Paying off mortgage vs investing?

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jb1
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Paying off mortgage vs investing?

Post by jb1 » Wed Sep 19, 2018 7:56 pm

Hey all,

First time home buyer here. Just closed on a house last month,with a mortgage of 181k with 4.75% interest on a 30 year loan.

Principal and Interest are 944 per month. Taxes/insurance are 250 per month making my total payment ~1200 per month.

I am renting out 2 rooms for 925 total (500 and 425) meaning i essentially only pay 275 per month assuming everything is rented out.

After doing the math, i noticed that interest really is a silent killer. In fact with interest if I pay the minimum payment, the total cost is about 350k which is ridiculous!.

I do have extra money to put to the principal, but is it worth it paying it down right away? Or would you say to continue investing in the stock market while making minimum payments (1200 per month)?

Thesaints
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Re: Paying off mortgage vs investing?

Post by Thesaints » Wed Sep 19, 2018 8:05 pm

Generally, you would compare the total after-tax cost of mortgage (i.e. including mandatory insurance, etc.) to the expected after-tax return of the investment.

However, you also have to factor in:
- Depleting cash reserves to pay a mortgage is not a good idea, since should you need cash afterwards, cost would be much higher than the mortgage.
- Venturing into risky investments is also not a good idea, unless you can service the mortgage in any case and the expected return of the risky investment is sufficiently higher.

mortfree
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Re: Paying off mortgage vs investing?

Post by mortfree » Wed Sep 19, 2018 8:10 pm

I would pay $250 extra per month.

Wraps up in 19 years and interest will be $95950.

Versus $158900 in interest if you paid on the 30-year schedule.

jb1
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Re: Paying off mortgage vs investing?

Post by jb1 » Wed Sep 19, 2018 8:26 pm

mortfree wrote:
Wed Sep 19, 2018 8:10 pm
I would pay $250 extra per month.

Wraps up in 19 years and interest will be $95950.

Versus $158900 in interest if you paid on the 30-year schedule.
Thank you for the response above

Thank you also mort. As someone who is frugal, paying an extra 100k in interest is crazy!! I can comfortably add $600 extra. I will continue to do that.

delamer
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Re: Paying off mortgage vs investing?

Post by delamer » Wed Sep 19, 2018 9:52 pm

jb1 wrote:
Wed Sep 19, 2018 8:26 pm
mortfree wrote:
Wed Sep 19, 2018 8:10 pm
I would pay $250 extra per month.

Wraps up in 19 years and interest will be $95950.

Versus $158900 in interest if you paid on the 30-year schedule.
Thank you for the response above

Thank you also mort. As someone who is frugal, paying an extra 100k in interest is crazy!! I can comfortably add $600 extra. I will continue to do that.
It isn’t crazy if you can get a return of more than 4.75% on that $600 over the term of the loan if you invest it. Because you’d have more money in the end.

But whether you can get the higher return is unknown. Some here have suggested that’d need to get that return on bonds, to keep an equivalent risk.

wolf359
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Re: Paying off mortgage vs investing?

Post by wolf359 » Thu Sep 20, 2018 10:19 am

Pre-paying a mortgage pros:
- Savings on interest payments. Reduces total cost of ownership for the house.
- Frees up cash flow after the house is PAID OFF.
- Feels really good psychologically. It is much more difficult to go bankrupt if you don't owe anybody any money.
- A mortgage is like a bond with a negative interest rate. A bond currently pays less than your mortgage interest rate.

Pre-paying a mortgage cons:
- Reduces your cash flow during the pay-DOWN. Your cash flow doesn't improve until the mortgage is paid OFF (not just paid DOWN.)
- As you PAY DOWN the mortgage, you are locking up money in the house. Should you have an emergency (like long-term job loss), you have fewer liquid assets than if you had invested. If your money is in home equity, it is very difficult to tap, especially if credit gets tight.
- You may get a better long-term return in the stock market.

Note the difference between paying a mortgage OFF versus paying a mortgage DOWN. The compromise is to designate a mortgage paydown fund, and invest that into the stock market. That way, you have liquidity while you accumulate the funds to pay off the house. You also get the stock market to work with you during the 10-20 years or so it takes. You then can choose when it is appropriate to terminate your mortgage.

In other words, you do both. This strategy is called a "sinking fund." If you do this, be sure to segregate the money in a different account so it keeps its purpose.

I follow this strategy, and enjoyed the security of knowing the money was available and liquid if I needed it while it was building up. I also benefited from the lucky timing of being in a bull market, so I'm now about to terminate a 15-year mortgage after only 7 years.

Admiral
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Re: Paying off mortgage vs investing?

Post by Admiral » Thu Sep 20, 2018 11:31 am

You cannot look at the amount in interest you would pay over 30 years (which is indeed fearsome for any loan, because 30 years is a long time).

1) You might not be in the home for 30 years
2) You might refinance
3) Inflation eats away at the true cost of the loan because the rate is fixed (i.e. in 20 years each dollar you pay in interest is worth much less to you than a dollar you pay today).

Don't get hung up on that number. What you need to do in determine the best use for and return on any extra money you have: are you better served paying down the loan, or keeping the money and investing it. Most on the board would agree (I think) that you should not pre pay any mortgage until ALL legally available pre-tax retirement space is filled, and then only AFTER you have a fully funded emergency fund (in whatever that amount is.)

Only then does it make sense to pre-pay, and that's only if you are comfortable with reducing your liquidity. Just remember: every $200, $300, $400 you use to pre-pay is that amount that is no longer available for any other purpose. It's in your house.

There are approximately a billion threads on this topic on the forum...

JBTX
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Re: Paying off mortgage vs investing?

Post by JBTX » Thu Sep 20, 2018 11:44 am

Thoughts/Factors:

- If interest is 4.75%, and inflation is 3.0%, you are only paying 1.75% in "real" interest.
- whether 4.75% is good or bad depends on what you do with that money if you don't pay it off
- Long term stocks and bonds will likely exceed that, but there will be a lot of volatility along the way
- Have you maxed out all tax advantaged and retirement contribution opportunities? If not, definitely do so before considering paying off mortgage
- There is some value in having liquidity, and if you get 3.0% in low risk bond investments, the real cost is 1.75% per year. If interest rates go back down, you can always pay off faster. If interest rates go up, then you are locked into a below market rate.

If you have maxed out all other opportunities, if you wanted to pay a little extra on it, that is fine. I wouldn't pay it off aggressively though.

runner540
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Re: Paying off mortgage vs investing?

Post by runner540 » Thu Sep 20, 2018 12:45 pm

Didn't see this mentioned: do you have a healthy emergency fund? If not, build that up before paying down the mortgage. If yes, then make sure you don't deplete it for mortgage paydown.

I'm curious about your negative reaction to the interest. The 30 yr fixed rate mortgage is a pretty sweet deal for the borrowers. Not widely available outside the US. Other countries have shorter terms (10-15 years) amd variable rates.

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bigROI
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Re: Paying off mortgage vs investing?

Post by bigROI » Thu Sep 20, 2018 1:10 pm

I think of my mortgage balance as an inverse hedge against inflation or hyper inflation. Not a terrible thing to have and when young there should be plenty of time to cover it but would probably have it paid in full before retirement and use it as real estate value in my portfolio. Make sure you have enough insurance coverage for your tenants and your living situation. Some policies may want a rider or to include multi non familial parties under one dwelling.
A penny saved is much more then a penny earned when you consider the tax/SS/medicare cut.

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Meaty
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Re: Paying off mortgage vs investing?

Post by Meaty » Thu Sep 20, 2018 1:41 pm

wolf359 wrote:
Thu Sep 20, 2018 10:19 am
Pre-paying a mortgage pros:
- Savings on interest payments. Reduces total cost of ownership for the house.
- Frees up cash flow after the house is PAID OFF.
- Feels really good psychologically. It is much more difficult to go bankrupt if you don't owe anybody any money.
- A mortgage is like a bond with a negative interest rate. A bond currently pays less than your mortgage interest rate.

Pre-paying a mortgage cons:
- Reduces your cash flow during the pay-DOWN. Your cash flow doesn't improve until the mortgage is paid OFF (not just paid DOWN.)
- As you PAY DOWN the mortgage, you are locking up money in the house. Should you have an emergency (like long-term job loss), you have fewer liquid assets than if you had invested. If your money is in home equity, it is very difficult to tap, especially if credit gets tight.
- You may get a better long-term return in the stock market.

Note the difference between paying a mortgage OFF versus paying a mortgage DOWN. The compromise is to designate a mortgage paydown fund, and invest that into the stock market. That way, you have liquidity while you accumulate the funds to pay off the house. You also get the stock market to work with you during the 10-20 years or so it takes. You then can choose when it is appropriate to terminate your mortgage.

In other words, you do both. This strategy is called a "sinking fund." If you do this, be sure to segregate the money in a different account so it keeps its purpose.

I follow this strategy, and enjoyed the security of knowing the money was available and liquid if I needed it while it was building up. I also benefited from the lucky timing of being in a bull market, so I'm now about to terminate a 15-year mortgage after only 7 years.
This is what I’m doing as well. Of course, the market could tank causing my sinking fund to yield less than the fixed rate of the mortgage but that’s a risk I’m willing to take to preserve liquidity
"Discipline equals Freedom" - Jocko Willink

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Watty
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Re: Paying off mortgage vs investing?

Post by Watty » Thu Sep 20, 2018 2:01 pm

There is a wiki on this choice if you have not seen it.

https://www.bogleheads.org/wiki/Paying_ ... _investing
jb1 wrote:
Wed Sep 19, 2018 7:56 pm
I am renting out 2 rooms for 925 total (500 and 425) meaning i essentially only pay 275 per month assuming everything is rented out.
Remember that is taxable income for you and it needs to be included on your tax return. You may want to file quarterly estimated taxes or change your payroll withholding so that you do not have a under withholding penalty. I don't really know how this works so you should be sure to research this. It might also impact the homeowners capital gains exclusion when you sell the house so you might look into that too.

I would assume that renting the rooms is allowed in your area and any HOA and that you checked on that. You also need to check on restrictions on the number of cars you can have at the house.

Your home insurance company will also need to know about you renting rooms.

That may see obvious but in the past there have been posts by people that were trying to rent rooms without going through all the right steps. In my subdivision someone bought a house and tried renting out all the rooms but the local zoning has limits on that which they were way over. They got shut down real quick.
Admiral wrote:
Thu Sep 20, 2018 11:31 am
Most on the board would agree (I think) that you should not pre pay any mortgage until ALL legally available pre-tax retirement space is filled, and then only AFTER you have a fully funded emergency fund (in whatever that amount is.)
+1

You might also want to save up a good chunk of money, like 20% of the balance, and then try to "recast your mortgage"(Google this) if it makes sense then.

bradpevans
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Re: Paying off mortgage vs investing?

Post by bradpevans » Thu Sep 20, 2018 2:03 pm

Meaty wrote:
Thu Sep 20, 2018 1:41 pm
wolf359 wrote:
Thu Sep 20, 2018 10:19 am
Pre-paying a mortgage pros:
- Savings on interest payments. Reduces total cost of ownership for the house.
- Frees up cash flow after the house is PAID OFF.
- Feels really good psychologically. It is much more difficult to go bankrupt if you don't owe anybody any money.
- A mortgage is like a bond with a negative interest rate. A bond currently pays less than your mortgage interest rate.

Pre-paying a mortgage cons:
- Reduces your cash flow during the pay-DOWN. Your cash flow doesn't improve until the mortgage is paid OFF (not just paid DOWN.)
- As you PAY DOWN the mortgage, you are locking up money in the house. Should you have an emergency (like long-term job loss), you have fewer liquid assets than if you had invested. If your money is in home equity, it is very difficult to tap, especially if credit gets tight.
- You may get a better long-term return in the stock market.

Note the difference between paying a mortgage OFF versus paying a mortgage DOWN. The compromise is to designate a mortgage paydown fund, and invest that into the stock market. That way, you have liquidity while you accumulate the funds to pay off the house. You also get the stock market to work with you during the 10-20 years or so it takes. You then can choose when it is appropriate to terminate your mortgage.

In other words, you do both. This strategy is called a "sinking fund." If you do this, be sure to segregate the money in a different account so it keeps its purpose.

I follow this strategy, and enjoyed the security of knowing the money was available and liquid if I needed it while it was building up. I also benefited from the lucky timing of being in a bull market, so I'm now about to terminate a 15-year mortgage after only 7 years.
This is what I’m doing as well. Of course, the market could tank causing my sinking fund to yield less than the fixed rate of the mortgage but that’s a risk I’m willing to take to preserve liquidity
To me this is the way to go. And your fund doesn't have to perform better than the interest rate ALL the time, just better
in time to pay it off faster than paying down the fixed rate.

Admiral
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Re: Paying off mortgage vs investing?

Post by Admiral » Thu Sep 20, 2018 2:23 pm

Also keep in mind that when you pay down (as opposed to paying off) a mortgage, the savings are not realized until the day in the future (whenever that day comes) that the loan is paid off in full and your payments disappear. Thus, you're realizing the saving in future (inflated) dollars, which are likely to have less value than current dollars (unless there's deflation.) When you invest, it's the opposite: the savings (via interest) compounds over time. Still affected by inflation of course, but hopefully returns will be greater than inflation.

wolf359
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Re: Paying off mortgage vs investing?

Post by wolf359 » Thu Sep 20, 2018 5:42 pm

Meaty wrote:
Thu Sep 20, 2018 1:41 pm
This is what I’m doing as well. Of course, the market could tank causing my sinking fund to yield less than the fixed rate of the mortgage but that’s a risk I’m willing to take to preserve liquidity
If you're comparing the sinking fund to a 10-20 year timeframe that you would have just been pre-paying, then the odds are that the sinking fund will have a superior return, especially considering that you would be dollar cost averaging through any downturns. So a market downturn isn't a risk, it's a feature.

Mako52
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Re: Paying off mortgage vs investing?

Post by Mako52 » Fri Sep 21, 2018 8:52 am

If I were in your shoes it would depend what my job security and expected cash flow looked like. The fact that you have renters to lower the net outflow is great! Hopefully they're clean and quiet.

If you pay $10,000 off now, you're going to save roughly $28,000 in interest over 30 years. If you pay $20k now you'll save roughly $50k.

Then if you pay $100k off now, you'll save roughly $138k in interest, vs roughly $142k if you pay $110k now. So why tie up that $10k for 30 years if it only saves you $4k? There are diminishing returns for each additional dollar that you use as a lump paydown.

I'd put no more than 15% of your liquid net worth as a mortgage paydown now, and use income to invest in a Roth IRA every year before any other investments. And maybe pay an extra $150/month towards principal if cash flow permits.

Admiral
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Re: Paying off mortgage vs investing?

Post by Admiral » Fri Sep 21, 2018 9:08 am

Mako52 wrote:
Fri Sep 21, 2018 8:52 am
If I were in your shoes it would depend what my job security and expected cash flow looked like. The fact that you have renters to lower the net outflow is great! Hopefully they're clean and quiet.

If you pay $10,000 off now, you're going to save roughly $28,000 in interest over 30 years. If you pay $20k now you'll save roughly $50k.

Then if you pay $100k off now, you'll save roughly $138k in interest, vs roughly $142k if you pay $110k now. So why tie up that $10k for 30 years if it only saves you $4k? There are diminishing returns for each additional dollar that you use as a lump paydown.

I'd put no more than 15% of your liquid net worth as a mortgage paydown now, and use income to invest in a Roth IRA every year before any other investments. And maybe pay an extra $150/month towards principal if cash flow permits.
Again, not to beat this horse to death, but this is only true in constant dollar terms, not in terms of purchasing power. Even at 2% inflation, in 10 years a dollar will have lost 20% of its purchasing power. In 20 years, it'll be worth 50 cents (assuming constant 2% inflation...this is just an example).

So...yes, one saves a lot of interest. But the effects are muted the further out one goes. This is not an argument against a pay off, but it is a consideration for any paydown strategy.

LiterallyIronic
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Re: Paying off mortgage vs investing?

Post by LiterallyIronic » Fri Sep 21, 2018 9:23 am

This is one of the "personal" things about "personal finance". Usually the numbers are such that investing will result in more money than paying off the mortgage.

For me, I calculated how much I needed to invest every month in order to reach my goal amount by my goal date (assuming a 7% annual growth), and I now invest that amount. Any extra goes towards the mortgage. Because I don't need to invest that money, as long as my assumptions are correct, then I can use it to alleviate the psychological stress of having a mortgage. Yeah, that money would probably do better in the market than paying off my 3.875% mortgage, but if I don't have the need to take that risk (because I'm already investing enough), why invest it?

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Meaty
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Re: Paying off mortgage vs investing?

Post by Meaty » Sun Sep 23, 2018 4:40 pm

wolf359 wrote:
Thu Sep 20, 2018 5:42 pm
Meaty wrote:
Thu Sep 20, 2018 1:41 pm
This is what I’m doing as well. Of course, the market could tank causing my sinking fund to yield less than the fixed rate of the mortgage but that’s a risk I’m willing to take to preserve liquidity
If you're comparing the sinking fund to a 10-20 year timeframe that you would have just been pre-paying, then the odds are that the sinking fund will have a superior return, especially considering that you would be dollar cost averaging through any downturns. So a market downturn isn't a risk, it's a feature.
Agree, but in my case I’ll have enough to payoff the mortgage in 3 years so it’s possible I’ll come out behind
"Discipline equals Freedom" - Jocko Willink

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grabiner
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Re: Paying off mortgage vs investing?

Post by grabiner » Sun Sep 23, 2018 8:35 pm

jb1 wrote:
Wed Sep 19, 2018 7:56 pm
First time home buyer here. Just closed on a house last month,with a mortgage of 181k with 4.75% interest on a 30 year loan
If you are considering making extra payments, you should probably refinance to a 15-year mortgage at a lower rate. This will reduce the interest you pay, whether you pay faster than the 15-year schedule or not.

And since you are renting out part of the house, the interest is partly deductible (against your rental income) even if you don't itemize deductions. Given the partial deduction, it's likely not worth making extra payments unless you are maxing out your IRA and 401(k); money there can grow at a similar rate tax-free without much risk, and you will have more tax-deferred savings when the mortgage is paid off.
Wiki David Grabiner

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grabiner
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Re: Paying off mortgage vs investing?

Post by grabiner » Sun Sep 23, 2018 8:38 pm

Admiral wrote:
Thu Sep 20, 2018 11:31 am
You cannot look at the amount in interest you would pay over 30 years (which is indeed fearsome for any loan, because 30 years is a long time).

1) You might not be in the home for 30 years
2) You might refinance
3) Inflation eats away at the true cost of the loan because the rate is fixed (i.e. in 20 years each dollar you pay in interest is worth much less to you than a dollar you pay today).
Another way to look at this is that the money you aren't using to pay off the mortgage is earning interest as well. If you have a $100K mortgage at a 3.2% rate after tax, you are paying $3200 in interest less tax savings. But if you have $100K in your Roth IRA invested in Total Bond Market, you are earning $3200 in interest at the current yield of 3.20%, so you break even. (And you come out ahead because the money in your Roth IRA will grow tax-free in the future.)
Wiki David Grabiner

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