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| wallace6 |
 Posted: Mon Mar 21, 2005 12:33 pm Post subject: To pay off loan or invest |
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Investing Sr. Associate
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| Do you think it is better to pay off your mortgage or to invest the money elsewhere and keep the tax write-off for the mortgage interest? |
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| thrilla |
| Posted: Wed Mar 23, 2005 3:22 pm Post subject: |
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Investing Sr. Associate
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This really depends on the rate you are getting on your mortgage. If you can make a relatively safe investment that can make a higher rate of return than you are paying on your mortgage, then maybe. There are other considerations like tax consequences for your earnings on your investments and tax benefits on the interest paid on the mortgage.
I would check with my tax advisor first because each individual is unique in their situation. |
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| Dave Rathbun |
| Posted: Tue Apr 12, 2005 9:35 am Post subject: |
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CFO
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Here's my opinion, and it's not always a popular one. I say pay off the house. But of course it's not that simple.
Real-estate is not fluid. So don't pay off your house until you have a nice cushion saved for a "rainy day". If you pay off your house and then need cash all of a sudden, you're out of luck.  Some folks suggest keeping up to 3 months of expenses in a fluid (savings) account, others up to 6. My job is somewhat risky; I have 12 months of savings in a readily available account.
So assuming that you have that cushion saved up somewhere, do you pay off your house? Or invest?
Here's my rule: If you can find a guaranteed investment that pays 5% more than you are paying on your house, then invest. Otherwise pay off your house. Where did the 5% come from? I made it up.
Seriously, suppose you're paying 10% interest on a $100,000 house, and have a $50,000 balance on your loan. Great Uncle Purvis dies and leaves you $50,000. You're currently in a 25% tax bracket and will itemize your deductions. You'll pay $5,000 in interest on the $50K balance on your home loan this year. (Numbers have been simplified some to make the math easy to follow.)
Because of the 25% tax bracket, you'll get $1250 of that $5000 back via tax deductions. So your "net loss" on the interest, if you will, is $3750. That's money that is gone and you can't do anything about it. You took Uncle Purvis' money and invested it at 5% for a year. You get $2500, right? Wrong! You get $2500 less whatever you pay in taxes! 25% of the top leaves $1875. You get bitten on both ends... you paid interest, and you paid tax on the interest from Uncle Purvis. So instead of a 5% return, suppose you find an investment to return 10%? That's the same rate as your loan, so it should be a wash, right? You made $5,000 in interest on your 10% investment, paid $1250 in tax, leaving you with $3750. You got screwed on both ends. You paid $3750 in interest on your mortgage (after tax deductions kicked in) and you made $3750 in interest after taxes on the income, so you end up paying $5000 in interest + taxes (taxes on your income + interest on your house). By finding an investment at 10% you essentially break even, but your mortgage isn't paid off, so you'll keep paying interest next year.
Now suppose you pay off your mortage. You don't pay $5,000 in interest. You also don't have $5,000 in income either... but wait, you have the "negative interest" (interest you didn't pay) which is essentially income. So by keeping your house mortgage and investing the money, you lose $5000. By paying off the house you break even except for the fact that you're no longer making house payments! You take that money and invest it however you want, and that difference is the "bonus" for paying off your house.
And the 5% I mentioned earlier? I'm getting back to that. Suppose you don't pay off your house, leaving you with $3750 net interest after deductions as calculated earlier. You do invest Uncle Purvis' money, but this time making 15% guaranteed. (Good luck finding that investment, by the way.  ) Now what happens? You make $7,500 with your uncle's money, pay taxes (25% of the income) leaving you with $5,625 left. Take the income (after taxes) minus the interest (after deductions) and you have $1875 net. $1875 return on a $50,000 investment is about 3%.
That's a lot of work for a 3% return. I say, pay off the house, and pur your extra "income" (formerly known as a house payment) to work for you instead of your mortgage company. You will be amazed how quickly your savings grows. Trust me, it works. I managed to pay off my first house before I was 40 and it was an amazing feeling. |
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| bigdave |
| Posted: Mon Apr 25, 2005 5:20 am Post subject: |
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Investing Sr. Associate
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the guy who posted above me has some good advice! head it and you will be good to go....
I think best thing is have a nest egg of atleast 3 months.... 6 months preferred.... 12 months is great!!! I have 6 months!!!
Pay off the mortgage... Espically if you been in your home for over 10 years as money is moving more to prinicipal and less on interest so the tax right off isnt as much... |
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| MrT |
| Posted: Mon Apr 17, 2006 9:46 am Post subject: |
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Investing Sr. Associate
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I will disagree with your original calculations, although it is mainly that extra 5% that I have a gripe with, because I think its probably closer to breaking even.
Unless I am incorrect, when you receive that money from Uncle Purvis, no matter what you do with it, you will pay $12500 (25%) in taxes. I am not familiar with tax implications of inheritance, so anyone correct me if I'm wrong.
So you have $37500 to pay off the home loan, or invest, but what you invest, you only pay %15 in taxes on. So if you pay off $37500 of the loan, you save $3750 for that year, or 10%. But there is nothing you can do about that other $12500, and still pay that $1250 in mortgage interest ($1000 after the mortgage interest deduction). Net: -$1000
If you invest the $37500, get 10% return, then pay 15% in taxes, you are left with $3187.50. But you paid $5000 in mortgage interest, or $3750 after the mortgage interest deduction. Net: $-562.50
From another angle, you pay 10% in interest, by get 25% back from the deduction, so you really only pay 7.5%. If you make 10% on the stock investment, get taxed 15%, then you have made 8.5%, which is greater than 7.5%.
So by using these assumptions, You would actually be better off investing that money (10% isn't TOO unrealistic). Of course, for many people though, they don't truly save 25% off the mortgage interest, because they might not be able to do itemized deductions except for the mortgage interest. For example, the joint standarized deduction is about $10000 now, if (before mortgage interest deduction), they can only deduct $5000, but is makes sense just to do the standarized deduction of $10K, and get back $2500 (25%). If they have mortgage interest deduction of say, $5000, they still get back $2500, so the mortgage interest deduction does nothing for them. Now say, they have $10000 interest deduction, so they itemize, get back $3750, so the mortgage interest deduction was only a 12.5% return! Doesn't seem worth it right?
The point is, if you aren't even close to itemizing your deduction before the mortgage interest, you are probably making a better return by paying the mortgage principal because you don't get any of the interest you paid back. However, if you are in a high tax bracket, and you could itemize all of your taxes even before the mortgage interest, and possible get back 35% of what you paid in mortgage interest, essentially making your mortgage interest much cheaper. In that case, for many, investing would be a better option.
And (now that I am way off my original topic), if you are still reading along, and haven't found any fatal errors in my analysis, the conclusion is: Because people in a higher income bracket pay a higher % taxes, in general, they get a better break on mortgages than people in lower income brackets. Therefore, mortgage interest deduction should just be an across the board tax credit. (Recently proposed by white house, and shot down by the real estate lobby for no real reason I can fathom.) |
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| Dave Rathbun |
| Posted: Mon Apr 17, 2006 12:01 pm Post subject: |
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CFO
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One assumption you made that I will disagree with is the tax on the inheritance. From what I remember from my estate planning, you can have an estate of 500,000 that is distributed tax free, and that number is supposed to be going up every year for a while until it's a million, I think. And the estate pays the taxes, not you, so the 50,000 from Great Uncle Purvis is safe from taxation. I think.  That means that you have what you need to pay off the 50,000 balance on your house. Either way, let's assume that the windfall is enough to pay off your mortgage, so if you have to get 80K and pay 30K in taxes, net 50K from Uncle Purvis. That's really not important for the example, what is important is that you got $50K from somewhere.
And the 15% tax on investing assumes long term rates, correct? I believe short term trades are taxed as ordinary income. I made that assumption so I would not have to deal with the difference in tax rates on long term investments, and I should have made that clear. Longer term gains are taxed at a lower rate, and that could be factored into the scenario.
I stand by my assessment. If you have a 50,000 balance on your house, and you inherit 50,000 and invest it for the long term, what has happened after 10 years? Suppose your mortgage rate is 5% and you investment returns 5%, what do you have?
Here's a link to a post where I linked to a worksheet (Excel format) a while back that lets you play with loan numbers. Specifically it was for a 30 year versus 15 year comparison, but if I put in 100,000 for the loan amount and 5% for the interest rate I found out that I would have a 50K balance on or near payment 242. From payment 242 to the end of the loan you would have paid $13,595 in interest. That's on a total of 360 payments, so 360 - 242 = 118 months, or 9.8 years. Let's round to 10 years.
Let's assume that you get 25% of that interest payment back over the years in the form of a deduction. So that means that you paid out $13,595 but over the years got $3,398.75 back from the tax man. Your net expense, then, for interest is 10,196.25.
What about the $50K from Uncle Purvis? If you invested it, and it returned 5% per year, and you paid taxes yearly (to make it fair we can't compound the interest without taxes since we're getting an annual refund on interest paid) then your 50K makes 2500, and you pay 25% of that in taxes, netting you $1,875 per year. Over ten years that's $18,750, assuming that you don't reinvest. You made $8,553.75 by investing rather than paying off your mortgage. So far, sounds like a winner. Without any compounding your 50K is worth $68,750 in ten years at a 5% return rate. With simple compounding (reinvesting your return each year) the number grows to $72,252.20. You have a house that is paid off, and $72,252.20 in the bank. Remember that number: $72,252.20, as I will be using it again later in this post. That is the amount in cash you would have if you invested your 50K at 5% after 10 years, paying 25% taxes along the way. Here's the table, the first column is the year, the second is the starting principal, the next interest earned at 5%, next the amount after tax, last the new principal that is used as the base for the following year, thus compounding the interest.
| Code: |
1 $50,000.00 $2,500.00 $1,875.00 $51,875.00
2 $51,875.00 $2,593.75 $1,945.31 $53,820.31
3 $53,820.31 $2,691.02 $2,018.26 $55,838.57
4 $55,838.57 $2,791.93 $2,093.95 $57,932.52
5 $57,932.52 $2,896.63 $2,172.47 $60,104.99
6 $60,104.99 $3,005.25 $2,253.94 $62,358.93
7 $62,358.93 $3,117.95 $2,338.46 $64,697.39
8 $64,697.39 $3,234.87 $2,426.15 $67,123.54
9 $67,123.54 $3,356.18 $2,517.13 $69,640.67
10 $69,640.67 $3,482.03 $2,611.53 $72,252.20 |
But in this scenario you also paid 10,196.25 in interest! So your "net" after 10 years is $62,055.95. Now remember that number.
If you maintain your mortgatge, you are paying $536 per month in house payments in order to make your monthly mortgage. Let's look at that as a part of the bigger picture.
Take Uncle Puvis' money and pay off the house. For the next 10 years you have no mortgage, and no interest expense. But for ten years you have $536 every month to invest. The future value of 10 years worth of $536 in monthly deposits invested at 5% is $83,231.30. In 10 years of paying interest / principal and earning returns on $50K you ended up with a house that was paid off, and an investment worth (after interest expense) $62,055.95. If you paid off the house now and invested that money instead, at the same 5% rate, you get $83,231.30, which is over $21,000 more than you would have had if you had not reinvested. And you still paid off your house.
Ah, but taxes. We paid taxes out of the earlier scenario, so we should pay taxes out of this one too. Here's what a periodic investment of $6,432 per year + 5% interest would be worth after 10 years, including paying taxes at the same 25% rate on an annual basis, same format as before:
| Code: | 1 $6,432.00 $321.60 $241.20 $6,673.20
2 $6,432.00 $13,105.20 $655.26 $491.45 $13,596.65
3 $6,432.00 $20,028.65 $1,001.43 $751.07 $20,779.72
4 $6,432.00 $27,211.72 $1,360.59 $1,020.44 $28,232.16
5 $6,432.00 $34,664.16 $1,733.21 $1,299.91 $35,964.06
6 $6,432.00 $42,396.06 $2,119.80 $1,589.85 $43,985.92
7 $6,432.00 $50,417.92 $2,520.90 $1,890.67 $52,308.59
8 $6,432.00 $58,740.59 $2,937.03 $2,202.77 $60,943.36
9 $6,432.00 $67,375.36 $3,368.77 $2,526.58 $69,901.94
10 $6,432.00 $76,333.94 $3,816.70 $2,862.52 $79,196.46 |
The bottom line, with everything being equal (5% mortgage, 5% interest, 25% tax rate) you make more by paying off the house and investing your house payment yourself.
To summarize:
Setup:
50K balance on house
50K (tax free) windfall from Uncle Purvis
Scenario 1:
Pay mortgage schedule over 10 years
Net interest after tax deduction is 10,196.25
Net value of 50K invested at 5% is $72,252.20.
Investment value - interest expense = $62,055.95
Scenario 2: Pay off house
Pay off mortgage with $50K
Net interest over 10 years: $0
Starting investment value: $0
Make regular $536 deposits, earning 5% / year
Value of $536 invested per month at 5% is $83,231.30
Net value of $536 invested after tax $79,196.46
Investment Value - interest expense = $79,196.46
Even if you ignore the interest expense on the mortgage, paying off the house results in a net gain, if you have the discipline to continue investing in yourself by paying the mortgage payment for another 10 years.
So I stand by my original numbers. If you have a windfall, and you can pay off your house, and then invest your house payments, you will come out ahead in the long run. If you invest the windfall and continue to make payments, your investment must be 5% or more higher than your mortgage rate guaranteed (because of course your mortage rate is guaranteed, afterall ) in order to make it worthwhile. I didn't try to rejustify the 5% number in this post, I just tried to show the difference between paying off your mortgage or not, using the same rate for the entire example.
FWIW, here are some Excel formulas that you might find useful to verify these numbers:
This formula gives you the future value of $536 invested at 5% per year over 10 years:
| Code: | | =FV(0.05/12,120,-536,0) |
This formula gives you the interest amount paid in a specific period on a 30 year loan of $100,000, "np" is the period number
| Code: | | =IPMT(0.05/12,np,360,50000) |
This formula gives you the principal amount paid in a specific period on a 30 year loan, same items as before:
| Code: | | =PPMT(0.05/12,np,360,100000) | |
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| Dave Rathbun |
| Posted: Mon Apr 17, 2006 12:32 pm Post subject: |
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CFO
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I realized that something about these numbers might look funny:
| Quote: | Value of $536 invested per month at 5% is $83,231.30
Net value of $536 invested after tax $79,196.46 |
How can there only be a $4K difference for taxes? Well, it's simple.
For the first year, take $536 * 12 and get $6432. At 5% that returns $321.60. I realize that treats it as if the entire amount was there for the whole year, but that's minor. Reduce the amount of income by 25% and you get $241.20. Add that to the base amount and increase it by another $6432 and you get $13,105.20. Apply interest, pay taxes, reinvest the number + new money. Repeat for 10 years. The bulk of the investment comes from the regular deposits; remember you get $64,320 just by paying yourself, without accruing any interest at all. So the reason the difference in the numbers above is so small is the total interest earned over 10 years at 5% is only about $19.8K. 25% (tax) of that comes to just under $5K, which is the difference in the numbers. |
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| frusnak |
| Posted: Mon Apr 17, 2006 1:50 pm Post subject: |
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CFO
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My head is spinning from all these numbers being bantied about.  I would think you would be better off if you paid off the home loan as soon as possible to avoid all the interest money you would pay during the life of the loan. I do not know how to figure the total amount paid during the term of the mortgage but I would guess that most of us would not be able to beat the interest charges.
We own our home outright and I can't describe the feeling of paying ourselves instead of the bank. |
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| Dave Rathbun |
| Posted: Mon Apr 17, 2006 2:44 pm Post subject: |
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CFO
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There was an article in Money magazine today that covered this very subject. I have not read it yet; my wife relayed it to me over the phone. In their scenario you only got a $5,000 (not $50,000) windfall, and it was not enough to pay off the house. In that case it could very well be more worthwhile to invest it, since the difference in the amount of interest paid would be negligable.
If you read my original post, I suggested that if you have cash sitting around that is above and beyond your "emergency fund" then it makes sense to pay off your house. I believe the figures support that. There are very few ways to get a guaranteed income that is as good or better than the income that you can get from paying yourself your own mortgage payment. |
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| MrT |
| Posted: Tue Apr 18, 2006 3:56 am Post subject: |
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Investing Sr. Associate
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Wow, that is certainly a detailed analysis, except that I still disagree with how you do the comparison. In this case, scenario 1 and scenario 2 both start with $50000 (after taxes) and $50000, home loan. But for the remaining 10 years, you have only included the $536/month mortgage payment in the second scenario, but not the first. In reality, you still have that $536 as "income" to pay the mortgage down even if you invested all $50000 in stocks.
By making it a totally fair comparison, when you look at your net worth (investments-debt) at the end of the first scenario, the correct number would be $72,252.20+whatever you get back in taxes from the deduction that you could reinvest. This is about 25% of 13K, or $3400, which I would not have the financial rigor to reinvest elsewhere. (It somehow always ends up invested in wine, usually a poor investment because of its ability to liquidate quickly. )
Of course, that is still less than $79000 total net after scenario 2, which you are left with all investments and no debt.
My argument is that your end number will be close to the same, and if someone were very good at putting that house payment into stocks instead and not missing a payment to your investment account, then yes, the numbers look plausible that paying off the home is better. I just don't think that it is as high as a 5% difference.
I agree with you totally though, that if you can be reasonably sure of an investment at least 5% higher than the mortgage, then you would be better off with that investment. |
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| Dave Rathbun |
| Posted: Tue Apr 18, 2006 4:04 am Post subject: |
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CFO
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| MrT wrote: | | Wow, that is certainly a detailed analysis, except that I still disagree with how you do the comparison. In this case, scenario 1 and scenario 2 both start with $50000 (after taxes) and $50000, home loan. But for the remaining 10 years, you have only included the $536/month mortgage payment in the second scenario, but not the first. |
That's because it's gone. The $536 per month in the first payment is used to pay off the house, so the value there is in the house, not in any other bucket.
Let me think about it and see what I can come up with. In the scenario where you pay off the house, then the $536 is "free and clear" and available for something else. In the scenario where you invest the 50K windfall, you still have to pay that into the house mortgage. Some of the $536 is principal, and becomes an asset known as equity. I did not track that in my scenario... but in both cases you end up with a paid off house, so maybe it's hidden in there somewhere. |
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| crazymonk |
| Posted: Fri Apr 28, 2006 2:58 am Post subject: Re: To pay off loan or invest |
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| wallace6 wrote: | | Do you think it is better to pay off your mortgage or to invest the money elsewhere and keep the tax write-off for the mortgage interest? |
I just borrow money from friends, family and pay off the house. It's great when you can do that. |
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