional money into a Traditional IRA. You may consider upping your 401(k) contributions, which would be similar to investing through a traditional IRA.
pkcrafter
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Re: Extra Principal vs. Investing

Post by pkcrafter »

bicker wrote:Can someone please let me know how to "Notify me when a reply is posted" without posting a reply?
Go into User Control Panel (top left corner) and then click on board preferences/edit posting defaults.

Paul
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Calm Man
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Re: Extra Principal vs. Investing

Post by Calm Man »

I always believe in paying off any debt regardless of rate, comparisons to investments, etc, as I am allergic to debt. EXCEPT for the poster. His cash on hand is low (which is nothing to be ashamed of as you are a young person) and he needs to have it around for easy liquidity. I would advise building up the emergency fund for true emergencies and avoid overbuying until you are in a better spot cashwise, such as cars, housing upgrades, fancy vacations, etc. Good luck and I know you will do well.
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bUU
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Re: Extra Principal vs. Investing

Post by bUU »

pkcrafter wrote:
bicker wrote:Can someone please let me know how to "Notify me when a reply is posted" without posting a reply?
Go into User Control Panel (top left corner) and then click on board preferences/edit posting defaults.
Thanks but that setting actually doesn't do that: That sets the default notification for when I DO post a reply. It doesn't do anything to send me a notification about replies in a thread where I haven't posted a reply.
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Watty
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Re: Extra Principal vs. Investing

Post by Watty »

Tax Rate: 25% in NV (no state tax)
Since you are in the 25% tax bracket I would max out any deductable retirment accounts first.

With the tax saving you can put an extra $266 a month into a deductable retirment account instead of paying $200 towards the mortage and paying $66 in taxes.
origami
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Re: Extra Principal vs. Investing

Post by origami »

I'm trying to answer a similar question to myself. My mortgage interest rate is 2.85%. I have enough saved in the emergency fund.
My alternatives are: to pay extra principal with guaranteed 2.85% or to invest into, let's say, U.S. Broad Market ETF in a taxable account.

So the real question is: should I expect more than 2.85% annual return after taxes from U.S. Market in the next 3-5 years?
Sure, nobody can predict the future, but I was wondering what the general consensus is.

Currently I split between extra mortgage payments and investing.

Thank you!
Default User BR
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Re: Extra Principal vs. Investing

Post by Default User BR »

STC wrote:If the effective rate (rate on mortgage * (1-marginal tax rate)) is higher then the "risk free rate of return" (i.e. treasuries) for the same duration (i.e. if you have 15 years left on your mortgage, compare against the 15y tres), then pay down the mortgage. Else invest.
I disagree with this. A young person should take advantage of the inexpensive leverage to get invested sooner. Forget the risk-free rate.


Brian
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Re: Extra Principal vs. Investing

Post by Default User BR »

Calm Man wrote:I always believe in paying off any debt regardless of rate
And I don't fear debt at all. Debt is a tool. It's a sharp one that the unwary can hurt themselves with careless use. The low rates available now are a good opportunity for inexpensive leverage and provide a cheap hedge against potential future increase in rates and inflation.


Brian
stonerolled
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Re: Extra Principal vs. Investing

Post by stonerolled »

Paying off a car loan is great but it usually leaves you with an older car that will need replacing at some point.
Why not set aside the "extra money" in a separate account that is safe and easy to keep track off and begin saving the cash to avoid all future car loans. You only have to get to a point of cash + trade = next car. regards.
STC
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Re: Extra Principal vs. Investing

Post by STC »

stonerolled wrote:Paying off a car loan is great but it usually leaves you with an older car that will need replacing at some point.
Why not set aside the "extra money" in a separate account that is safe and easy to keep track off and begin saving the cash to avoid all future car loans. You only have to get to a point of cash + trade = next car. regards.

Why stop at Cars? What about a new deck, roof, furnace, jewlery for presents, vacation... yada yada.

All of these things require liquidity. There is a much more efficient way to support your overall liquidity needs then poping up segregated accounts like baby bunnies...
NorCalDad
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Re: Extra Principal vs. Investing

Post by NorCalDad »

Default User BR wrote:
Calm Man wrote:I always believe in paying off any debt regardless of rate
And I don't fear debt at all. Debt is a tool. It's a sharp one that the unwary can hurt themselves with careless use. The low rates available now are a good opportunity for inexpensive leverage and provide a cheap hedge against potential future increase in rates and inflation.
I generally agree.

However, the one reason in Mark's case I might disagree is that he's underwater. As someone who was underwater and only recently got back above water by paying down our mortgage aggressively and riding a market rebound, if Mark wants to have the ability to sell his house, he should pay down his mortgage. Reaching the water line isn't enough - he will need at least 7-8% equity to cover closing costs and commissions.

Absent this, Mark's options should he find another house are: 1) invest/save the money elsewhere and bring cash to close sale; 2) hope for a market turnaround; 3) walk away; or 4) become a landlord. I'd prefer the risk-free return of paying down the mortgage until he gets enough equity that he can sell. After that point, I would consider investing. Otherwise, OP has fewer good options when he wants to move.

This all presumes he doesn't already have a pot of money available to close the underwater gap. If he does, I'd focus on investing the extra funds.
stonerolled
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Re: Extra Principal vs. Investing

Post by stonerolled »

STC wrote:
stonerolled wrote:Paying off a car loan is great but it usually leaves you with an older car that will need replacing at some point.
Why not set aside the "extra money" in a separate account that is safe and easy to keep track off and begin saving the cash to avoid all future car loans. You only have to get to a point of cash + trade = next car. regards.

Why stop at Cars? What about a new deck, roof, furnace, jewlery for presents, vacation... yada yada.

All of these things require liquidity. There is a much more efficient way to support your overall liquidity needs then poping up segregated accounts like baby bunnies...
You are correct, it can done for anything. The difference is in how many people you know have taken out loans on the things you listed? The magnitude and basic need for transportation that will never go away and is constantly acrueing deserves special consideration. To provide for transportation is right behind shelter. In fact, some live in their car between jobs which can get them to their jobs to be extreme. The needs on the list you provided should come out of the emergency fund. Keeping a car until it breaks puts it in emergency fund land which to me is poor planning.
STC
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Re: Extra Principal vs. Investing

Post by STC »

stonerolled wrote:
STC wrote:
stonerolled wrote:Paying off a car loan is great but it usually leaves you with an older car that will need replacing at some point.
Why not set aside the "extra money" in a separate account that is safe and easy to keep track off and begin saving the cash to avoid all future car loans. You only have to get to a point of cash + trade = next car. regards.

Why stop at Cars? What about a new deck, roof, furnace, jewlery for presents, vacation... yada yada.

All of these things require liquidity. There is a much more efficient way to support your overall liquidity needs then poping up segregated accounts like baby bunnies...
You are correct, it can done for anything. The difference is in how many people you know have taken out loans on the things you listed? The magnitude and basic need for transportation that will never go away and is constantly acrueing deserves special consideration. To provide for transportation is right behind shelter. In fact, some live in their car between jobs which can get them to their jobs to be extreme. The needs on the list you provided should come out of the emergency fund. Keeping a car until it breaks puts it in emergency fund land which to me is poor planning.

A Few points:
1: Bogleheads are not most people. I doubt very much if any bogleheads over 30 are financing a roof or a car - unless they are using it as cheap leverage i.e. 0.9% financing
2: Emergency fund is one level of liquidity... for emergencies. Other liquid needs include normal expenses like shelter maintenance (roof) and things like transportation
3: spinning up a segregated account for a bigger purchase is NOT the most effective strategy for managing liquidity (IMO)
4: a more effective strategy then spinning up savings accounts everywhere that are fit for purpose, is to determine your OVERALL liquidity needs and manage those centrally
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Re: Extra Principal vs. Investing

Post by grabiner »

Default User BR wrote:
STC wrote:If the effective rate (rate on mortgage * (1-marginal tax rate)) is higher then the "risk free rate of return" (i.e. treasuries) for the same duration (i.e. if you have 15 years left on your mortgage, compare against the 15y tres), then pay down the mortgage. Else invest.
I disagree with this. A young person should take advantage of the inexpensive leverage to get invested sooner. Forget the risk-free rate.
This is reasonable if your investments are 100% stock. If you own any bonds, selling bonds (decreasing the amount others owe to you) has the same leverage effect as borrowing money (increasing the amount you owe to others), so you should do whichever one is less expensive, taking secondary benefits into account.

The OP is 70% in stock, so if he wants to increase his stock allocation, he can do that whether he pays down the mortgage or not. He could use the spare money to buy stock funds, or he could pay down the mortgage and sell his bond funds to buy more stock. And paying down the mortgage may be more attractive for him, since he gets a 2.81% return (or 3.75% if he doesn't itemize deductions) on the mortgage payment.

The other reason I would recommend the OP pay down the mortgage is that he will get to 80% LTV faster, which may make it possible to refinance later.
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MarquisMark
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Re: Extra Principal vs. Investing

Post by MarquisMark »

Thank you for all the replies everyone. You have all made many good points and given me many options to consider...

When I think about it, I have to admit I might be short on cash for everyday expenses, small home improvement projects that I have planned (always more expensive than you think), future purchases, etc. My emergency fund will get me through 6 months of unemployment no problem, but I do not want to be dipping into this for other reasons.

Having said this, I do like to pay a little extra on mortgage, just for peace of mind. I might just make an extra payment a year (about $60/month), which will shave 5 years off a 30 year loan and give me about 10-30K in equity in 5 years, depending on how the housing market out here fares. The left over money will just be saved in a short term tax-free Muni fund. Does this sound reasonable?
phish_indexer wrote:If you plan on maxing out a Roth each and every year, you can't put additional money into a Traditional IRA. You may consider upping your 401(k) contributions, which would be similar to investing through a traditional IRA.
Really? I was not aware of this. So if I max out my Roth, I will not be able to contribute anything to a Traditional IRA? It's either one or the other? My 401(k) options are not that hot and they only offer a 50% match on the first 6% up to $750 for the year, better than many other companies, I know, but I have only been contributing to this until I reach the match, which is $1500. I thought it would be an option for me to contribute any extra money to a Trad IRA once my Roth has been maxed out.
umfundi
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Re: Extra Principal vs. Investing

Post by umfundi »

bicker wrote:
pkcrafter wrote:
bicker wrote:Can someone please let me know how to "Notify me when a reply is posted" without posting a reply?
Go into User Control Panel (top left corner) and then click on board preferences/edit posting defaults.
Thanks but that setting actually doesn't do that: That sets the default notification for when I DO post a reply. It doesn't do anything to send me a notification about replies in a thread where I haven't posted a reply.
Scroll to the bottom of the thread and click on "Subscribe Topic".

The reverse also works: If you are subscribed, you can click on "Unsubscribe Topic".

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MarquisMark
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Re: Extra Principal vs. Investing

Post by MarquisMark »

STC wrote:Its a pretty simple decision point. If the effective rate (rate on mortgage * (1-marginal tax rate)) is higher then the "risk free rate of return" (i.e. treasuries) for the same duration (i.e. if you have 15 years left on your mortgage, compare against the 15y tres), then pay down the mortgage. Else invest.
Could you see if I have this right for a marginal tax rate of 25% and 30 years left on mortgage?

3.75 * .75 = 2.81

30 year treasury = ~2.80 [based on this link]

So based on this calculation, there's not much of a difference?
umfundi
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Re: Extra Principal vs. Investing

Post by umfundi »

MarquisMark wrote:Hi folks,

I would like to ask the very wise minds here in the community whether it is better to pay extra principal on a mortgage or take that money and invest in mutual funds. I know this topic has been done before but I wanted to see what would be best based on my situation here...
The short answer is, save the money whichever way you like.

The less short answer is, it is better to save the money in a tax advantaged plan like an IRA or 401(k)

The medium answer is, save the money in a 401(k) or IRA even if the contribution is not deductible, but the earnings are deferred.

That said, take a look at your mortgage statement. If you make an extra payment equal to this month's principal, you have just knocked an extra month off the term of your loan! That is a very good way to make a small investment and visualize a long term advantage.

Most people need a place to live, and they need to save for retirement. For most of their lives they will need to do, and balance, both. Later on in life you need to maintain that balance. Do not be house rich and cash poor. Also, do not leverage your house for other investments or, even worse, for spending.

Keith
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bdpb
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Re: Extra Principal vs. Investing

Post by bdpb »

MarquisMark wrote:
STC wrote:Its a pretty simple decision point. If the effective rate (rate on mortgage * (1-marginal tax rate)) is higher then the "risk free rate of return" (i.e. treasuries) for the same duration (i.e. if you have 15 years left on your mortgage, compare against the 15y tres), then pay down the mortgage. Else invest.
Could you see if I have this right for a marginal tax rate of 25% and 30 years left on mortgage?

3.75 * .75 = 2.81

30 year treasury = ~2.80 [based on this link]

So based on this calculation, there's not much of a difference?
Except, you likely won't hold the mortgage for 30 years. If you sell the house, it may only be 5 years. You could refinance in 1 or 2 years. You can't find a 2 or 5 year CD anywhere for 3.75%. A 30 year mortgage is often compared to 10 year treasuries for rate comparison.
stonerolled
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Re: Extra Principal vs. Investing

Post by stonerolled »

STC wrote:
stonerolled wrote:
STC wrote:
stonerolled wrote:Paying off a car loan is great but it usually leaves you with an older car that will need replacing at some point.
Why not set aside the "extra money" in a separate account that is safe and easy to keep track off and begin saving the cash to avoid all future car loans. You only have to get to a point of cash + trade = next car. regards.

Why stop at Cars? What about a new deck, roof, furnace, jewlery for presents, vacation... yada yada.

All of these things require liquidity. There is a much more efficient way to support your overall liquidity needs then poping up segregated accounts like baby bunnies...
You are correct, it can done for anything. The difference is in how many people you know have taken out loans on the things you listed? The magnitude and basic need for transportation that will never go away and is constantly acrueing deserves special consideration. To provide for transportation is right behind shelter. In fact, some live in their car between jobs which can get them to their jobs to be extreme. The needs on the list you provided should come out of the emergency fund. Keeping a car until it breaks puts it in emergency fund land which to me is poor planning.

A Few points:
1: Bogleheads are not most people. I doubt very much if any bogleheads over 30 are financing a roof or a car - unless they are using it as cheap leverage i.e. 0.9% financing
2: Emergency fund is one level of liquidity... for emergencies. Other liquid needs include normal expenses like shelter maintenance (roof) and things like transportation
3: spinning up a segregated account for a bigger purchase is NOT the most effective strategy for managing liquidity (IMO)
4: a more effective strategy then spinning up savings accounts everywhere that are fit for purpose, is to determine your OVERALL liquidity needs and manage those centrally
I used to have a separate account but now I simply have it in one fund, better interest. For me, I like spinning up a special account for transportation because if I can reach a point where the daily driver is financed and there is money for another vehicle, for me it will be toggle that now you can afford that completely impractical two seater. I do not expect this to happen in my working years.
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