pay down mortgage vs. invest in taxable?

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mookie
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pay down mortgage vs. invest in taxable?

Post by mookie » Sat Apr 27, 2019 4:31 pm

I am in year 4 of a 30 year, $450K ($418K remaining), 3.75% mortgage. I am in the 24% tax bracket. I have maxed out my tax-protected space, and contribute about half of the annual gift maximum to my children's 529's. I will hopefully have about $20K each year to either invest in a taxable account or to pay down the mortgage ahead of time.

Should I pay down the mortgage or invest in taxable? I am leaning towards paying down the mortgage. I don't think that this will significantly affect my decision, but I currently exceed my standard deduction by about $5K, which will probably not be the case if I pay less interest.

Is the best way to pay down the mortgage early to give a lump sum once I've accumulated $20K each year vs. convert to a 15 year mortgage vs. "recast the mortgage"?
Last edited by mookie on Sat Apr 27, 2019 8:51 pm, edited 1 time in total.

KlangFool
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Re: pay off mortgage vs. invest in taxable?

Post by KlangFool » Sat Apr 27, 2019 4:48 pm

OP,

You have a 450K mortgage. So, let's assume that you have a 600K house. Is your investment besides home equity more than 1.2 million? If not, why would you put more money into your house basket?

Invest in the taxable. Diversify your investment.

KlangFool

smitcat
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Re: pay off mortgage vs. invest in taxable?

Post by smitcat » Sat Apr 27, 2019 5:32 pm

In your situation I would save in taxable.
Truth be told we were in your situation and we did save in taxable.

lakpr
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Re: pay off mortgage vs. invest in taxable?

Post by lakpr » Sat Apr 27, 2019 5:36 pm

Mookie,

By my calculation, once your mortgage balance reaches $390k, you essentially lose any tax benefit from holding the mortgage. You will switch to standard deduction at that point. That is about three years at your stated rate of $20k per year.

At that time, the 3.75% interest you are paying on the mortgage is post-tax, and to just break even, your taxable investment must yield year in and year out 3.75% / 0.73 = 5.13% guaranteed. Why 0.73? I just searched your old posts and it seems that you are in a 24% tax bracket, and in Pennsylvania which has a 3% state tax rate, together it is a 27% marginal tax rate. 1 - 0.27 = 0.73

It essentially boils down to the question of how confident are you getting a nominal CAGR return of 5.13% over the same time as the rest of your mortgage. If you are feeling pretty confident, go with taxable. If you don’t, prepay mortgage.

Personally, I will suggest prepaying mortgage, the required yield of 5.13% is almost exactly double of what treasuries and CDs are yielding now.

stan1
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Re: pay off mortgage vs. invest in taxable?

Post by stan1 » Sat Apr 27, 2019 5:39 pm

I will hopefully have about $20K each year to either invest in a taxable account or to pay off the mortgage ahead of time.
You have created a false decision. There's nothing that says you have to do one or the other. You can do both. Make one or two extra mortgage payments per year and save the rest in taxable. There's no way to predict the future. The liquidity that comes with a taxable account is also important. Home equity is less liquid.
Last edited by stan1 on Sat Apr 27, 2019 5:46 pm, edited 1 time in total.

mortfree
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Re: pay off mortgage vs. invest in taxable?

Post by mortfree » Sat Apr 27, 2019 5:40 pm

You said Pay Off the mortgage quite a few times in the OP

I believe you mean Pay Down the mortgage.

There is a big difference.

Edit: consider refinance to a 15-year if you are fully committed to paying it off.

Also, if you have 20k to spare, as another poster said - I would start thinking invest 10k, use 10k towards mortgage. Definitely play around with a loan amortization schedule to plan your mortgage pay down strategy


Disclaimer: I paid down a mortgage for a few years then paid it off (under 10 years and at age 39). Unfortunately we moved and I have a mortgage again which I am paying down, a little extra each month.
Last edited by mortfree on Sat Apr 27, 2019 5:46 pm, edited 1 time in total.

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bligh
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Re: pay off mortgage vs. invest in taxable?

Post by bligh » Sat Apr 27, 2019 5:42 pm

lakpr wrote:
Sat Apr 27, 2019 5:36 pm
.

Personally, I will suggest prepaying mortgage, the required yield of 5.13% is almost exactly double of what treasuries and CDs are yielding now.
Those would also be the only investments one should compare against. The 5.13% return is a risk free return. Put another way, the stock market has historically returned much more, but if , in today’s investment environment, you were getting a 5.13% CD right now, you would almost certainly go for that over investing in stocks.

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Re: pay off mortgage vs. invest in taxable?

Post by grabiner » Sat Apr 27, 2019 6:54 pm

See Paying down loans versus investing on the wiki.

Your mortgage is large enough that you should be itemizing deductions, as the mortgage interest plus your state and local taxes should exceed $24,400. Therefore, your return on a small mortgage payment would be only 3.75% taxable, which is about the return on taxable long-term bonds (3.74% on Vanguard Long-Term Bond Index). If you are in a high tax bracket, you are better off buying municipal bonds than paying down the mortgage at that rate; in a 32% tax bracket, your after-tax return would be 2.55%, which is the return of the shorter-duration Vanguard Long-Term Tax-Exempt Admiral shares. Therefore, you don't gain much from paying down the mortgage unless you pay it down enough that you can start paying down non-deductible interest.

While another poster suggested refinancing to 15 years, I don't think this is worthwhile for you, as your 26-year rate is close to the market rate on 15-year mortgages.

Thus, my recommendation is to invest instead. If rates fall, refinance to 15 years rather than adding more to your taxable account. If rates are steady, use your investments to pay down the mortgage if you can start paying off non-deductible interest. If rates rise, keep investing, as you will be able to earn more on bonds than on mortgage prepayments.
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Topic Author
mookie
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Re: pay down mortgage vs. invest in taxable?

Post by mookie » Sat Apr 27, 2019 9:13 pm

OP here. Thanks for all the replies. I edited my original post to include my tax rate and the amount remaining on the loan.

I'm now leaning towards investing in taxable. If I do pay down the mortgage, is there a particular strategy for doing so that takes into account the amortization schedule and when I will fall below the standard deduction?

I read the wiki and it's very helpful. In terms of the math involved, is there a calculator or equation that takes into account tax bracket, amount of itemized deductions, years remaining, amount remaining, current interest rate and loan interest rate?

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Re: pay down mortgage vs. invest in taxable?

Post by bhsince87 » Sat Apr 27, 2019 9:25 pm

mookie wrote:
Sat Apr 27, 2019 9:13 pm
OP here. Thanks for all the replies. I edited my original post to include my tax rate and the amount remaining on the loan.

I'm now leaning towards investing in taxable. If I do pay down the mortgage, is there a particular strategy for doing so that takes into account the amortization schedule and when I will fall below the standard deduction?

I read the wiki and it's very helpful. In terms of the math involved, is there a calculator or equation that takes into account tax bracket, amount of itemized deductions, years remaining, amount remaining, current interest rate and loan interest rate?
IMO, this is more than just a math problem. There are psychological issues and personal preferences that make it "fuzzy".

As others have mentioned, liquidity is a huge issue. I was in the "pay it of ASAP" camp for years, until I was unexpectedly laid off from my job. At that point, the equity in my house did me no good.

Ask yourself, if you suddenly lost your job, would you rather have $20,000 (or 40 or 60, or 100k) in a taxable account, or would you rather have "only 4 more years to go" on your mortgage?

I personally did the investing thing until I had enough to just pay off the mortgage in one fell swoop, and still had plenty of extra cash on hand afterward.
"If ye love wealth better than liberty, the tranquility of servitude better than the animating contest of freedom, go home from us in peace." Samuel Adams

pdavi21
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Re: pay down mortgage vs. invest in taxable?

Post by pdavi21 » Sat Apr 27, 2019 9:45 pm

Pay down the mortgage. Do you have any bonds in your portfolio? Do any of the less risky ones yield over 3.75%? I thought not...pay off the mortgage (keep a cushion of taxable in case you lose your job though).
"We spend a great deal of time studying history, which, let's face it, is mostly the history of stupidity." -Stephen Hawking

ERguy101
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Re: pay off mortgage vs. invest in taxable?

Post by ERguy101 » Sat Apr 27, 2019 9:49 pm

mortfree wrote:
Sat Apr 27, 2019 5:40 pm
Edit: consider refinance to a 15-year if you are fully committed to paying it off.
This is good advice. My mortgage company let me refinance to a 15 year loan, and then do biweekly payments so it pays off in like 12 years or something. Just by making the regular payment (my overall payment did go up by a few hundred or more). This fits in line with I want to retire in 12-13 years so it times just right that I can retire and mortgage be paid off.

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Re: pay down mortgage vs. invest in taxable?

Post by grabiner » Sat Apr 27, 2019 9:57 pm

mookie wrote:
Sat Apr 27, 2019 9:13 pm
OP here. Thanks for all the replies. I edited my original post to include my tax rate and the amount remaining on the loan.

I'm now leaning towards investing in taxable. If I do pay down the mortgage, is there a particular strategy for doing so that takes into account the amortization schedule and when I will fall below the standard deduction?
Check it each year. Whether you fall below the standard deduction depends on how the standard deduction increases, and also on the other deductions you take, such as how much you donate to charity.

(I have the same decision to make, but my answer is "never." I am single, and have enough in state taxes and charity that I would itemize deductions even if I didn't have a mortgage.)
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rai
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Re: pay down mortgage vs. invest in taxable?

Post by rai » Sat Apr 27, 2019 10:05 pm

I have a similar situation and just elected to pay down +$350/month and invest the rest in taxable account. If you feel like you want to put more towards your mortgage you can maybe split the difference with half savings and half towards your mortgage. It's advantageous to have some money in taxable accounts (IMO) when you retire may not want to tap into the tax shelter until you have to and/or convert to Roth IRA while you can live mostly off taxable account savings in order to lower you income subject to tax.

For OP have you paid into 529 accounts sufficiently and have you considered HSA investing to gain more tax sheltered space?
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Re: pay down mortgage vs. invest in taxable?

Post by LeeMKE » Sun Apr 28, 2019 5:04 am

I'm in the camp to pre-pay the mortgage.

Here's how I analyze mortgage pre-payment: The difference between the interest you pay with each monthly payment, and the interest you will pay with each subsequent payment AFTER a principal reduction COMPOUNDS each month by your next payment reducing principal further. The IRR is MUCH higher than your mortgage interest, and that tips it heavily in favor of pre-paying a 30 year mortgage. In some circumstances, the yield is extremely high (over 50%). In all cases, the return is tax free and compounds every month.

Of course, safety first, so make sure your emergency fund is funded first. Then I throw everything at the mortgage. Once the balance is down to less than 12 years, the yield drops significantly. But in the early years of a 30 year mortgage, you'd have to be dealing drugs to beat the return on pre-paying your mortgage.
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Re: pay down mortgage vs. invest in taxable?

Post by JTColton » Sun Apr 28, 2019 6:36 am

OP do you have PMI on your loan?

You may consider the math of paying down and trying to recast the mortgage to remove PMI, then taper that off and add more to taxable.

If no PMI I would send it all to taxable.

dmk395
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Re: pay down mortgage vs. invest in taxable?

Post by dmk395 » Sun Apr 28, 2019 7:24 am

I'd go 50/50. You can't go wrong either way, gives you eggs in both baskets.

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Re: pay down mortgage vs. invest in taxable?

Post by DVMResident » Sun Apr 28, 2019 7:54 am

Taxables account gives you liquidity. You should demand a premium return for giving up liquidity. I doubt you're getting that premium by paying down this mortgage.

Personally, I wouldn't consider giving up the liquidity until assets were larger than liabilities, i.e. taxables accounts > $450k. After that, it's just a math question.
mookie wrote:
Sat Apr 27, 2019 4:31 pm
Is the best way to pay down the mortgage early to give a lump sum once I've accumulated $20K each year vs. convert to a 15 year mortgage vs. "recast the mortgage"
Your rate is good now. Refis to 15-year are at best 3.5-3.875% (per Bankrate in my zip code). I wouldn't give up the lower minimum monthly payment for no discount. You can build your own shorter amortization by increasing payments.
...
I'm now leaning towards investing in taxable. If I do pay down the mortgage, is there a particular strategy for doing so that takes into account the amortization schedule and when I will fall below the standard deduction?
Good.

A quick point on the amortization schedule: mortgages apply simple interest. The amortization keeps the monthly payment the same. This creates an illusion of "front-loaded" interest, but it's not real. The amortization schedule should not have a bearing in your discussion.

This statement assumes no PMI-if there is a removable PMI (e.g. at 5 years/79.5% LTV), this is a different conversation.

student
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Re: pay down mortgage vs. invest in taxable?

Post by student » Sun Apr 28, 2019 8:08 am

For a pure mathematical perspective, go with grabiner's suggestion. I think you are doing well with an extra $20,000 annual savings, just do what you feel best (pay down mortgage, invest, or a combination of both) even for psychological reason. Personally, I would do both.

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Re: pay down mortgage vs. invest in taxable?

Post by grabiner » Sun Apr 28, 2019 9:12 am

LeeMKE wrote:
Sun Apr 28, 2019 5:04 am
I'm in the camp to pre-pay the mortgage.

Here's how I analyze mortgage pre-payment: The difference between the interest you pay with each monthly payment, and the interest you will pay with each subsequent payment AFTER a principal reduction COMPOUNDS each month by your next payment reducing principal further. The IRR is MUCH higher than your mortgage interest, and that tips it heavily in favor of pre-paying a 30 year mortgage. In some circumstances, the yield is extremely high (over 50%). In all cases, the return is tax free and compounds every month.
The IRR is an annualized return, so it is not the total dollar return. Another way to view this is that the return of an investment compounds in the same way.

For example, the OP is considering paying down a 26-year mortgage at 3.75%. If he pays $1000, he will eliminate $2604 from the last year's payment. This is a 160% gross return.

But the IRR is also 3.75%. If he instead made a 26-year investment with a 3.75% return, $1000 there would also grow to $2604. So the mortgage payment is equivalent to an illiquid investment with a risk-free return of 3.75% and a duration of 26 years (or until he sells the home or refinances the mortgage).

Also, the return is not tax-free if the mortgage interest is deductible. While most mortgage interest is non-deductible under the current tax laws, the OP would be eliminating deductible interest, at least with the first few payments. At a 24% tax rate, the after-tax return is only 2.78%.
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Re: pay down mortgage vs. invest in taxable?

Post by zlandar » Sun Apr 28, 2019 9:21 am

There usually needs to be at least a half point spread between your current mortgage and a new mortgage for the refi to make sense. My local CU is giving a 3.625% rate (4% APR after closing costs) on 15 year loans. Highly doubt it's worth refinancing at the current interest rates. You want to break-even on refi costs by 36 months. There are online calculators to help you figure out the time to break-even on a refi.

If you are paying PMI on your mortgage (You have ~7% equity in your home) it might make sense to prepay the loan balance to get rid of it. Check your mortgage statement and see how much it's costing you annually.

rai
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Re: pay down mortgage vs. invest in taxable?

Post by rai » Sun Apr 28, 2019 9:28 am

I had a similar question you may get some additional insight here:

viewtopic.php?f=1&t=278161&p=4482147

My mortgage is a full 1% lower and I only have 12 years left on a 15 year mortgage so my bang for the buck is far less than yours.

I'm also closer to retirement so was on a glide path to more bonds as well as less debt and have a sizable taxable investment account (years worth of expenses).

My question was something like this, if mortgage is a fixed income (it is) and it's negative return so it likely cancels out some of my bonds (bonds are positive fixed income).

SO for example if I have 70:30 (Stock:Bonds) but then $300K of my mortgage cancels out $300K of bonds my S:B ratio is more stocks may be 75:25

I don't think 5% one way or the other is a huge deal, the fact is I'm trying to lean more towards bonds so paying off some mortgage to me is like buying more bonds.

Paying off mortgage is a bird in the hand, some say it's better to invest that in stocks which offer historically more return that's the proverbial 2 in the bush.
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Re: pay down mortgage vs. invest in taxable?

Post by OSUperu » Sun Apr 28, 2019 10:06 am

DVMResident wrote:
Sun Apr 28, 2019 7:54 am
Taxables account gives you liquidity. You should demand a premium return for giving up liquidity. I doubt you're getting that premium by paying down this mortgage.
Good point. There should be some "premium" for that liquidity loss.

Some of the premium is that it's a "now/cashed in" return of X, as no matter the market, you "don't get paid" until you decide to sell your high earning fund, even after seeing "great gains". You stick in a bit more, to sell after the Holidays, and voila! there's some volatility, then your premium gains look average or less. Seems the mortgage is a guarantee.

For refinancing, sometimes CU's give promo rates. I am just about to confirm on a 2.99% 15yr, that combines an 80% LTV 30yr $252k primary at 4% and a 15yr $57k HEL at 4.99%. Also can do an 80% LTV 30yr for 4.375%.


I am looking at the differences in pay down strategies. Comparing everything to the higher payment 15yr plan: I would have to pay an additional ~$185/month (PITI still 100% not confirmed) if I wanted to pay the 4.25% down in 15 years. That's expensive "insurance" to be flexible on whether paying more or less! I can send the 30yr at 75% LTV and then that 'insurance' to be flexible drops to about $105/month, but I would have needed to put down about $10k at refinance close. Better that lump sum goes to taxable.
If I were to leave everything as is, save some refinance closing costs, and just pay down my current 30yr to 15yrs (as well as pay my current HEL normally), that difference would be ~$205/month compared to that 2.99% 15yr. If I wouldn't have stumbled across this 2.99, I don't think I would have refinanced, but just paid down my currents at a steady clip.

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Re: pay down mortgage vs. invest in taxable?

Post by Admiral » Sun Apr 28, 2019 10:35 am

If it were me, I would invest in taxable to maintain liquidity, get a nice big amount, then when rates drop throw that cash at the mort while at the same time doing a refi to a 15 year loan.

If you have a lot of extra cash every month pre paying doesn’t make sense IMO. Refinancing does, with a good rate spread. I don’t know how old you are but whatever decision you make, it should include a plan to have the mort go away when you retire. That likely means a refi.

I went from 30 year 4.0 to a 15 year 2.25 for this very reason. It won’t be totally gone by retirement but the balance will be so low that I will be able to pay it off if I choose to.

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Re: pay down mortgage vs. invest in taxable?

Post by LeeMKE » Sun Apr 28, 2019 12:43 pm

For example, the OP is considering paying down a 26-year mortgage at 3.75%. If he pays $1000, he will eliminate $2604 from the last year's payment. This is a 160% gross return.

But the IRR is also 3.75%. If he instead made a 26-year investment with a 3.75% return, $1000 there would also grow to $2604. So the mortgage payment is equivalent to an illiquid investment with a risk-free return of 3.75% and a duration of 26 years (or until he sells the home or refinances the mortgage).

Also, the return is not tax-free if the mortgage interest is deductible. While most mortgage interest is non-deductible under the current tax laws, the OP would be eliminating deductible interest, at least with the first few payments. At a 24% tax rate, the after-tax return is only 2.78%.
Here's the math your banker doesn't want you to understand:

P&I is $2084.02 per month under the terms described by OP. You will pay $300,247 in interest over the course of this loan.

If you prepay $20K/year, it is $1666.70 per month.
Adjusting to the remaining 26 years, and prepaying each month, after 5 years you will owe $253,770.09.
Adjusting to the remaining 26, with no prepayments each month, after 5 years you will owe $365,589.57.
This gives you $111,819.48 in additional principal for your $100,000.00 investment, which using rough numbers, is a 5 year return of 8.46%*, or 4.5% compounded comparable to a taxable investment. The benefit continues to grow if you stop prepayments after 5 years. You don't pay taxes on this "income" but you will on a taxable investment.

Don't let a tax deduction get in the way of your best financial decision.

* It would have been quite a bit more if you'd started pre-payments earlier, and it appears you have made some prepayments, but to keep it clean, I'm working with the provided numbers.
The mightiest Oak is just a nut who stayed the course.

j0nnyg1984
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Re: pay down mortgage vs. invest in taxable?

Post by j0nnyg1984 » Sun Apr 28, 2019 3:53 pm

I’m paying off the last 72k of my mortgage loan on Wednesday :sharebeer

I feel that maxing out my t401k, rIRA, and HSA is enough investing, and I would prefer that everything else goes to get me 100% out of debt. Starting Thursday morning, I’ll start saving every penny (in my money market account) again for something else in the future / probably a down payment for a bigger and better home.

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Re: pay down mortgage vs. invest in taxable?

Post by welderwannabe » Sun Apr 28, 2019 3:59 pm

j0nnyg1984 wrote:
Sun Apr 28, 2019 3:53 pm
I’m paying off the last 72k of my mortgage loan on Wednesday :sharebeer
Congratz! :beer
I am not an investment professional, but I did stay at a Holiday Inn Express last night.

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Re: pay down mortgage vs. invest in taxable?

Post by Notsobad » Sun Apr 28, 2019 4:09 pm

Take a look at your savings goals and see how you are doing. I would have the first priority for retirement savings (including taxable account investing) then college savings, then paying down the mortgage. This assumes you have no credit card, auto, or educational debt.

In your situation, I would put at least 75% in taxable and investments and the remainder to pay down your mortgage. I personally maxed out 529 before extra principal payments. How much we put away for kids college is very personal and there are varied opinions here about how much is appropriate or desirable.

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Re: pay down mortgage vs. invest in taxable?

Post by Bud » Sun Apr 28, 2019 8:42 pm

Tomorrow I will pay off a remaining $73k mortgage.

My interest rate is 5% and so the decision was easier.

One way to think about the question of paying off a mortgage is to ask yourself if you would borrow money at x% to invest in the market.

Home or investment property loans are also a different type of asset from bonds or equities - paying down a loan increases diversification across asset classes, not just within equity types.

My 2 cents? split the difference and put $10k towards paying down the loan and the other $10k into investing. Either way, the OP will be ahead :).

All the best.

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Re: pay down mortgage vs. invest in taxable?

Post by sergio » Sun Apr 28, 2019 9:59 pm

I'd put $5k towards the mortgage and $15k in taxable.

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Re: pay down mortgage vs. invest in taxable?

Post by grabiner » Sun Apr 28, 2019 10:20 pm

Bud wrote:
Sun Apr 28, 2019 8:42 pm
Home or investment property loans are also a different type of asset from bonds or equities - paying down a loan increases diversification across asset classes, not just within equity types.
Paying down a loan has the same diversification benefit as buying a bond.

This is easiest to see if you have a bond portfolio which pays enough every year to make your loan payments. If you sold that bond portfolio, and used the proceeds to pay off your loan, your financial situation would not change (except for any difference between the market value of the bonds and the loan difference),

The effect of paying down a loan is independent of what the loan is for, except for the tax situation and the consqeuences of defaulting. The amount of equity in a property depends on the size of the loan, but the amount of equity does not correspond to the risk. If you own a $500K rental and home prices drop by 20%, your net worth drops by $100K regardless of your loan balance.
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