There is a ray of hope in a Personal Finance blogosphere that currently seems to be ruled by Ramsey Clones: Moolanomey says that you should NOT pay off your mortgage early:
I can now say for certain that I fully oppose the idea of paying off your mortgage early because there are several related factors that make this a bad idea.
Yay!
[AJC: I’ll leave you to read Pinyo’s excellent post to discover the ‘several related factors’ for yourself]
Look, if Pinyo’s post – or, my earlier posts – haven’t yet convinced you, let me draw it out for you:
We have two people, each sitting on a $150,000 house with a $100,000 mortgage remaining; they both have just signed up for a 25 year fixed rate mortgage … their payments are currently $585 at 5%. They both decide that they can afford to ‘invest’ an extra $100 a month.
Person A
This person puts the extra $100 a month into their mortgage, shaving off 6 years on the total time to pay back the loan, saving $20,000 in interest in the process.
Being a smart investor, and once the loan is fully paid off, this person then starts to put both the mortgage payments AND the extra $100 a month into an Index Fund and waits 25 years to cash out (hopefully, allowing enough time to get as close as possible to the 30 year 8% stock market return ‘guarantee’ that he’s heard so much about).
Person B
This person lets the mortgage ‘ride’ and instead invests the $100 ‘extra money’ a month straight into a low-cost Index Fund returning an average 8% over a 30 year period, adding the mortgage payment at the end of the 25 year period when the mortgage is paid off, then waiting the additional 19 years so that he finally cashes in his financial ‘chips’ on the same day as Person A.
The Result
At the end of (19 + 25) years or (25 + 19) years – depending upon which person you are 🙂 – you have an identical and fully-paid off house (so, the value of that is irrelevant in this comparison) and an Index Fund.
Let’s see how you fared with that Index Fund …
Now, we’re looking at a very simplified example, where the homes only cost $150,000 to begin with, and we’re only adding $100 a month … yet the difference between the two graphs represents a total additional return to Person B of nearly $100k by NOT putting the additional money into their mortgage.
In the ‘real world’ he would be even better off by:
1. Increasing his additional monthly investment in his Index Fund to at least match inflation,
2. Expecting better than the worst-case 30 year stock market returns that I have provided for here,
3. Reinvesting the ‘tax advantages’ of the larger remaining home mortgage.
Which camp do you sit in?
Great example AJC. In light of 2008-2009 stock market crash where we see 50%+ wiped out, do you still feel that 8% plus return is feasible? In other word, do you think we will be averaging 8% between 2007-2037?
I did an analysis like this for myself a few years back using some of my own projected numbers, ie;, my then-mortgage on a 300k home and my own personal monthly savings numbers at that time.
The difference between the two scenarios over a 30 yr period where staggering. It was a difference of over 1.5 million dollars added to my portfolio by not paying off my mortgage early.
@ Pinyo – That’s actually a great question; my reference books are in storage because of our move, but from memory, the AVERAGE return for any 30 year period was ~12% and there were ONLY two 30 year periods as low as 8.5% (and NONE lower, of course) … one of those commenced the day before the greatest stock market crash in history (i.e. the one that heralded the Great Depression).
So, unless the total basis of macro economics in the US – and globally – has permanently changed … HELL YES 🙂
@ Scott – I bet it was the best hour or so that you ever spent with a spreadsheet and/or online calculator!
Nice post. I also used a similar comparison when planning my own finances.
One word of caution, however…when analyzing a series of cash flows for a specific evaluation period, such as the monthly investments described in the post, each of those cash flows has a different holding period. For instance, the first $100 investment made by person B has a holding period of 44 years…but each subsequent investment will be held for less time. As the holding periods get smaller and smaller, the accuracy of the estimated 8% return lessens. In other words, the assumption that an index fund will provide an 8% return for monthly investments that will be held for less than 25-30 years is a little more speculative than the post makes it seem.
That being said, it probably does not make a difference in this example because the shortest holding period where person A and person B made different investments is 19 years.
@ Jeff – True; but for periods > 30 years we could also presume that returns would tend towards the average (~11.5%, from memory). On balance, I think that person B is actually holding MORE money for LONGER periods in the stock market …
@Adrian –
From what I’ve read, if you hold long enough the market historically will provide you a 9.5% return (not including taxes/expenses/etc). Regardless of whether the average market return is 9.5% or 11.5%, the length of your holding period determines the swing around the average market return that you can expect to receive. Thus, Person B, by holding longer, is just increasing their chances of receiving the average market return–increases the reliability of the return.
“On balance, I think that person B is actually holding MORE money for LONGER periods in the stock market …”
Person B is definitely in the market for LONGER period than Persion A…but doesn’t ‘necessarily’ have more money in the market. If Person B does not receive a higher return from the market than the mortgage interest (5%) over the first 19 years, there is a good chance that Person A will have more money in the market by the time Person B pays off their mortgage (and also at the end of the 44 year period).
In most cases Person B will be better off at the end of the 44 years, but there are a non-trival number of cases where Person A will be better off.
@ Jeff – There have been no 20 year periods where the market has returned less than 4% … which is pretty close to the 5% over 19 year mortgage period that you mention … but, yes, if there is a prolonged period of high interest rates that happen to coincide with an equally prolonged period of low stock market returns, the simple example that I have provided may not work out.
No reason to pay down your mortgage for a hugely non-trivial number of people, huh? 🙂
@Adrian –
“There have been no 20 year periods where the market has returned less than 4%”
That doesn’t sound right to me. Look at the 20 year periods starting between 1/1929-12/1929 and you’ll find they are all under 4% and one as low as 2.05%. You might be looking at data that doesn’t go that far back…what source are you using?
No matter what the returns are for a 20 year period, when you are analyzing a series of cash flows, you cannot assume that the return for each cash flow within the 20 year period will receive the long term (20-year) average return. Only the very first cash flow (that is held for 20 years) will.
To illustrate my point, look at the last 19 years, where the compounded return (with dividend reinvestment) was 7.25%, i.e., the first monthly ($100) investment received this return. Each subsequent monthly ($100) investment, however, received a different compounded return–some greater than and many less than 7.25% (quite a few were negative). Overall, a series of $100 monthly payments over the last 19 years would have grown to $35,200 or provide an average compounded return of 4.31%. As you see, 7.25% 19-year lump sum return is much different than the actual return you received from the series of period cash flows over the same period.
Don’t get me wrong, I liked your example because it shows (in a very understandable way) that if you have extra money to invest and can reliably get a higher rate of return than your mortgage interest, you would be better off investing than paying down your mortgage. What I thought deserved a little more discussion, however, was the reliability of market returns for a series of cash flows, i.e., that a series of cash flows over a long period often has a rate of return that is quite a bit more speculative than the lump sum return over the same period the example uses.
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