It’s tax refund time. You’ve got a few thousand dollars coming back from the IRS, and you’ve got to decide what to do with it. Do you pay down your mortgage or use the money for a downpayment on a new house?
This is the question that JD over at the Get Rich Slowly blog asks his readers. I’m going to give my take on the issue, looking at it from both sides. Then you can decide for yourself.
First, let’s go over why paying down your mortgage is a bad idea.
1. You Won’t Save As Much As You Think
If your mortgage is locked in at 6% interest, then paying it down by $3000 dollars will essentially save you 6% or $180 per year, right?
Actually, no.
In most cases, interest payments on real estate are tax-deductible. You can write off the $180 in interest, so in actuality, you’re saving much less, if anything at all.
2. You Can Make More Than You’ll Save
As a real estate investor, if you can’t make more than 6% on your money then you’re doing something seriously wrong. You could probably invest that $3000 as a portion of a downpayment on another property and make a lot more.
For example, let’s say you have an additional $10,000 in savings. You find a little fixer upper for $60,000 and make a 10% downpayment of $6,000. Combining your tax refund money, you have $7,000 left to make repairs and cover interest payments.
With about $67,000 in it, you sell it for $95,000, subtract a 6% commission for the realtor, and net a clean $20,000 or so. That’s over a 100% return — clearly much more than you would save from paying down your mortgage.
Now, if you’re just beginning to invest in real estate, I can understand how this might be difficult, but you should still be able to make much more than 6%, even if you’re just loaning the money to an experienced investor. For example, investors with perfect track records pay about 15% per year (paid annually) in Charlotte.
It’s still better than the minuscule savings.
3. You Can Use It to Create a Safety Net
Even if you don’t invest the money, you can still put it in savings to serve as a safety net. Unexpected tragedies happen all the time that cost lots of money, and it’s always good to have several months of income saved up. Personally, I recommend having six months of living expenses in the bank.
If you’re spending an average of $3,000 per month, then a $3,000 tax refund gives you a one-month safety net. It’s not much, but if you lose your job, go through a divorce, or end up in the hospital, it may be the difference between surviving and bankruptcy.
Use the money to pay down your mortgage and you’ll have to pull out a credit line to get it back. It’s not only time-consuming, but the problem with unexpected tragedies is they typically impact your credit. So, you may have to pay a high interest rate, or you might not be able to get the money at all.
That about covers the downside of paying down your mortgage. Tomorrow, I’ll post another entry, going over the advantages. Stay tuned.
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If a mortgage is locked in at thirty years, I can see the point. A lot aren’t, and foreclosure rates are up. Here in Raleigh and especially Cary, NC, some property is still undervalued, but it is catching up.
My own preference for investing is mutual funds, low overhead ones like Vanguard. Also lucked into a really nice Dodge and Cox international fund when my 401K at Time Warner went through some changes. Doing much better then six percent myself.
My own personal preference is no debt at all, and I was able to do it. At the time, my job had gone away, but I had a lot of equity and was able to do cash for this place. The roof over my head is mine, and in this day and age of unsteady employment and a shaky economy, it’s a great comfort knowing that is secure at least. I had to move three hundred miles to do it, but I’m not freezing so much in the winter now.
doesn’t argument #1 leave out the fact that your asset (hopefully) is appreciating over time as well? So you are paying off more of your principal balance, and the home is appreciating in value?
I am not saying that I agree mathematically with your reasoning, it seems sound.
One other thing that these “why you shouldn’t pay off your mortgage early” posts always forget to consider, is how old is the person holding the mortgage? If you are in your late 30’s or 40’s and taking out a 30 fixed mortgage, it seems to me that paying that debt off early would allow you a greater quality of life and increased ability to retire when you want to, not when you are done paying off your mortgage. I imagine that your $600-1500 P+I payment would be more difficult to make if you had to retire early, or became disabled. Or maybe you really would rather retire at 60 or 65, not 70+ (crazy as that sounds today). I can’t imagine trying to make a mortgage payment a fixed income.
Your thoughts?
that should have been “disagree” in the second paragraph.
balogh: I think it all depends on your market and your lifestyle. Personally, I move every 2-3 years to cash in on the tax-free profit from selling my primary residence. So, I’m not worried about paying it off. I usually just pay the minimum payment, which is negative amortization. It betters my debt to income ratio and allows me to buy more property.
Then again, that’s a risky approach for most people, so I don’t recommend it. If you’re in your 30s or 40s and you’re planning to live in the same house for the rest of your life, I would recommend paying it off on a 15 year amortization schedule, if you can. Because yes, if you’re on a fixed income such as Social Security or a retirement check, a mortgage payment could put you in financial trouble. It’s much better to pay it off and be done with it.
More on this in the next article.
By the way, thanks for commenting!
Balogh, can you clarify this comment?:
“doesn’t argument #1 leave out the fact that your asset (hopefully) is appreciating over time as well? So you are paying off more of your principal balance, and the home is appreciating in value?”
Argument #1 was that the effective interest rate on a mortgage is lower because the interest is tax deductible. The fact that the place is appreciating is totally separate from the tax deductibility, no? And, really, the fact that the property is appreciating is totally separate from the whole of the mortgage. If you buy a place for $100,000 and sell it a year later for $150,000, you’ve made $50,000 (commissions and closing costs aside) whether you owe $99,000 or $9,000 on your mortgage at the time of the sale.
I agree that appreciation is irrelevant. The property is appreciating whether you’re paying extra on it or not.
I also find age irrelevant. Let’s say you could have paid off your house by age 65, but instead you invested that money. You still have that wad of cash and can use it to pay off your house at any time. And you can use it to pay off your house one month at a time, just as you always have. The point is that you have more money and more flexibility on how to spend it.
One more point–getting loans based on your home equity costs high fees. You can give yourself a loan out of your own savings either for free or for the cost of selling your stocks or whatever–a much lower cost.
I’m one of those people who would love to have my house paid off but I’m investing my extra money instead for the reasons listed above. And by the way, just because your house is paid off doesn’t mean you have no worries. In the Great Depression, people’s houses got repossessed when they couldn’t afford the taxes. You still have to pay for taxes, insurance (if you are wise), and maintenance even after your mortgage is taken care of.
From argument 1:
In most cases, interest payments on real estate are tax-deductible. You can write off the $180 in interest, so in actuality, you’re saving much less, if anything at all.
I agree with you in principle (no pun intended), but you would absolutely save something. Interest on a mortgage is tax-deductible, but not a tax credit. In other words, the $180 you would save in your example is would actually save you about $135 if you are in a 25% tax bracket. That works out to a 4.5% return, which is not great, especially right now. As finance professors are fond of pointing out, the overall stock market has historically averaged about a 12% return.
Another small issue is that I believe on the Get Rich Slowly blog, J.D. talks about paying down a HELOC, not the original mortgage. Correct me if I’m wrong, but most HELOCs have a higher base rate than your primary mortgage. If it were an 8.5% HELOC, you would earn about 6.4% after the tax effect.
Age is relevant insofar as the investment you choose should be lower in risk (and therefore lower in returns) the closer you are to retirement. But even so, you can ladder CDs these days at over 5% APY–taxable, for sure, but maybe worth the extra liquidity.
thanks for all of your comments. Call me stubborn, or perhaps just conservative about the state of our economy 15-20 years down the pike, but my gut is still telling me to try to get out of as much debt as possible.
Re: the depression, I think that your argument, while true, might be somewhat misleading. I am sure that the percentage of people who lost their homes was much much higher in the group of people that still held a mortgage, vs. the group that owned their home outright and only had to worry about taxes.
I see your point about my first comment, appreciation vs. tax deductibility.
Hi all, from a regular Get Rich Slowly reader.
A few things crossed my mind as I read the arguments above.
From point 1, mortgage interest isn’t always deductible. Standard deduction for a single person is ~$5K and a married couple is ~$10K. Probably for most people mortgage interest is what brings the standard deduction up to or beyond those limits. For people who don’t have big mortgages to start with, or are a long way into the amortization curve, the amount of the mortgage payment that goes to interest over the course of the year may not be that much.
The argument that the mortgage interest deduction is a good reason to stay in debt is way, WAY overrated. If you’re married, $10K has to leave your pocket permanently before you start to see *any* benefit from it.
From point 2: I don’t know where the author lives, but in most urban areas in the US I’d wager it’s pretty freaking hard to find a fixer for less than $100K. In Seattle, my hometown, completely uninhabitable fixers are considered bargains at $250K.
Those things said, I’m totally in support of point 3. If we end up with a refund, we’ll use it to shore up our safety net.
Nice to “meet” this blog–I’ll be back to read more.
Angie: Thanks for commenting! I’ll take your word on the standard deduction, but if my memory serves, our corporations regularly deduct quite a bit more than that.
I live in Charlotte. Yes, I’m sure there are areas where it’s impossible to find a fixer upper for less than $100,000, but I used it as more of a example. My point was you should be able to make much more than 5-6%, regardless of your market.
Also, I’m sure some of my suggestions are going to rub Get Rich Slowly readers the wrong way and spawn a lot of interesting debates. My perspective is very different from your average personal-finance blog, in that I focus more on making money than saving it.
I look forward to your comments in the future!
Paying down a mortgage is stupid if you still have a long way to go. Basically, once you put the money, the money is tied up and you can’t get it back out readily. For example, if you have 100k available and you dump it into your mortgage and you still have another 500k to go, then that 100k is not going to do you much good. You have to pay your monthly mortgage every month, so your cash flow hasn’t changed. You have not changed how fast your house appreciates. The only advantage is that you pay off your mortgage sooner, and the amount you used to pay in your mortgage can be used to invest in other stuff. But is it really that big a deal. So you pay off your mortgage in 25 years instead of 30 years. Whoopee-dooo! With stocks investing it is better to invest in stocks early in life, and you will gain more from it than paying down your mortgage. If you really want to pay down your mortgage, invest in stocks, and when you do have enough, pay it all down in one lump sum at the end. If you need to refinance, don’t pay it down until it is time for you to refinance.
Read my article:
http://wisdomfrommywife.blogspot.com/2007/03/home-equity-in-your-house-is-not-yours.html
Thanks for the nice greeting, Jon. I admire your entrepreneurial spirit and assure you that I’m also interested in making money…I’m also strongly averse to giving it away!
Here’s another thought. Paying down a mortgage in advance limits your return to the rate of your mortgage–but it’s also an absolutely guaranteed, risk-free return. What kind of returns can you get in other instruments that are totally risk free? Passbook savings are netting 1%, long-term (5 year) CDs are running 4-5%. Getting a point or so over that for however long the rest of your mortgage lasts ain’t bad.
I know we all can cite chapter and verse about historical long-term stock market returns, etc. etc., but then every single piece of literature I’ve ever seen from an investment company has the disclaimer that “past performance is not an indicator of future returns.”
And getting out from under your morgage altogether…priceless! A friend of mine once joked, “Buying a house is the American dream. Having a paid-off mortgage is the American fantasy.”
That’s a great quote!
Guaranteed savings? Hmm. That’s a creative way to look at it, and if you’re looking for guaranteed savings, I guess it’s a solid argument. As the saying goes, “You don’t get rich by making money. You get rich by keeping it.”
You’ll hear me say this a lot on this blog, but I still think it all depends on your goals and strategy. For instance, if you’re trying to create another $1 million of cash in the bank before the end of the year, then paying off your mortgage isn’t going to help you. On the other hand, if you’re instituting solid money habits that will put you in position to retire comfortably in 20-30 years, I think it’s perfect.
In any case, I’ll catch you guys tomorrow morning with why paying off your mortgage is a good idea. Then we’ll have some more stuff to chat about.
I am surprised no one has taken the other factor of investing into account.
R-I-S-K
Its one thing to compare numbers to numbers, but how can you avoid the issue of risk on both sides of the equations. The Stock Market is not guaranteed to get you 12% return. What if your investments tank?
Carrying any debt is also a RISK. Should you become disabled say, and your mortgage payment is no longer do-able. But had you put your money toward principle in your mortgage, you can refinance, and lower your payment.
IMO…this argument fails the RISK test.
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