Better to Pay Down Mortgage Principal or to Invest in Market

[llscott195]

Thanks in advance to anyone who would be kind enough to provide their views on the following question:

We hold a mortgage with the following terms:
-- $775K principal; 10/1 ARM (interest only); 6.25% interest rate.

Assume we invest in funds along the following lines:
-- 60% U.S. market; 30% foreign market; 10% bonds

We are trying to figure out whether it is better to put a lump sum (for purposes of the example, let's say $50K) all into the funds or to do half in the funds and half into the mortgage principal.

Once again, thanks to anyone who would be willing to provide their thoughts.

[market timer]

Any chance you could pay down enough of your mortgage to refi into a sub-5% 30-year fixed rate?

[llscott195]

We would rather not put that much cash into the apartment at this point.

Should also have mentioned that we are in the 2nd year of the 10/1 arm.

[market timer]

We would rather not put that much cash into the apartment at this point.

Why not? Are you underwater?

[llscott195]

Not at all. We are just starting to put money into the funds, and we'd like to increase our investments there for the time being. That desire is part of the reason we're considering whether it even makes sense to pay down mortgage principal at this point. Whether it makes more sense to start making $50k investments in the market, in the mortgage, or a combination of the two.

[market timer]

Any interest savings should be considered as part of the returns. For example, if paying down an extra $50K allows you to refi and save 1% on $700K (5% vs. 6% mortgage), that's 14%/year ($7K interest savings on $700K) + 6%/year interest savings on the original mortgage (owing $50K less) + potential PMI savings, all risk-free and after-tax.

[kevincohen]

6.25% interest rate.

Assume we invest in funds along the following lines:
-- 60% U.S. market; 30% foreign market; 10% bonds

We are trying to figure out whether it is better to put a lump sum (for purposes of the example, let's say $50K) all into the funds or to do half in the funds and half into the mortgage principal.

Assume you had no mortgage and were debt free. Would you borrow money on your house @ 6.25% in order to invest in stocks and bonds? If the answer is no, then you should put everything you can (i.e., the lump sum you mentioned) into paying down the mortgage.

[Snowjob]

Everyone looks at things a little differently.

I view saving for retirement on an aftertax basis while holding a mortage on a similar basis as I view using leverage in my portfolio. Are you willing to borrow at 6.5% to invest for an extended duration? For me thats a steep price considering where the market sits today. You can get margin rates far cheaper -- more than 5x cheaper actually.

On a relative basis you're giving up 5% risk free to use your mortgage to lever your investment portfolio as an alternative. I'd stick with paying down the mortage instead -- of course this all depends your job, income etc.

[llscott195]

This may be an unsophisticated view, but I dont think we would borrow to invest because we are fairly risk averse. Does it make sense to put some toward the mortgage and some into the market?

(Thanks very much for your time)

[Snowjob]

Based on all of the above I would suggest putting as much as you can against the mortgage and then look into Market Timer's suggestion of trying to a better rate.

[llscott195]

Thanks. I may be betraying my ignorance, but if I am not going to ever pay down the mortgage all the way (i.e., assume we will sell the apartment within 10 years), doesnt it make sense to begin to take advantage of compounding interest in the market while simultaneously reducing the mortgage principal?

Put differently, does the time horizon of the apartment change your analysis?

[nisiprius]

Why are you asking this question? Is some "advisor" trying to convince you that you should invest? Or is a friend who's decided to invest instead of paying down the mortgage bragging about his shrewdness?

[Snowjob]

If you have spent much time at all on this website you'll hear one liners about not knowing the future direction and performance of the financial markets. While the markets have rewarded investors over time, there is no garantee the next ten years will yield an after tax compouned rate of return in excess of your mortgage cost. Just look at how many sensible investors have done over the last 10.

If you have money in the market already, you've just particpated in one of the altime great rallies and you will continue to particpate in whatever lies ahead. Like Nisiprius mentioned though, its easy to get greedy (I feel it myself) but I'd take the safe bet at this point and pay down the mortage.

[ram]

Thanks in advance to anyone who would be kind enough to provide their views on the following question:

We hold a mortgage with the following terms:
-- $775K principal; 10/1 ARM (interest only); 6.25% interest rate.

Assume we invest in funds along the following lines:
-- 60% U.S. market; 30% foreign market; 10% bonds

We are trying to figure out whether it is better to put a lump sum (for purposes of the example, let's say $50K) all into the funds or to do half in the funds and half into the mortgage principal.

Once again, thanks to anyone who would be willing to provide their thoughts.

The answer to your question - Yes, absolutely pay 50/50.

Actually it makes more sense to pay ALL 50000 to the mortgage.

I believe "A bird in hand is better than 2 in the bush". Extrapolating - An assured 4.5% return is better than possible 9.0 % return. Based on past data it is very difficult to get 9% returns, so I am happy to get assured 4.5% returns.
I have a fixed 4.5% , 15 yr mortgage and I pay extra towards principle each month.

[mfen]

Are you paying PMI? Would the $50K eliminate PMI? I agree with the suggestion to refinance. The best laid plans.... Rates are historically low and in 10 years, if your plans are thwarted, you will be locking into a much higher rate. In 10 years holding a 5% 30 year mortgage will make you look like an financial genius.

[mikep]

Thanks in advance to anyone who would be kind enough to provide their views on the following question:

We hold a mortgage with the following terms:
-- $775K principal; 10/1 ARM (interest only); 6.25% interest rate.

Assume we invest in funds along the following lines:
-- 60% U.S. market; 30% foreign market; 10% bonds

We are trying to figure out whether it is better to put a lump sum (for purposes of the example, let's say $50K) all into the funds or to do half in the funds and half into the mortgage principal.

Once again, thanks to anyone who would be willing to provide their thoughts.

You need to compare risk-adjusted return for both cases. Comparing a 90/10 portfolio to paying down the mortgage is comparing apples to oranges; you should be comparing a risk-free investment return to paying down the mortgage (such as treasuries or CDs), and there is notthing risk free that pays you 6.25% out there so I would lean toward directing some money to the mortgage. Please see Paying down loans versus investing on the Bogleheads Wiki.

[Harold]

If you have spent much time at all on this website you'll hear one liners about not knowing the future direction and performance of the financial markets.

I think it's more that this fundamentally a personal risk decision. Not a calculation about which will return more, rather how much risk someone has decided to take (and choosing investments of comparable risk, rather than the apples/oranges of stocks/mortgages).

If one wants to borrow (through a mortgage or whatever) to buy stocks, he should probably be considering how it lines up with the asset allocation he's selected commensurate with the risk he wants/needs to take.

[pochax]

Thanks. I may be betraying my ignorance, but if I am not going to ever pay down the mortgage all the way (i.e., assume we will sell the apartment within 10 years), doesnt it make sense to begin to take advantage of compounding interest in the market while simultaneously reducing the mortgage principal?

Put differently, does the time horizon of the apartment change your analysis?

whether you pay down the mortgage entirely is irrelevant. you still owe the money regardless. i am not sure you are clearly seeing the mortgage as a liability and the risk that goes along with it.

since you answered the previous posters with the sentiment that you are risk-averse and that you would not borrow money at 6.25% in order to invest in the stock market, i think you've answered the queston at least to a degree: use some if not all of the $50k to pay down the mortgage especially if it allows you to refinance to a better rate or gets rid of any PMI (if it exists).

[gouldnm]

From what I've read so far, everyone seems to be saying it's better to pay off your mortgage before investing in the stock market. Do does this mean that everybody here has paid off their mortgage? Something doesn't add up.

[DSInvestor]

From what I've read so far, everyone seems to be saying it's better to pay off your mortgage before investing in the stock market. Do does this mean that everybody here has paid off their mortgage? Something doesn't add up.

Nobody is suggesting they pay off their mortgage entirely, then invest. If they had a different type of loan, say a 30 YR Fixed mortgage, they'd at least be paying some principal every month. A 775K Interest Only 10/1 ARM at 6.25% is a large loan and somewhat risky. It would cost them 48K/yr in mortgage interest alone. Do they really want to hold the property for 10 yrs, pay close to 500K in mortgage interest and still owe 775K?

OP did not provide any details about their financial position other than the mortgage. We have no idea about what investments they hold, what tax brackets they are in, what other debts they may have. Are they paying PMI? Are they young, high earners perhaps MDs just out of residency? Are they closer to retirement?

http://www.mtgprofessor.com/tutorials2/ ... t_only.htm
According to mortgage professor, most interest only loans are responsive to principal reduction and their future monthly payments will be reduced:

Payment Responsive to Principal Reduction: On most IO loans, whether fixed or adjustable rate, the monthly mortgage payment will decline in the month following an extra payment. This is the only type of mortgage that has this feature. On a conventional FRM, the payment never changes while on ARMs, the payment doesn't change until the next rate adjustment.

[HomerJ]

Thanks. I may be betraying my ignorance, but if I am not going to ever pay down the mortgage all the way (i.e., assume we will sell the apartment within 10 years), doesnt it make sense to begin to take advantage of compounding interest in the market while simultaneously reducing the mortgage principal?

Put differently, does the time horizon of the apartment change your analysis?

Paying down the mortgage ALSO takes advantage of compounding interest... the less you owe, the less the interest will be... that 6.25% will be compounded over the years...

Paying down the mortgage is a guarenteed 6.25% (before your tax deduction)... You might be able to beat that in the market... but you might not

[stoneman]

on a side note....775K for an apartment!!! Why?

[llscott195]

Thanks to everyone for the posts, which were exceedingly helpful.

After considering this further, we decided to pay down the mortgage to refinance into a 30-year fixed rate at 5.25%.

A couple of responses to questions raised by others throughout the dialogue --

we took out the 10/1 ARM (I only) to permit us to make low payments throughout the year and then to drop lump sums at year end (given that each of us get year-end bonuses) --- we never intended to, nor have we, considered it an I only for 10 years, followed by a $775 K principal remaining;

its a 2BR/2BATH NY apartment, which explains the mortgage for the one poster who wondered why

[Toons]

Easy decision for me,Pay down then Pay off the mortgage then invest.
It workied for me.Now I invest the hypothetical "mortgage payment" with Vanguard

[dkdoy]

Easy decision for me,Pay down then Pay off the mortgage then invest.
It workied for me.Now I invest the hypothetical "mortgage payment" with Vanguard

Did the same, one of the best things I have done financially.

[baw703916]

After considering this further, we decided to pay down the mortgage to refinance into a 30-year fixed rate at 5.25%.

A couple of responses to questions raised by others throughout the dialogue --

we took out the 10/1 ARM (I only) to permit us to make low payments throughout the year and then to drop lump sums at year end (given that each of us get year-end bonuses) --- we never intended to, nor have we, considered it an I only for 10 years, followed by a $775 K principal remaining;

I think you made a good decision--you got a lower interest rate, and eliminated the risk of interest rates rising after 10 years.

I admit I was a little curious about the decision to do the interest-only mortgage, it makes a lot more sense in the context of a significant year-end bonus.

I think it makes sense to split the difference, allocate some money to paying down the mortgage, and some to investing. The problem with saying "I'll pay off the mortgage first, then invest, is that you probably lose about 10 years in the market by doing so. Say, for instance someone had made that decision in 1990, spent until 2000 paying off the mortgage, and completely missed the 1990s rally?

Best wishes,
Brad

[mfen]

The problem with saying "I'll pay off the mortgage first, then invest, is that you probably lose about 10 years in the market by doing so.

Optimally the OP will dedicate the difference from his reduced monthly mortgage payment to investments.

[dkdoy]

The problem with saying "I'll pay off the mortgage first, then invest, is that you probably lose about 10 years in the market by doing so.

I think for most people that is incorrect, most people will continue to invest. However, extra funds will be diverted towards principal on mortgage note. It is not an all or nothing proposition.

[grabiner]

Thanks in advance to anyone who would be kind enough to provide their views on the following question:

We hold a mortgage with the following terms:
-- $775K principal; 10/1 ARM (interest only); 6.25% interest rate.

Assume we invest in funds along the following lines:
-- 60% U.S. market; 30% foreign market; 10% bonds

I don't know your tax bracket; I would assume 28% given that you can afford $48,000 a year in mortgage interest. If you live in New York City, your state and city tax rate is 10.496% (possibly a bit higher; there is a funny bracket stucture in New York), but that is deductible on your federal taxes, so your overall tax bracket is 35%.

Therefore, if you put $1000 towards paying off the mortgage, you will owe $1062.50 less on the mortgage next year, but you will lose the $62.50 mortgage deduction and pay an extra $21.87 in taxes. You wind up $40.63 ahead, a 4.06% risk-free return, but you won't benefit from that return until you pay off or refinance the mortgage, so it is a long-term investment.

If you put $1000 into long-term Treasury bonds in your IRA or 401(k), you would earn 3.82% risk-free (current yield on Long-Term Treasury); therefore, it is a better investment to pay down your mortgage than to buy such bonds. In a taxable account, the situation is even worse, as you can earn 3.29% with a small amount of risk (current yield on New York Long-Term Tax-Exempt).

Therefore, it can only make economic sense for you to avoid paying down the mortgage if you are willing to invest 100% in stock, and you would then effectively be borrowing against the house. (Do invest enough to get the match in your 401(k) if available; that's an instant 100% gain.)

A side benefit is that, by paying down the mortgage, you may make it easier to refinance to a lower-rate loan. If you refinance from 6.25% interest-only to 5% fixed-rate, you will save almost $10,000 a year, and $6500 after taxes. (You won't save it all in payments, but every dollar paid toward the principal is one dollar more that you will get when you sell the apartment.)

From what I've read so far, everyone seems to be saying it's better to pay off your mortgage before investing in the stock market. Do does this mean that everybody here has paid off their mortgage?

No, because it depends on your situation. You have a high rate on your mortgage, and therefore you get a high return for paying it down. If you had a 5% mortgage and were in the same 35% bracket, the return on paying down the mortgage would be 3.25%, and the return on Treasury bonds in your IRA would still be 3.82%. Therefore, it would make more sense to buy bonds in an IRA and keep the mortgage; you might still choose to take the risk and buy some stock as well. In that situation, I would recommend even buying stock in a taxable account and keeping the mortgage.

[German Expat]

How much equity do you have in your home ? Can you get it to 20% or more ?

If yes then why not refinance into e.g. a 5/5 or 30 year fixed at Penfed. Up to 750k its relative easy to get a jumbo mortgage if you are above 20% equity.
You pay 1 % origination fees but payback is really quick.
Penfed 30 year fixed is 4.875%.

Here are their rates :

https://www.penfed.org/productsAndRates ... isting.asp

They don't cover closing costs anymore though for 30 year fixed (they used to until end of November 2009).

[retcaveman]

Aside from the comments on refinancing, my understanding is that money applied to a mortgage does not affect (reduce) current payments; it gets applied to the end of the mortgage. The additional money doesn't earn any interest; it just sits there.

If my understanding is correct (it's what I have been repeatedly told by banks when I've asked the question), putting it into some kind of interest bearing account and adding to it as you can until you have enough to pay the mortgage off completely may be a good option. Given the size of your mortgage, it may be a while before you accumulate that much $$. That way, the money continues to be available to you if you need it for something important (and assuming you won't just raid it for casual spending).

[German Expat]

Aside from the comments on refinancing, my understanding is that money applied to a mortgage does not affect (reduce) current payments; it gets applied to the end of the mortgage. The additional money doesn't earn any interest; it just sits there.

If my understanding is correct (it's what I have been repeatedly told by banks when I've asked the question), putting it into some kind of interest bearing account and adding to it as you can until you have enough to pay the mortgage off completely may be a good option. Given the size of your mortgage, it may be a while before you accumulate that much $$. That way, the money continues to be available to you if you need it for something important (and assuming you won't just raid it for casual spending).

You should fire your banker, at least I wonder less why those people in banks created the mess they did .

It is one of my pet peeves that in the US everybody tries to talk about monthly payments. I don't care about my payment (as long as I can aford it) for a mortgage or a car lease or loan. I care how much interest I pay and what other costs they might sneak into the contract. Whether I pay something off faster (e.g. 15 year vs 30 year mortgage) is a strict cash flow issue, do I have the extra money available or not and even if I have it are there better investments on hand. At this time I think you will be hard pressed to find an investment that close to guarantees 6.25% return.

The additional amount isn't just sitting there, it does get applied to your principal (thats what you should do, make sure the bank doesn't put it in escrow).

The banker is right, your payment will stay the same but you will pay less interest and more principal after your one time payment.

End result is :

Payment stays the same (your banker is right on this one)
Your mortgage will be paid earlier (e.g. instead of paying it in 30 years you might be done in 25 years) and you will pay a lot less interest over the live of the mortgage.

Your return on the 'investment' into your mortgage will be the interest rate you pay on it (before tax considerations).

So it would be stupid to put the money into an interest bearing account that might pay you 3%-4% during you pay 6.25% mortgage interest.

[baw703916]

Aside from the comments on refinancing, my understanding is that money applied to a mortgage does not affect (reduce) current payments; it gets applied to the end of the mortgage. The additional money doesn't earn any interest; it just sits there.

At least for my mortgage, extra money doesn't reduce the succeeding months' payments, but it does mean the mortgage gets paid off sooner. And it means that the amount of the next month's principal+interest which goes to interest is reduced, so you are paying more principal. So effectively, it does earn the interest rate of the loan (because you have that much less principal and accrue less interest each month), so you do get a compounding effect.

Brad

[DSInvestor]

retcaveman,
Here's a mortgage calculator that will show you an amortization table. Make sure you enter some prepayments. To see the amortization table (payment schedule), click View Report.
http://www.dinkytown.net/java/MortgageLoan.html

[retcaveman]

Obviously my "understanding" is incorrect. Thanks for the explanation.

[YDNAL]

We hold a mortgage with the following terms:
-- $775K principal; 10/1 ARM (interest only); 6.25% interest rate.

Assume we invest in funds along the following lines:
-- 60% U.S. market; 30% foreign market; 10% bonds

This may be an unsophisticated view, but I dont think we would borrow to invest because we are fairly risk averse. Does it make sense to put some toward the mortgage and some into the market?

llscott,

Separate from the borrow/invest discussion - you have plenty of input and opinions to consider - a risk averse investor doesn't hold a 90/10 Stock/Bond allocation.

[sommerfeld]

we took out the 10/1 ARM (I only) to permit us to make low payments throughout the year and then to drop lump sums at year end (given that each of us get year-end bonuses) --- we never intended to, nor have we, considered it an I only for 10 years, followed by a $775 K principal remaining;

so, one thing that raised a red flag for me here is the assumption that you will get the bonus every year. My mental accounting system views a "bonus" as an unexpected and unanticipated thing -- I don't budget under the assumption that I'll get the bonus; I budget under the assumption that I'll only get the base salary and then decide separately how to allocate additional income if it shows up.

I'm glad you decided to refi to the 30-year-fixed.

[grabiner]

Aside from the comments on refinancing, my understanding is that money applied to a mortgage does not affect (reduce) current payments; it gets applied to the end of the mortgage. The additional money doesn't earn any interest; it just sits there.

If my understanding is correct (it's what I have been repeatedly told by banks when I've asked the question), putting it into some kind of interest bearing account and adding to it as you can until you have enough to pay the mortgage off completely may be a good option. Given the size of your mortgage, it may be a while before you accumulate that much $$. That way, the money continues to be available to you if you need it for something important (and assuming you won't just raid it for casual spending).

You should fire your banker, at least I wonder less why those people in banks created the mess they did .

Banks can handle payments in two ways: as advance payments, or as payments of principal. Sometimes, you need to specify that you are making a principal payment.

If you make an advance payment (paying the June mortgage payment in May), you get no interest benefit, but then you won't owe the June payment in June.

If you pay down the principal, the bank will only charge you interest on the remaining principal balance. Your required payment for the next month will be the same, but since you are paying less interest, more of the payment will be principal, so your principal reduction will grow at the interest rate.

[superthan34]

This is an interest only mortgage, so additional principle payments will reduce the monthly payments.

[zaplunken]

The problem with saying "I'll pay off the mortgage first, then invest, is that you probably lose about 10 years in the market by doing so. Say, for instance someone had made that decision in 1990, spent until 2000 paying off the mortgage, and completely missed the 1990s rally?

How true! I have to say it depends upon the times and the market.

I did NOT pay down a mortgage in the late 80's to 2000, I paid the mortgage month by month and plowed as much as I could into my 401k. But that was the beginning of the biggest bull market in history. I made out like a bandit in the stock market and had I paid my mortgage off I'd have missed turning my contributions into my ability to retire early. So in this day and age, I'm not sure.... time makes money in the stock market. The today's market is a far cry from the boom times of the 90's but you are buying cheaper. 25, 30 years from now you may amass millions by ignoring the mortgage. IMO if you are young, in your 20's to 30's pay the mortgage month by month and invest as much as possible. When you get to your 50's and 60's you'll have a good sized portfolio and in that time the mortgage will be paid off. You arbitraged your money via the mortgage.

[baw703916]

The problem with saying "I'll pay off the mortgage first, then invest, is that you probably lose about 10 years in the market by doing so. Say, for instance someone had made that decision in 1990, spent until 2000 paying off the mortgage, and completely missed the 1990s rally?

How true! I have to say it depends upon the times and the market.

I did NOT pay down a mortgage in the late 80's to 2000, I paid the mortgage month by month and plowed as much as I could into my 401k. But that was the beginning of the biggest bull market in history. I made out like a bandit in the stock market and had I paid my mortgage off I'd have missed turning my contributions into my ability to retire early. So in this day and age, I'm not sure.... time makes money in the stock market. The today's market is a far cry from the boom times of the 90's but you are buying cheaper. 25, 30 years from now you may amass millions by ignoring the mortgage. IMO if you are young, in your 20's to 30's pay the mortgage month by month and invest as much as possible. When you get to your 50's and 60's you'll have a good sized portfolio and in that time the mortgage will be paid off. You arbitraged your money via the mortgage.

Hi zaplunken,

I'd say that whether by luck or skill, your market timing has been excellent!

You're absolutely right that whether investing first or paying off the mortgage first is the better move is very dependent on the market at that particular time. In the 1990s, investing was the better move, but in this decade paying off the mortgage was. In the coming decade, who knows? I think splitting things to make sure one at least takes advantaged of 401k,s IRAs, etc. and then maybe pay a little extra on the mortgage if there's extra money available makes sense.

Brad

[zaplunken]

I'd say that whether by luck or skill, your market timing has been excellent!

Brad,

All luck! All I knew back then was to invest as much as possible each paycheck. I was lucky no doubt about it!

The late 80's thru the 90's was a once in a lifetime event. I retired early in 2008 due to the accumulation of a nice nest egg despite the 2000-2002 recession. After posting a question about paying off my mortgage (I had to refi in 2003 on a newer different house due to divorce) I am going to pay off the mortgage over the next few months. The investing during the 90's has allowed me to pay it off so for me paying down the mortgage from the late 80's thru the 90's would have been a disaster. But now is different. i still say if you are young keep the mortgage and invest like mad. Time makes money.

[WorkToLive]

I have been going back and forth with the issue of paying off the mortgage vs. investing. We are one year into a 30 year fixed at 5.25% with a balance of about $300,000. After considering multiple options, we are going to max out my 401k (husband is not eligible) and both of our Roth's, plus put a bit into kiddo's college fund each year, and then use any surplus to pay down our mortgage instead of investing it in taxable accounts. Our hope is to pay off the mortgage in about 15 years so that when our daughter starts college, we will be mortgage-free or nearly there. I feel this plan gives us a balance between investing and getting us the "guaranteed" return of paying the mortgage off early.