So with the promise of employment on the horizon and in the spirit of my never-ending quest to avoid law school, I've been thinking a lot about money. Specifically, about houses and mortgages and investing (insert greedy young lawyer joke here). In perusing some of the information out there, I came across different arguments for paying off a mortgage early - as opposed to just investing the money elsewhere. The consensus seems to be that it makes more sense to pay your mortgage on schedule and put the money somewhere else where you can earn more interest on the investment than you are paying in interest on the mortgage.This got me thinking. If it makes more sense to not pay the mortgage off early, wouldn't it make sense to not pay down your mortgage at all? Why not get an interest only loan, and then take the money you would have paid on the principal and invest it somewhere riskier with a higher long-term interest rate?
So I ran the numbers. On a $300,000 loan, paying interest only will net you an extra $291,695 over the course of a 30 year loan. I got that number by assuming that you are taking the home loan interest deduction on your taxes and that you are in the 20% marginal tax bracket for that deduction. I also assumed a 6.5% interest rate on the mortgage and an estimated return of 9% compounded annually on the investment. I then took the difference between what you would get investing the principal payment at 9% over the life of the loan and what you would get if you invested the difference between the interest payment on a normal mortgage and the interest payment of an interest only loan at 9%. (Here's my spreadsheet)
So over the course of a 30 year loan you would expect to pay an extra $167,171 in interest in an interest only loan. If you paid a normal loan and then invested that extra interest as you went along at 9% you would have $383,330 when the loan was paid off in 2038.
If, however, you pay interest only, you would save $300,000 in principal payments over the life of the loan. Investing that at 9% gets you a haul of $975,025 in 2038. Subtract the $383,330 you could have made investing the extra interest and the $300,000 you would have to pay to pay off your loan and you're still $291,695 better off.
Now, I don't think that 9% is an unreasonable rate of return (at 8% you're still $192,936 better off) and the numbers only get better if you have a higher marginal tax rate. Plus, you would still be earning the equity investment in the home as the value of the property appreciated (once the market rebounds and starts growing again).
So what gives? Why is anyone paying off their mortgage?
P.S. - yes, I justified this post by including the tax consequences of the different investment plans as a weird way of studying for Federal Income Tax.
5 comments:
So what gives? Why is anyone paying off their mortgage?
I see two factors your analysis misses that can weight towards paying off the mortgage (and you're hardly alone in ignoring said factors). The first is risk. You can assume a 9% rate of return, but you only ever gain interest on investments when those investments are at risk. The risk may be "reasonable", but it still exists. Whatever you are doing for your 9% interest has a chance of blowing up in your face. Paying off dept, on the other hand, is absolutely risk-free.
I'll add as a corrallary that most people don't have a very good sense of "secured" debt. They feel that the debt is tied to the security. What they forget is that if selling the security doesn't cover their debt, they're still liable for everything that's left over. So if housing prices drop so that the loan is more than the value of the home, they can't just walk away, confident that the bank is now in charge of the loss. Banks can and will sue you to make pay the difference (and throw in all their transaction costs while they're at it).
The second factor you miss is liquidity. If you have to get out of that debt and your investments haven't "matured" enough yet, you're stuck selling the house to do it--which generally means moving as well. That's a huge PITA. If you end up moving due to, say, carrer or job change, well, you can find yourself in a bad position if that loan is still maxed. Hey, layoffs happen. One of mine happened about four months after closing on the only house I ever tried to buy...
And just for kicks, I'll throw in the religious angle. Proverbs 22:7 says that "the borrower is servant to the lender" in the KJV but I kind of prefer the New American Standard or God's Word translations that say "a borrower is a slave to the lender." Or, if you want to stick with LDS sources, President Hinkley (quoting your namesake) waxed quite elloquent on the topic. Executive summary: debt is bad; avoid it.
And finally, I'll offer lessons I've learned from making mistakes with zeroes on the end: debt sucks and interest is only your friend when it is paying money to you. I've seen a lot of tricky people looking to game the system end up wondering why their treadmill never seems to slow down. One reason is that they've locked themselves into a situation where they have to keep doing what they've done to avoid paying the price of stopping. Cash and savings represent flexibility. Debts, on the other hand are rigid. You want flexibility, go with paying off the debts.
You have to make a lot of assumptions in order for your plan to work. Many of these might not be safely assumed in our unpredictable world. Once your house is paid off, it's yours and you can't be kicked out of it when the market crashes, we are attacked by terrorists and global warming wipes out 3/4 of earth's population.
Best to follow the prophet and get out of debt.
However, you will be in the unique position of having a small family and a large income. You can still invest much of what you earn simply by living on less.
The assumptions I'm making are pretty typical. Plus, you still come out ahead if you tweak the assumptions a bit. The main one is probably the tax bracket, but most people looking at investment options are at or near that tax bracket.
I also get the risk angle. But the risk on a long term diversified investment portfolio is not terribly worse than the risk involved in owning your home. Housing prices (along with market investments) almost always go up in the long term. So that may be a better argument to not buy a house, but not to only go interest only. You're only really screwed if you have to move in the next couple of years. Then you have problems no matter what kind of mortgage you have.
I also have a hard time believing that money locked in a house is somehow MORE liquid than money invested elsewhere. While there is usually a penalty for withdrawals on some investments, there is also a cost to home equity loans and moving fees. I would think that liquidity is actually an argument to have your money somewhere else.
Aren't interest only loans for a short term? Can you get a 30 year interest only? If you have to refinance every few years, that's going to cost you.
Anyway, I think the religious angle is the best. Follow the prophet, not the profit, he usually gives good advice.
Bryce says " because if it's too good to be true, it probably is".
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