mortgage prepaying

[crabbypatty]

I know a lot of people believe that you should invest vs prepaying a mortgage based on the expected rate of return. We're new to investing so we are starting slowly with that, as well as continuing our plan of prepaying 1 extra mortgage payment a year. (Maybe next year we'll change our plan)

I'm not sure I fully understand though. Say the mortgage is at 5%. Wouldn't you be getting more than a 5% return on the investment by prepaying b/c of the compounding factor? This isn't straight intrest, right? How do I figure this out?

[sweeps]

The compounding works both ways. Money that you invest now gets compounded too. Putting $1,000 in an investment that earns 8% will earn you more than putting $1,000 toward a 5% mortgage.

[crabbypatty]

The compounding works both ways. Money that you invest now gets compounded too. Putting $1,000 in an investment that earns 8% will earn you more than putting $1,000 toward a 5% mortgage.

OK, that makes sense. The (hypothetical) difference is 3%. Say I put 1500 toward my mortgage. 3% would be 45$. That's 45$ initially and then each year after that $45 could earn intrest. BUT After that first year, the $45 is now earning the full 8%?

[sweeps]

First, we have to define what the percentages really are. Are they the base interest rate, the APR, or the APY. The APR is usually used for loans and does not include compounding, but may include some other costs/fees. The APY is usually used for investments and already includes intra-year compounding.

For simplicity, let's assume we're talking APY. Let's ignore any tax-deduction your mortgage may offer. Also let's assume your investment is in a Roth IRA so we can avoid taxes. If you put an extra $1500 towards your 5% mortgage, you will save $75 in the first year, about $2,500 total over a 20-year period. If you invest that $1500 in an investment that earns 8% a year, you will earn $120 in the first year, about $5,500 over a 20-year period if you don't touch it. This shows you what a small difference an interest rate can make over a long period of compounding.

[anonymous_saver]

Despite the fact that you probably would earn more money by putting more money in your 401(K) or whatever retirement account, I would still rather put extra money towards a mortgage. In my situation, I am 25 and save 25% of my income towards retirement (in addition to having a pension plan). In fact, I forsee myself potentially raising this percentage as I get pay increases (maybe 1% a year or so). Since in my situation, I am already pretty agressive I would rather put more money towards my (fictional!) mortgage payment since it would give me a ease of mind. For one thing, if I ever decided to refinance a mortgage, it would make me feel very good if I could refinance a lower amount of money. This is only a perfernce for me, this is what would matter more to me. Plus, I am planning to retire early (somewhere around 50) so pre-paying the mortgage will allow me to retire without a mortgage payment. I am also personally 100% into keeping money seperate between couples, so if for some reason my partner couldn't pay extra towards the mortgage, I would likely put the extra money I have towards retirement or other goals until they are able to pre-pay on the mortgage with me.

At the very least, I would suggest doing pre-payments until you hit the 20% so you don't have to pay PMI (if you had a lower than 20% down payment).

If I didn't save so much already towards retirement. I would probably feel differently. If I only saved 5% towards retirement for example, I would probably rather put additional money towards retirement and not my mortgage payment.

[sweeps]

I would rather put more money towards my .... mortgage payment since it would give me [piece] of mind.

I ... save 25% of my income towards retirement.... In fact, I forsee myself potentially raising this percentage as I get pay increases (maybe 1% a year or so).

Anonymous, it sounds like you're in the fortunate position of having extra funds after aggressively contributing to retirement. I think the original question is for those who must make a tough decision doing one or the other.

[Scanner]

I advocate substituting your "bond mix" for "debt reduction."

Lets say you are 35 y.o. Theorectically, the T. Rowe Price Target Retirement funds that everybody are always pushing here are probably going to mix you at 65% equities/35% bonds/cash. Let's say they go as high at 80%/20% or even 90/10.

I say forget the Target fund and just put 80% of your savings into equities (but still diversify) and take 20% of that and prepay your mortgage.

Why, because, it's a guaranteed 5-8% return, depending on your mortgage rate, and there's no market risk like bonds and that your bond manager is going to sell prematurely, etc.

You see what I am getting at?

There's so many here who I can tell really, really, really want to pay down the mortgage and yet seem conflicted at the same time. It doesn't have to be that way.

[anonymous_saver]

Anonymous, it sounds like you're in the fortunate position of having extra funds after aggressively contributing to retirement. I think the original question is for those who must make a tough decision doing one or the other.

hehehe... yes, I said the "piece of mind" comment incorrectly, I have always said "ease of mind" even though I know it's incorrect.


I see your point about the original point of the question. Your probably right. I am lucky that I have always been a saver and not a spender.

[msnln]

Scanner. I can see your reason for recommending bond % allocation for debt reduction as you are looking at fixed % of return. However, based on the modern portfolio theory, by having various investment class mixture, you get higher return for reduced volatility. For instance, usually when stock markets go down, bond markets go up as money from stocks tend to go towards safer bond markets. So, you will be losing money from stocks but making money on the bond portfolio and offsetting losses. Opposite would happen if stock market goes up.

However, if someone was to follow your advise, the portfolio would not benefit from inverse price movements between stocks and bonds as debt principal amount is fixed and cannot be priced based on the market action. You will get the same price effect with bond funds and thus the reason for stock/bond/cash mix from various brokers.

[msnln]

Crabby, I would take 5% guaranteed return over 8% possible return any day. Also, you have to consider 8% is taxable and depending on your tax bracket and type of investment, you may only end up with about half of that return, especially if you live in high tax region like NYC as I am (federal, state and city taxes).

[crabbypatty]

Thanks, the explanations help with next years planing. In my mind I was considering the prepay amount to be a conservative part of our investing. A step up from EF in a bank, but below investing in the stock market. one part of the larger financial picture. Not the only thing.

Overall we are still much more conservative than others. It's been tough to get DH on board with stock market investing at all. Which leads me to my next new post......

[disneysteve]

you have to consider 8% is taxable

Only if you are talking about a taxable account. If, however, you would put that money in your Roth or 401K, it grows and compounds tax-free.

[msnln]

I agree Disney but you will pay taxes eventually on 401K when you withdraw the funds. I back 401k investments especially if you have company match but I am not as enthusiastic about these plans as I had been when I was younger. The reason for that is in taxable account, long term gains are taxed at 15% capital gains rate but 401k or traditional IRA withdrawals are considered ordinary income and taxed at your income tax rate. So, it is better to invest bond portion of portfolio in tax deferred assets but invest equities in taxable accounts.

That said, there are no bond funds that offer 8% return unless you go into toxic junk bond arena, and even then I think return is in the mid 6% range.

[sweeps]

I agree Disney but you will pay taxes eventually on 401K when you withdraw the funds.

Missed the point. OP has after-tax funds. A 401k has nothing to do with this. She could put the money in a Roth or pay down the mortgage. Also what is not mentioned is the mortgage is likely tax-deductible, further tipping the scale toward investing.

For many people paying down the mortgage is the right thing to do. But financially speaking, investing is usually the better choice. Also I agree there are short-term risks associated with stock investing. But paradoxically stock investing has very low long-term risk associated with it. Paying down a low-interest-rate mortgage comes with it's own risks: inflation and reduced liquidity.

[msnln]

A step up from EF in a bank, but below investing in the stock market.

That is not what I read. I suppose the answer lies in where funds will be invested. I personally invest in leveraged index funds and my investments will stay there for many years. My investments are supposed to replicate double the returns of S&P, Nasdaq 100 and Russell 2000 minus management fees. So, if they go up 10%, my investments will return in the high teens. I have mortgage too but I feel my returns from these will likely compensate for any risks and taxes.

However, if the funds will not be invested in stocks or stock type funds then I say prepay mortgages.