What rate beats paying off mortgage?

18 years ago

I think this is my third "pay down the mortgage or save?" post!

So here's the latest version of the question.

Let's say I am paying 6.1% for my mortgage. In my case, my interest is low enough that I can't deduct it.

So what rate of return do I have to make in order to justify simply saving the money rather than paying down the mortgage?

Is the answer as simple as suggesting that I'd need to make better than the 6.1% mortgage?

I might be wrong in my estimation techniques, but I ran some numbers through an online calculator, and it seems that I can do worse than 6.1% and I *still* do better if I just save the money.

Could that be?

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Comments (10)

dave_donhoff
18 years ago
Hi behaviourkelton,

Is the answer as simple as suggesting that I'd need to make better than the 6.1% mortgage?

That is a VERY simple answer, of course. If you have a face-value return better than the face-rate of the mortgage, then it is simply & truly a financial 'no brainer.'

I might be wrong in my estimation techniques, but I ran some numbers through an online calculator, and it seems that I can do worse than 6.1% and I *still* do better if I just save the money.
Could that be?

Absolutely! You are discovering the magic of compounding interest! Depending on the timeframe, the amount in question, and the rates themselves, an compounding savings/investment vehicle with a lower return rate can outperform the costs of a higher straight-interest loan.

Add in the considerations of safety (what you may otherwise call "insurance protection premiums") for the value of having access toyour cash in accessible accounts, and a lower rate of return in liquid funds has even more power versus entrapped "savings" from mortgage elimination.

Weighing it out makes a difference.

Cheers,
Dave Donhoff
Strategic Equity & Mortgage Planner
quasifish
18 years ago
We are in the process of paying off our mortgage ASAP. There are also personal reasons that this can makes sense. In our case, my DH is in a field where he is regularly laid off (downsizing or change of contract both happen)- hopefully he is at the point where he has enough experience and reputation that he won't be out of work long, but a few years back he was unemployed for well more than a year.

While we do have a hefty emergency fund in case the worst happens again, we feel that prepaying the mortgage is a form of security that we want. Once the mortgage is paid in full, our house costs very, very little to maintain and our expendable income will skyrocket.

We've also been homeless twice- neither time was so much about money as it was about tight housing markets. That is another situation I don't want to find myself in again.

Based on our lifestyle and experiences, prepaying the mortgage makes perfect sense. If, OTOH, DH had a great job that was incredibly secure and recession proof, prepaying the mortgage might not be so much of a priority.

So look at your lifestyle, decide what's right for YOU, and what makes sense when you crunch the numbers.
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I have such a love hate relationship with the sorts of articles such as "Never pay off your Mortgage" etc. The benefit is that it gets people thinking, the bad thing is that it paints a narrow, ill conceived, rosy picture that doesn't hold up too well under scrutiny. Life is never so black or white. Several potential fallacies: #1. The assumption that everyone will have other debt in their life. #2. I'd like to find a bank that will give you a 95% 30FRM (as per his example) with out requiring an 80/15, or PMI, etc., all costs which he neglects to account for. #3. If his rosy fellow Ed is out of a job, he'll have no earned income. It's tough to make a deduction from that, so his "after taxes payment" will be readjusted back to original, meaning his $40K will last a much shorter time than this article (which also fails to account for basic costs of living beyond housing) accounts for. Fact is that if either of them are out of work for any amount of time, they're screwed. I'm not sure yet if we'll pay our mortgage of early or not. As per the article's example, our income has increased so that it's not the drain on us that it was 2 years ago. If we do prepay, we'll do it in a lump sum capacity after the point at which it is not longer a beneficial tax deduction to us. Right now we're investing the money that would go to extra payments. -meg
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green-zeus
18 years ago
There is another thing to consider. If you have enough money to pay the house off AND invest for retirement, then continue to pay on the house. But if it is an either/or choice, then invest for retirement.

Money put into a house is "dead" equity. The only way to get money is loans or reverse mortgages. It is far more important to use extra money for retirement and not worry about paying off the house.

You really have to take your own situation and job security issues,age,etc. into consideration when trying to figure this out. But most financial consultants would agree that money for retirement is more important. It takes a lot of years to get a retirement portfolio in a secure position.
devorah
18 years ago
I'm not following your logic quasifish unless you are saying that you want to and think you can pay off your mortgage before your husband is hit with another round of unemployment.
quasifish
18 years ago
devorah, yeah you have a point. That is always a possibility, but that's why we also have the emergency fund- it's a road I hope we don't have to take. At present he's in a job he doesn't love, but it is relatively secure. At our current payoff rate it will be just a few more years with a mortgage and then he will be free to take chances with other jobs that may not be as secure.

I should also mention that in addition to prepaying the mortgage, we are continuing to save for retirement as well as for short term goals (new appliances, unforseen repairs, etc.) When the house is paid off, it will mean a substancial chunk of expendable income coming our way each month- even taking into consideration taxes, insurance, and additional monies that will be earmarked for retirement accounts. The way we looked at it was to struggle very hard for a few short years, and have the stress of a house payment removed rather than having larger demands of both mortgage and retirement hanging over our heads for 30 years. I should probably also mention that we are beyond the point where we are able to deduct the interest- so no tax break for us there to offset the amount of interest needed to break even.

I don't expect others to fully understand the method to our madness- there are so many more facets to it beyond just that. It's a personal decision based on current circumstances, hopefully the right one for us. Now that I think about it, I've never heard someone say they were sorry they paid their house off early...

Sorry to get so wordy- I've been sitting on hold with an insurance company for 30 minutes....
devorah
18 years ago
and I am not at all against paying off a house. Mine is paid for. I know that I have a very low tolerance for risk and I would drive someone like Dave Donhoff screaming from the room if we sat down to plan my financial future the way it should be. I was just not seeing your objective in your original post.
dave_donhoff
18 years ago
Hi Devorah,

I know that I have a very low tolerance for risk and I would drive someone like Dave Donhoff screaming from the room if we sat down to plan my financial future the way it should be.

HAHAH!!!! That made me belly-laugh.. thanks for that!!!!!

In return... given your self-acknowledged disdain for risk... if we DID sit down & I pulled back the curtain to show the real risks behind naked unleveraged real estate equity, and the exposure it puts on your retirement nest-eggs... it may very well be YOU who runs screaming ;~)

Rarely do emotional-driven assumptions and financial realities quite line up (at all) as we would otherwise hope.

All the best!!!
Dave Donhoff
Strategic Equity & Mortgage Planner
dontknow
18 years ago
We are in a similar situation. No longer qualifying for a tax deduction on the house and spouse's job in jeopardy.

Although the numbers show differently (being invested in the market, etc..), there is something to say for trying your best to ensure you have a roof over your head.

There are many aspects to investing and savings and while facts and figures are much easier to prove, there can be more to the financial / life equation beyond number crunching.

While we could have made more money in the market, we have put ourselves in a position if either - or both - lose our jobs, we have made the blow extremely lighter. Especially when you consider the demands that situation puts on required cash flow.

As you have said, as long as saving for retirement and a well cushioned emergency fund remain part of the overall equation, I think having the mortgage in a position where you can create other options, is a good place to be - at least it has absolutely proven for us.

With an honest assessment of your specific situation and tolerances (as it sounds like you've done) should tell you what is best for you.
landmarker
18 years ago
The answer to the original question... If you have non deductable rate of 6.1%, the equavlent earnings are 1+Your Tax Rate times 6.1%. This is becuase you are not reduceing your intersted via a tax deduction, but you would have to pay taxes on the investment interest.

Example if your tax rate is 25%, you would have to earn 7.625%.

If you were deducting your mortgage, you can compare rates 1 for 1.
behaviorkelton
Original Author
18 years ago
Also, if one wants to make the bet that the stock market could be flat or worse over the next few years...maybe... maybe...it's not a horrific idea to simply pay off the house.

You get a guaranteed "return" and the fun of knowing you don't owe anyone anything! (except the gov't)

You often hear about environmentalist buying solar cells and such to "get off the grid". Sometimes I think of being truly debt free as another way of getting off the grid.

It's cool.

caveat: Mr. Donhoff is probably correct in recommending against it.

What rate beats paying off mortgage?

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What rate beats paying off mortgage?

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