Wednesday, August 12, 2009
Is it worth to overpay your mortgage?
This is the story of how a math mistake saved me money.
When my wife and I purchased our first home, I asked myself: Given a little extra disposable income, do I overpay my mortgage or invest that same amount in the stock market? After listening to a few financial pundits on the radio, I decided to overpay my mortgage. I did not do the math, I just relied on “expert opinions” to guide me.
Three and a half years ago, my wife and I purchased our second home and I decided that this time I would do it right. I did the calculations by applying the interest rate that I was paying at the time (5.65% over 30 years) and figuring in federal and state income tax. I came up with a return of about eight percent if I overpay my mortgage. So I started to overpay my mortgage instead of investing into the stock market. Well as it turns out, I had made a simple mistake in my Excel calculations. The return was actually less than four percent. I did not even realize my mistake until we refinanced our home at the end of December, 2008.
Thankfully, luck was on my side. Had I invested that money in the stock market, I would at this point have had negative returns. In the long run, however, I would not have lost out. I would have invested the dollar cost average over a number of years, buying stocks when they are high and when they are low, and my average return would have most likely beaten four percent.
After we refinanced, just before the new year, we got a 4.25% interest rate over 30 years. Figuring in federal and state income tax, we would probably receive a 2.9% rate of return. Having figured this out, I began putting my extra mortgage payments into the stock market indexes such as S&P 500, MSCI EAFE, MSCI US Small Cap 1750, etc., properly diversifying among all asset classes. Assuming that I will obtain approximately eight percent return over the long run and pay taxes on dividends and gains, I plan to be well ahead of the curve!
It is true that many financial pundits rave about overpaying your mortgage so that you can become debt free. However, if I can produce my mortgage balance from my bank account, that, to me, is also debt free. Furthermore, it is important to take into consideration the facts of life: what if you are overpaying your mortgage and you lose your job or are hit with extensive medical expenses? All of your built up disposable income is now sitting in the equity of your home and you must rely on bank loans (which you may or may not easily obtain).
So in case you are still wondering where I stand on the subject, here it is: overpaying your mortgage is not the best idea, assuming the interest rates are low as they are right now. If you have extra money, you are better off buying stock, mutual funds, or index funds. If you have the option, put the money in a Roth IRA so that it will grow tax free. Just do not try to time the market and switch frantically between investments. Be disciplined in this!
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Alex, couldn't agree more on this idea! I almost always advise my clients not to over-pay their mortgage. Instead of putting your money into such highly illiquid investment, you're better off investing it in something more liquid, and hopefully more tax-efficient.
ReplyDeleteGood point.
Dmitriy
Financial Advisor
Your calculations showing around 8% were probably correct, assuming about 25% as your top federal tax bracket, and some state income tax.
ReplyDeleteI agree that paying down the mortgage may not be before you have taken all available tax-advantaged opportunities to invest for retirement, such as a 401(k), 403(b) or IRA. And it is especially important to get any available employer matching payments, since that is the equivalent of a raise in pay and a return of anywhere from 25% to 100% or more for your contributions in the first year.
But once you have maxed all your tax advantaged opportunities; and have eliminated consumer debts other than perhaps a car loan and student loans; and have cash reserves for6 months to a year of living expenses in case of a job loss or cut in pay, etc; then paying down your mortgage gives you a better guaranteed rate of return than virtually any other after-tax savings/investment available.
You pay taxes on earnings in a taxable savings or investment account, but there are no taxes on money that you choose to keep for yourself instead of paying to someone else as interest, so the equivalent rate of return is actually better than the rate of the mortgage itself.
ReplyDeleteAs an example:
Per $100,000 owed at 5.65% for 360 months (30. years) the payment for P&I is $577.24 per month, and the total interest paid will be $107,805.
If you were to pay an extra $248.00 per month (per $100K) to reduce the principal balance starting now, the $825.24 per month payment will pay it off in 180 months (15. years) and the total interest will be $48,494. So paying the $248 on the mortgage guarantees you a savings of 180 months (15. years) and $59,311 in interest on the mortgage.
We know that the extra $248 per month will have the mortgage paid off in 179.9 months. Normally, you would still owe $69,977 at that time. So the $248.00 in some other investment would need to give you an absolutely guaranteed no-risk rate of return that would give you $69,977 after taxes in 180 months, which could then be used to pay off the mortgage balance at that time to have the same net result.
In a CD or MM account, paying 25% fed and 6% state and local income tax out of earnings yearly, your $248.00 per month investment would need to earn a guaranteed no-risk average of 8.15%.
In the unlikely event that you could defer all taxes on dividends for the entire time, and then paid 15% fed cap gains and 6% state and local income tax on the earnings, your $248 per month would need to earn a steady average of 6.725%.
If the cap gains rate were 28% like it was a while back, plus 6% state and local income tax on the earnings, your $248 would need to earn a steady average of 7.633%.
All of these rates are better than you can get in any other guaranteed return, no-risk investment nowadays. In fact, it's better than the stock market averages for most investors since before the crash of 2000-2001, and competitive with a lot of predictions for the stock market for some years to come.
The S&P 500 is probably the best indicator of what average people can expect in their long term investments. For the last 10 years ending Dec 2007 before the crash, , its 10 year average including dividends re-invested was 6.157% and that was before any expenses or fees. As of Dec 31, 2008 its return was -36.998 for 12 months, -8.344 for 3 years, -2.186 for 5 years, and -1.381% for the last 10 years.
After you’ve got a lot of your money at risk in the stock market in your 401(k) or other retirement plan, a 7 or 8% or better return guaranteed for 15 years with no risk at all looks pretty good by comparison as a part of your long term financial plan for some of your after-tax money.
I might agree with some points that jimb brought up. There are maybe instances when overpaying mortgage might make sense. But first you would need to make sure you have liquid assets for rainy day and your retirement savings are maxed out.
ReplyDeleteSure, if mortgage rates will be heading higher from today's level or your rate by some reason is greater than 7-8% then it would make more sense to overpay mortgage.
Another possible reason not to overpay your mortgage if you are concern that anybody can sue you for some reason. The less you have in equity the less chances that in case of litigation your home will be taken from you.