We're split down the middle …

… some agree that paying down your mortgage is the dumbest decision that you can make (not really the dumbest …. but certainly down there with the best – I mean, worst) and some simply don’t agree.

Right now, though, I want to pick up on one of Nick’s comments, since he has summed up the ‘pro-pay down argument’ really well:

I do a decent amount of investing myself, and while I don’t claim to be a master of the trade, I do well. That doesn’t change the fact that I don’t know how my investments will turn out. Everything could go horribly wrong, and I could end up taking quite a hit… or it could go really well and I could make a killing.

I don’t think anyone really knows for sure how well their investments will perform. I think anyone who does is either lying or fooling themselves. It is all about managing risk.

Putting a sizable portion of your cash as a down payment, and making prepayments to pay off your mortgage, is very good way to minimize risk. You end up with lower monthly obligations, less debt, more equity… Of course, this means less free money to invest and less money making potential..

Once again though, risk management philosophy comes into play. Is your primary residence something you want to take the risk with? In today’s market, putting less down, and making lower payments would turn out to be a very costly mistake if your investments don’t net the return you wanted (you’ll be stuck paying up to hundreds of thousand of dollars more in interest over time).. and this is only assuming you merely break even on the money you invested (and are not in the red).

I think everyone’s long term plan involves moving to a nicer house in a nicer area. This is something perfectly attainable by playing this situation safe. IMO, it is dangerous to put such basic life plans on the chopping block. I think this is how people could potentially get into serious trouble.

Now, don’t get me wrong. I’m not saying that you should immediately put any money you have towards prepayments, or you should put all your money down on that new house. I’m saying that you need to carefully balance this based on your confidence about making good investments and the amount of risk you are willing to take. In other words, I think its foolish for just about anyone to put very little down and not make prepayments when they can (i.e. tax return time, or portions of a raise). I think its equally foolish to put ALL of your money towards prepayment and down payment.

Make no mistake, that large down payment is a very good protection plan when you lose your job, your wife has a kid, or you encounter some medical emergency. Those lower monthly payments make things more manageable and prevent you from being overrun with debt.

A prepayment of only $300 a month on a $350,000 principal can save you well over a hundred thousand dollars in interest over 30 years. That money goes straight into your bank account or investments when your mortgage is paid off early.

These items are your safety net… and that’s part of good risk management isn’t it? To maximize gains and minimize risks. You can’t just focus on maximizing gains – you need to protect against potential pit falls as well.

By all means have your money work for you, and try to get investments that produce greater returns than your mortgage rate… but start off by minimizing your monthly payment (sizable down payment) and put a good effort in to pay your house off early (prepayments)… You know, just in case those investments don’t work out.

I have some questions of my own; let’s use Nick’s $300 per month example:

1. Is the $300 a month a sizable proportion of the amount that you intend to invest overall? If so, do you know what you are getting for it?

Nick says that paying down his mortgage by an extra $300 per month will save him $100,000 in interest over 30 years … let’s accept that number for now and assume that this $100k can be somehow freed up at the end of the 30 year period:

$100,000 in 30 years will have almost the same buying power then as $31,000 does today (assuming that inflation averages just 4%).

That should provide Nick a yearly stipend of just over $1,500 in today’s dollars (commencing in 2038, assuming that 5% can then be ‘safely’ withdrawn each year).

Now, there’s a problem right there; how can 5% be a ‘safe’ withdrawal rate in 2038?

If inflation is still just 4% Nick needs to find a ‘safe’ investment that will return him 9% after tax (4% to keep up with future inflation and 5% to spend) … he can’t get that return in retirement by paying down his mortgage any more, it’s already paid off!

So, now – in retirement – he has to look for a more ‘risky’ investment than the one he used to get there!

Therefore, I am assuming that Nick will either keep his paid off house and actually entirely forgo this income entirely or move into a smaller paid off house or unit to free up $100k of equity …

… in any event $1,500 or zero a month sounds pretty similar to me 🙂

2. Do you know what returns you can get elsewhere?

Even if Nick isn’t relying on this $100k (then why bother with it in the first place?!) – because he is also  investing elsewhere – what could he achieve if he also invested his $300 a month elsewhere?

Well, Nick is ‘saving’ 6% interest in the current market [AJC: if you aren’t prepared to fix an incredibly low interest rate like this, how can I help you?!], which could be equivalent to a 7.5% – 8% after tax investment return.

[AJC: Unlike investing in income-producing investments, there is possibly no income tax to be paid on your mortgage interest payments/savings … of course, there could be a tax disincentive if you have been itemizing your home interest on your tax return and can no longer claim that deduction]

But, what if he can find an investment that returns more than 8% after tax?

Even an extra 1% (after tax) additional return will improve Nick’s 30 year outlook by 20% (at least, for the $300 monthly extra that he is putting into his mortgage).

3. Do you care?

For me, this is the key question: can Nick achieve his financial goals even without investing this $300 a month elsewhere? If he can’t, is he willing to let these goals go for the apparent ‘safety’ of a home partly or fully paid off?

So, my real question to Nick is: can you achieve your financial goals at the same time as paying your mortgage off? It’s possible (hell, I did it!) but, for most people, not likely … they are already skating too close to the wind even before pulling extra money out of their investment portfolio.

To me, it’s the same thing as asking if you can fish for trout in a babbling brook without getting wet:

It’s possible, but you won’t probably won’t make a great catch unless you are prepared to (slowly, carefully, and not deeper than you can handle) wade in …

Be Sociable, Share!

7 thoughts on “We're split down the middle …

  1. I got lost at “your wife has a kid” – are we to assume this is not the husband’s child? How noble of him to take this on (assuming this was a surprise event, since it seemed to have been written as if it was a new expense). Good thoughts otherwise about the role of risk.

  2. I agree that paying off a mortgage early is usually a sub-optimal decision. However there can be situations where it is the right decision. As examples:

    1. if there are no investments which you find attractive at a given point in time, it is usually better to pay off a mortgage than to accumulate cash in the bank (different after tax interest rates) and then redraw when you do find a suitable investments (assuming the costs of redraw are sufficiently low);

    2. a person nearing retirement and likely to be giving up a regular paycheck and who wishes to focus on things other than investments may be better off paying down a mortgage than investing.


  3. @ Di – I just don’t see how paying down your mortgage is a risk-management benefit; if you lose your job, try asking a bank to give you back some of the equity.

    @ Trainee – re 1. – we seem to be saying the same thing; it’s all about investing where you get the best return (provided that you have the skills/stomach to handle the various investment choices on offer).

    But, I vehemently disagree with 2. – you can’t put bread on the table from a paid off mortgage … you can, however, buy a rental and live off the income from that (I have a video that should pop up in my Vodpod and/or ajcvault.com tomorrow).

    Look there are special situations when anything can be shown to be correct, but as a general get rich(er) quick(er) strategy, forget about paying down your mortgage … it’s as simple as that!

  4. “Look there are special situations when anything can be shown to be correct, but as a general get rich(er) quick(er) strategy, forget about paying down your mortgage … it’s as simple as that!”

    You are so right on this point.

    “$100,000 in 30 years will have almost the same buying power then as $31,000 does today (assuming that inflation averages just 4%).”

    People forget about inflation. Sure you will end up paying some serious interest $$$$(tax deductible)by having that large mortgage, but you will be paying it back with devalued dollars. I’ll take money now that I have to pay off with dollars that have a real value of less than half of the money I got up front any day!

  5. @ Shafer – You are right: a fixed mortgage and inflation actually DECREASING your payment in ‘today’ dollars … it’s a beautiful thing 😉

  6. AJC: I didn’t say that it was a “risk management benefit,” I just thought Nick brought up the idea of thinking about risk (which I think is an important aspect of whether or not someone wants to “play it safe” or get “rich quickly”) and few blogs or authors address this very much. Here’s (an example of) where we tend to pay the most for risk (think “OJ Simpson”) – for experts whose value we can’t evaluate, but we are facing dire consequences if we choose the wrong expert.

  7. @ Di – No you didn’t; we’re both commenting on Nick’s thoughts … which reminds, me I haven’t thanked Nick for putting pen-to-paper so comprehensively and, as I did say, he has summed up the ‘pro-pay-down-your-mortgage’ argument very well.

    I agree about your points about selecting an ‘expert’: your Number/Date should help you identify (and ignore) any advice/experts who a bit of quick number-crunching and common sense will tell you are taking you AWAY from your ultimate goal.

Leave a Reply