PAY OFF MORTGAGE OR INVEST? CRUNCHING THE NUMBERS.

I have read a lot of subjective articles and on the issue, so I have decided to do the math.  Paying down my s mortgage is a safe way for me to diversify my retirement investments.  I also believe that investing in the stock market is an important part of my overall strategy, but paying down my mortgage ensures that I am not putting all my eggs in one (risky) basket.

The easiest way to invest in the S&P 500 is to purchase shares of SPY.  SPY is a high-volume Exchanged Trade Fund (ETF) whose  inception date was January 29th, 1993.   SPY seeks to correspond generally to the price and yield performance, before fees and expenses, of the S&P 500 Index.

Simulation Information

To keep it simple, I have chosen to ignore trading fees but consider SPY’s average 2.5% dividends.

Start Date: 01/29/1993 (spy’s first trading day)

End Date: 02/23/2010

Number of trading years: 17

Dividends:  Every 12 months, my simulation deposited 2.5% of the market value into the account.

Monthly deposit into simulation trading account = $300  (I deposited $300 on 01/29/1993 and $300 on the first of every month from there on.  I kept my monthly contributions at $300 for the entire 17 years of simulation.  I kept it at a fixed investment amount because mortgage rates are also fixed.)

Results

Total Invested = $61,800

Total # shares purchased during the 17 years of simulation = 914

Current account value at $110.67 per share (that was SPY’s closing price on 02/25/2010 when I ran my simulation) = $100,414.98

Total return in 17 years = $38,614.98.   That’s a a total return of 62.48% in 17 years.

We would be in bad shape because it’s an average of 3.7% return per year.  At3.7% return average per year, our gains would have been outpaced by inflation whose rate is substantially higher than 3.7% per year.

MORTGAGE

Now let’s assume that we got a 30-year, fixed-rate mortgage at the very low rate of 5% 17 years ago (that rate did not exist back then).  Let’s borrow $100,000.  During the 17 years, we would have paid only paid the minimal payments.  The $300 extra money we had each month was used in the stock market while we only made the minimal payment of $536  (principal + interest).  After 17 years, we would still have 13 years left in our mortgage.   We would still have an unpaid balance of $61,487 left.

Now let’s go back in time and, instead of investing the $300 a month in the stock market, let’s apply it to our mortgage principal.  WE WOULD HAVE PAID IT OFF IN 2006.

But back in 1993, our mortgage rate would be 7%.  At 7%, the numbers look astronomical.  For our 30-year mortgage, if we paid only the minimal payment while investing our extra $300 a month, we would pay a total of $139,508 in interest in the life of the loan.  If we apply our $300 extra money towards our principal, we would again have paid off our mortgage in 2006.

So, the property that we purchased 17 years ago for $100,000 would be worth how much today, 17 years later.  (In my case, I know that the house that I purchased back in 1998 (that’s not even 17 years ago) is worth tens of thousands more today.)

Real estate as an investment

If you Google “housing prices chart,” you come across a site called investmenttools.com.  (I AM NOT AFFILIATED WITH THEM.)  And here’s their chart showing the historical housing prices in the United States.  You can see that real estate has been a solid investment vehicle even considering the recent drop in prices.  Our $100,000 property which we purchased 17 years ago would be worth substantially more today.

(I AM NOT AFFILIATED WITH INVESTMENTTOOLS.COM.)

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6 Responses to “PAY OFF MORTGAGE OR INVEST? CRUNCHING THE NUMBERS.”

  1. Paul Says:

    Hi,

    I found your analysis interesting, but found several problems with it, which I outlined in the GRS thread, and repeat here for your blog as well 🙂

    First, I would never blindly invest the market by throwing money into an index fund. They only do okay when the market is doing great, and they slammed when the market is doing poorly. I invest in a much more target manner, and strive to beat indexes (which I’ve consistently done thus far).

    Second, you assume a mortgage rate of first 5%, then corrects for 7% and dates this back to 1993. Interestingly, this is about the same time I took out my first mortgage. No where in this model do you account for refinancing at better rates as they become available. My first mortgage was for about 7%, and I’ve subsequently refinanced twice such that I am now at 5.375%. Both re-financings have saved me huge amounts of money over the long term.

    Third, you ignore trading fees and dividends. Trading fees are negligible, so I’ll allow that. In most cases, for recurring automatic investments, a brokerage account can be eligible for free trading.

    But dividends I can’t allow you to ignore. Dividends account for huge percentage of the returns. Especially when investing in an index like SPY where a significant number of the companies in the index pay dividends. Every one of those dividends, if re-invested, goes on to buy more shares of the index which can and will, have a dramatic influence on the total return.

    Fourth, you ignore the fact that it’s really easy to re-allocate investments over time such that performance will increase even in a down market. Yet the best one can ever hope for by paying off a mortgage is a return rate equal to the mortgage interest rate itself. In other words, if your mortgage rate is 5%, you’ll never get better than a 5% return by paying off the mortgage early. Whereas, even in a lousy market such as this one, I can get a 15% or better return (in fact, one of my portfolios is up over 25% vs. the S&P500 which is down 2% over the same time period, which means I’m flogging the market by 27%!!!)

    Fifth, you allude to the idea that one would have done horribly by investing in SPY over the past 17 years because of the recent economic issue plaguing us and imply that it would have been a bad idea vs. paying down your mortgage. What you completely fails to mention is the fact that the house your paying off during this time may well have, and in all likelihood has, lost significant value. Therefore, you’re actually sinking hard-earned cash into a depreciating asset which will not regain it’s value anytime in the near future (3-5 years). And, you’re paying the same price for that now depreciated asset as you were 17 years ago.

    Contrast that with investing in the stock market right now. These assets are also significantly depreciated, but the market has corrected their prices to reflect that depreciation. In other words, you currently get to buy depreciated assets on sale. The probability that those assets will increase significantly over the next 3-5 years is far more likely than your house doing so.

    I don’t find your argument convincing at all, but mostly because there are significant shortcomings with the assumptions of the model. If you have a decent emergency fund set up, and you’re not in any danger of missing payments on your mortgage, even if you lost your job, I think it’s best to invest any extra money for the long term, and to do so intelligently and actively as opposed to passively via an index fund.

    That being said, you must do what is right for you, because only you know all about your situation, your tolerance for risk, and what your relationship with money is.

    Thanks for the analysis. It was definitely an interesting read, and I’m glad someone has had a crack at modeling this, despite my issues with it.


    Cheers,
    Paul

  2. solidpersonalfinance Says:

    Paul, thanks for your kind reply.

    I simply used the S&P 500 as it shows us how the stock market has performed in the past 17 years (since the inception of SPY). Sure there are funds that beat the market, such as FAIRX, but even FAIRX, whose manager is one of the top managers, still did not perform that great if you take inflation and an expense ratio of 1.02%, which exceeds the mutual fund’s dividends of 0.8%.

    >>”No where in this model do you account for refinancing at better rates as they become available.”

    I used both, the 7% that you could get 17 years ago and the very low 5% that you can get today. That gives us a pretty good idea. I did not see the need for adding refinancing measures to my simulation engine because refinancing deals with closing costs that I didn’t want to deal with to keep the simulation simple. The purpose of the simulation engine is to give us an idea of how a stock performs when one deposits money into a simulation account on a monthly basis over a certain period of time, pure and simple.

    >>”Third, you ignore trading fees and dividends. ”

    Refresh your browser because I have edited the post to include dividends. Dividends make a big difference, so I updated my post above. The dividends get deposited into the account to get reinvested every 12 months. I selected a dividend of 2.5% every 12 months for SPY. As you can see in the results, your gains would still be outpaced by inflation, and you would have been better off by investing the $300 extra money to pay off your mortgage early.

    >>”Fourth, you ignore the fact that it’s really easy to re-allocate investments over time such that performance will increase even in a down market.”

    Let the so-called “experts” do it for you and watch your retirement struggle and, in the end, barely keep up with inflation. Considering the risks involved when you consider government spending, investing in your mortgage is a very competitive investment vehicle. If you are one of the lucky ones who can time and beat the market and inflation in the long run, fantastic! In that case, maybe you should to continue to invest in the stock market and only pay the minimum on your mortgage. Many financial “experts” recommend that path, but I am here to simply show the numbers of an actual long-term investment simulation.

    >>”you allude to the idea that one would have done horribly by investing in SPY over the past 17 years because of the recent economic issue plaguing us”

    My simulation engine was not aware of any market downturn. It makes no guesses. It simply kept depositing $300 on the 1st of every month for 17 years and purchasing as many shares as it could with the available cash in the account. There were good and bad market times during that time, and they all affected the total performance. The truth is, bad economic times will happen (Google 1929) and the stock market will react accordingly. The risk will always be there; however, paying down your mortgage is AN INVESTMENT WITHOUT RISK.

    What will happen to our economy and to the stock market when the burden of government overspending finally gets too heavy for us to carry? Some people think government spending may eventually lead us to a financial Armageddon. In 1929, it took 15 years for the US economy to fully recover. Thousands of investors lost everything in the epic market crash of 1929. Hoovervilles were the communities of homeless families who lost their homes during the Great Depression. I bet you they wished they had paid off their mortgages instead.

    We know one thing for sure, THE STOCK MARKET WILL CRASH, and paying off your mortgage has proven to be a worthwhile investment because it has no risk and it outperforms the stock market.

    Thanks!

  3. Brian Says:

    Interesting points you both make. They are both well thought out. Thank you.
    Some additional factors seem to be being ignored:

    Do the increased principal payments represent added risk through loss of liquidity? Nothing wrong with paying the loan balance down as long as sufficient funds are set aside to avoid unforseen financial needs.

    Given the degree of real estate appreciation over the past twenty years, would one’s net return (annualized) be greater as a result of prepaying or simply paying the minimum?

    RE: “paying down your mortgage is AN INVESTMENT WITHOUT RISK” tell that to those unfortunate souls who bought at or near the market peak, who are grossly underwater with little hope of recovery.

    I’m surely not saying one shouldn’t prepay a mortgage. I am saying that to do some of both (prepayment & investing cash outside of a mortgage) are a better way.

  4. solidpersonalfinance Says:

    >>”Do the increased principal payments represent added risk through loss of liquidity?”

    BRIAN, HAVING SUFFICIENT EMERGENCY FUND TO MAKE SURE ONE CAN COVER ONE’S MORTGAGE PAYMENTS IN THE EVENT OF A LOSS OF INCOME IS ABSOLUTELY NECESSARY AND SHOULD BE PART OF THE MASTER PLAN. IN MY CASE, I AM ACTUALLY COVERED FOR 14 MONTHS. IF I LOST MY JOB TODAY, I COULD STAY THE NEXT 14 MONTHS WITHOUT MAKING A SINGLE MORTGAGE PAYMENT. I HAVE MADE THAT MANY PAYMENTS IN ADVANCE. TODAY IS 03/19/2010 AND MY NEXT PAYMENT IS ACTUALLY DUE ON 06/01/2011.

    >>”Given the degree of real estate appreciation over the past twenty years, would one’s net return (annualized) be greater as a result of prepaying or simply paying the minimum?”

    PAYING DOWN YOUR MORTGAGE SAVES YOU A LOT OF MONEY ON INTEREST AS I SHOW ABOVE.

    IT IS A MEANS TO DIVERSIFY YOUR INVESTMENTS TO ME. I DO NOT BELIEVE IN PAYING ONLY THE MINIMUM ON MY MORTGAGE WHILE RISKING ALL MY EXTRA MONEY ON THE STOCK MARKET.

    <<"“paying down your mortgage is AN INVESTMENT WITHOUT RISK” tell that to those unfortunate souls who bought at or near the market peak, who are grossly underwater with little hope of recovery."

    THE UNFORTUNATE SOULS ARE NOT IN THAT POSITION BECAUSE THEY PAY DOWN THEIR MORTGAGE. THEY ARE IN THAT SITUATION BECAUSE THEY HAVE A HARD TIME PAYING THE MINIMUM. NOBODY PUT A GUN TO THEIR HEADS AND ASKED THEM TO BUY TOO MUCH HOUSE. I BOUGHT MY HOUSE BEFORE THE MARKET CRASH, AND I BOUGHT A LOT LESS HOUSE THAN THEY TOLD ME I COULD QUALIFY FOR. AND I GAVE 33% AS A DOWN PAYMENT. I FEEL SORRY FOR THE "UNFORTUNATE" SOULS WHO TOOK THE OPPOSITE PATH AND NOW CAN BARELY MAKE THE PAYMENTS. THEY DO NOT BELONG IN THIS LOG.

    • Brian Says:

      Hi,
      Thanks for your comments. We may agree or disagree, but I respect your opinion and value your thoughts.
      For the record, I own several properties. My own home, and seven rentals. Some of which I have made considerable prepayments on (and paid off). Some of which I make no prepayments on whatsoever. I believe there is value in doing both.

      >>BRIAN, HAVING SUFFICIENT EMERGENCY FUND TO MAKE SURE ONE CAN COVER ONE’S MORTGAGE PAYMENTS IN THE EVENT OF A LOSS OF INCOME IS ABSOLUTELY NECESSARY AND SHOULD BE PART OF THE MASTER PLAN. IN MY CASE, I AM ACTUALLY COVERED FOR 14 MONTHS. IF I LOST MY JOB TODAY, I COULD STAY THE NEXT 14 MONTHS WITHOUT MAKING A SINGLE MORTGAGE PAYMENT. I HAVE MADE THAT MANY PAYMENTS IN ADVANCE. TODAY IS 03/19/2010 AND MY NEXT PAYMENT IS ACTUALLY DUE ON 06/01/2011.
      I submit that 14 months is possibly an inadequate cash reserve.
      Further you confuse me when you refer to prepaying mortgages by having paid your payments in advance through 06/01/11. If this is the case, you’ve been prepaying principal and interest, rather than simply applying any payments to mortgage balance reduction. As I see it, you’ve paid “rent” on money that you don’t even owe yet. To some degree, you’ve buried it. What advantage is that over simply putting the interest portion of your prepayments into a money market account and withdrawing some each month as necessary (unless you don’t trust yourself). Your principal reduction is but a small portion of your gross mortgage payment unless you’re 20+ years into the loan. It does though buy you some time to keep the wolves from the door in the event of unforseen circumstances i.e. job loss, etc.
      When I have prepayed mortgages, I have done so by simply adding some money to reduce the principal. $100. here, $200. there. Yes it does add up, and yes, it does save some money in interest owed.

      >>IT IS A MEANS TO DIVERSIFY YOUR INVESTMENTS TO ME.
      True, but not the only way.

      >I DO NOT BELIEVE IN PAYING ONLY THE MINIMUM ON MY MORTGAGE WHILE RISKING ALL MY EXTRA MONEY ON THE STOCK MARKET.
      I’m certainly not suggesting you risk ALL your money in the stock market. While I do have a some of my cash in the market, I have some set aside in money market accounts as well. I’m certainly glad to have had some in the market this past year. I’m no market genius, but it’s up close to 30%. I did not get out at the bottom, nor get back in at the bottom, but I’ve done o.k.
      Further, what I’m saying is that there are quite a few other expenses one has to contend with other than one’s mortgage. Food, health insurance (until Obama “saves” us from that :-0), utilities, etc. And if you NEED to get at the monies you’ve prepaid on your mortgage GOOD LUCK asking for it!

      > THE UNFORTUNATE SOULS ARE NOT IN THAT POSITION BECAUSE THEY PAY DOWN THEIR MORTGAGE. THEY ARE IN THAT SITUATION BECAUSE THEY HAVE A HARD TIME PAYING THE MINIMUM. NOBODY PUT A GUN TO THEIR HEADS AND ASKED THEM TO BUY TOO MUCH HOUSE. I BOUGHT MY HOUSE BEFORE THE MARKET CRASH, AND I BOUGHT A LOT LESS HOUSE THAN THEY TOLD ME I COULD QUALIFY FOR. AND I GAVE 33% AS A DOWN PAYMENT. I FEEL SORRY FOR THE “UNFORTUNATE” SOULS WHO TOOK THE OPPOSITE PATH AND NOW CAN BARELY MAKE THE PAYMENTS. THEY DO NOT BELONG IN THIS LOG.
      With all due respect, if you are covered for the next 14 months that’s great…..what about the next 24, 36 etc. months? My attitude is “There but by the grace of GOD go I”.
      You are certainly correct that many people suffering hardship are in that position due to having purchased at the wrong time, and overbought beyond their ability to means to repay. What I’m simply saying here is that for many years, the National Association of Realtors has been saying “your home is your BEST investment”. Too many people have taken that to mean your home should be your ONLY investment.
      Frankly, income property is a better investment in many ways than home ownership. While it’s true there is no 250K-500K tax free status on appreciation, the home owner isn’t allowed to deduct hazard insurance, repairs, or depreciation as is the case with income property. Properly owned, the renters pay the mortgages and all expenses whether I lose my job, get sick or die for that matter. Do you think rents will go up or down in the next 10-20 years? Will my net mortgage payments go up? No.
      I have some properties on which I put 30-35% down on also several years ago. That equity has been erased to varying degrees. There is still equity as I have been steadily reducing the principal over the years, but if I were to sell them now, I would in some cases not recover all of my initial up front investment. Propably just break even.

      Final point (if I already haven’t belabored it): Prepaying one’s mortgage is good if done in conjunction with retaining sufficient liquidity.

  5. Brian Says:

    Ahhh, and one last thought:
    If at some point in the future, a SPECTACULAR investment opportunity pops up, I’d rather be in the position to say “here’s the money I’ll take it!”, rather than “let me go ask my banker if I can have some of my own money back”.

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