Extra money in budget: pay down mortgage or invest?

In My Humble Opinion
1

Ok, so last month I got a big tax refund (first full year with a house) + annual bonus from my company (unexpected, but nice, it worked out to just under an extra month’s income). I paid off some outstanding debts that I no longer have to budget for. I also adjusted my W4 witholdings to keep money in my own grubby little hands now rather than getting another big check from the government next year. I went over my expenses, and after all that, I’m looking at around $500 a month “discretionary” income that isn’t needed for anything else.

I’ve got an “buffer” account holding 3 months income as a hedge against financial emergencies. I’m saving for retirement with a 401k at work (at the point where I’ve maxed my employer’s match) and a personal Roth IRA. Between the two, I sock away ~700 per month, with an 401k match of $2000 annually from my employer. Credit card balance is paid in full every month. Only outstanding debt is the house mortgage.

Whenever I’ve had extra money in the past, my first response has always been “pay off debt”. Credit card balances were wiped out. Student and auto loans were paid off early. Big purchases were done either with cash or “same as cash” 0% financing deals, and in the second case I always made sure they were paid off before the special deal period expired so as not to get hit with the deferred interest.

But home loans seem to be a special case, they’re “good debt”. Honestly, that never really made sense until this year. When I entered that $10k mortgage interest deduction into TurboTax and my “expected refund” went from $100 owed to over $2000 refunded, it made an impression. On the other hand, another way of looking at it is one item in my annual financial report changed from -$10,000 to -$8,000. That’s still $8000 going to someone other than me. :slight_smile:

It’s a single mortgage, fixed-rate 20 year loan at 5.75%. There’s no early payoff penalty. The Loan-to-Value is currently around 90%, so I do have to pay mortgage insurance until the LtV gets below 80%. Extra payments automatically go to principal rather than pushing back the next payment date. If I put the full $500 into my mortgage payments, I can get out of mortgage insurance a year and a half earlier than scheduled and pay off the loan completely seven years early. For now I’m assuming that I’m not going to be selling the house.

Let’s assume all my short-term needs and wants are covered without the $500 (bills, vacations, fancy toys, beer and hookers, etc). So, what would be the pros / cons of paying down the mortgage rather than putting the money to work somewhere else? What other factors might I be missing for consideration?

2

If you can invest it at better than 5.75%, then you’re better off investing it.

Edit: From a strictly economic viewpoint, that is.

3

Have kids? You could put the money in a 529 plan.

If you don’t, to be honest, just do what makes you happiest. The point of investing is not to beat some arbitrary benchmark but to fulfill your financial and “peace of mind” goals. If you’ll sleep better at night knowing that you’re paying down your mortgage than you would if you were buying some stock fund… pay down the mortgage, for when you get right down to it, it’s all about sleeping better at night. :wink:

And since you seem to have your financial house in order, you have the luxury of doing “average”. Congratulations on a sound plan. :smiley:

4

5.75% fixed is very good. Take into consideration inflation at 2% to 3% a year and the real money cost actually goes down.

I’d be slow to pay down a mortgage at that rate. On the other hand getting out from under the insurance is also an incentive.

There’s one opinion.

5

Ah…something I “might” know a thing or two about…residential mortages!

When I first opened this thread, my first thought would be to not pay down, until I read about the M.I.

The biggest thing about paying down for that purpose is to be 100% sure that it will drop off.

You need to contact your servicer and find out their rules for dropping M.I.

There are many factors involved, and you need to discuss the potential policies. Since it’s a fixed 20 yr, it may or may not have been sold to a semi or private investor, then their rules come into play. Additionally, how long have you had it? Depending on the time, they could use your original appraised value, or you could have to pay for another appraisal.

My main point would be, call and find out before making your decision.

6

I have been wrestling with the same question myself. I started to think about what my financial life would be like in 15 years: would I rather have a home that I own (i.e., mortgage has been paid off) with no extra investments (other than my IRA - to which I can only contribute 4K a year - and my 401(k)) or would I rather have a home that I almost own (maybe just a few years left on the mortgage) and a big investment account for retirement? It’s true that paying down your mortgage will increase the equity in your home but that equity isn’t worth anything unless you actually sell the house (or take out a home equity loan which sort of defeats the purpose of paying down the mortgage). If you invest your extra cash, you will have a much more liquid asset.

Plus, I just did one of those scary retirement analyzers and I need to come up with 25K in cash each year to invest (in addition to my IRA and 401(k)) if I want to meet my retirement goals. So I’ll be socking away my cash - if I get in trouble with the house, I can always sell it and move in to a less expensive home.

7

I’d add extra payments until the principal is high enough to drop the pmi. Then I’d invest the rest. Last year some of our investments were up 20% with the average being around 10%. If you can beat your interest rate, you’re better off investing.

8

Do you have kids, or do you plan to have kids, and do you expect to pay for their college. If so, investing with the expectation of using it for college might be a good idea. You’ll still have it if it makes sense for them to go somewhere cheap, but their options will be open.

I’ve never had to pay M.I., so I don’t know how much it costs. I’d run a simulation with the options. For the case of paying down the mortgage, you’d include the reduction in MI as an additional return when you hit it (a plus), the reduction in interest payments as a plus, and the reduction of your tax benefit as a minus. For the investment route, you need to estimate your return, based on the level of risk you’re willing to assume, and count in increased taxes on them.

When you come up with the best approach, investment-wise, you might decide to take the other, but you’re winning either way.

I didn’t pay down my not very large mortgage, since I’m very debt averse, and much preferred having the money available as opposed to taking out a home equity loan. I’ve never done the simulation, but I think I’ve come out ahead, especially since we refinanced near the bottom.

9

One other point to consider – this is not an either/or proposition. It would be perfectly reasonable to pay another $250 per month toward the mortgage, and put another $250 per month into investments, or any other division of funds that makes sense to you. I often find with financial decisions that you can achieve greater peace of mind by splitting the money up. That way if you ever rethink one of your choices, you’ll be reassured that you didn’t put all your (extra) eggs in one basket. Of course if there is a specific goal that you are trying to achieve, like being debt-free, or reaching a milestone like eliminating your mortgage insurance, it might be worth it to put all the funds toward that goal. But in your case, with several equally valid options, splitting the difference could be a good strategy. If one or the other of your options didn’t work out, or stopped feeling comfortable to you, you could always change your approach.

10

Hehe, an answer so obvious I didn’t even think of it. Thanks for stripping out some of the extraneous details I’ve been rolling around in my head.

2pelo honey, after double-checking my paperwork, my lender’s rules for cancelling MI are:
[ul][li]Must have good payment history (no payments over 60 days late in last two years, no payments over 30 days late in last year). I take debt payments very seriously, so for me this is a given.[/li][li]Automatic cancelation when principal balance is scheduled to go below 78% of the original property value. I’m assuming that’s based on the initial amortization schedule, disregarding any extra payments. For me, that’s June 2011.[/li][li]Requested cancelation requires loan-to-value be under 80%, using the lower of the sale price or a new appraisal (so no getting out early if the house increases in value). An appraisal may not be required: if they want it, they’ll ask for it, and I have to pay for it. It’s probably based on the amount of time since the last appraisal (in this case the sale), although I couldn’t find any details on how long a given appraisal is good for. I bought the house in July 2006.[/li][/ul]
Considered as a “return on investment”, if I went this route I’d spend $11,000 between now and Jan 2009 (the 80% LtV date with an extra $500 a month), and save $3770 in PMI costs (what would’ve been spent without the extra payments). Since the extra money is “stored” as equity, I’d end up with $11,000 equity + $3,770 PMI savings = $14,770, divided by the cost of the extra payments (not counting the potential appraisal fee) comes out to $14770 / $11000 = 1.32 = 32% return. (Does that calculation make sense for these kind of things? It’s one metric I’ve been using for the various scenarios…). That appears to be a better “return” then investing over the same period. Well, barring a lucky pick on the stock market.

As for other stuff that’s come up: no kids for the immediate future (say the next 5 years). I’m still single, although I’m currently living with my girlfriend (who helps cover expenses), and I can definitely see marriage soon. I’m 30, so I still have a few decades for retirement investments to build up.

And SpoilerVirgin, I’ll probably end up doing a mix of stuff with the money anyway. I just usually start by considering the “extreme” positions to see how I feel about each, which I then use to figure out how to allocate funds.

Thanks, all, for the opinions. Since neither option elicited a “that’s crazy, definitely don’t!” respose, I’ll probably end up doing a mix of things: bump up 401k / IRA contributions, maybe throw an extra hundred or two at the mortgage (focussing more on getting rid of the PMI than interest savings), and look into some medium-term investment options for the rest.

11

You sound very fiscally conservative, which is a great thing IMHO. I would get your cash reserves to 6-12 months liquidity (up from your current 3 months) in something safe like cash deposits even though the interest sucks. You can always use that cash reserve for something, and even paying down the mortgage in the future.

If you believe like I do that 1. housing market is going to get worse before it gets better, 2. we’re at the point in the economic cycle where the likelihood of a downturn is increasing, 3. oil prices are not going to come down substantially, etc then having cash to weather months without a job is probably going to be worth a lot of peace of mind.

You should evaluate your portfolio of savings, investments, debt, risk and tax implications at least once a year. You can always tweak it.

In my experience, I’ve always valued having the cash. I have always had at least 1 year of mortgage payments in reserve. then I start paying down the mortgage faster if that makes sense at the time. It makes me sleep easier at night.

12

What makes you sleep better?

In theory, you can easily out invest the mortage interest rate adjusted for the deduction you get. But some people are much more productive/happy in life knowing the house is paid for.

Also, you can save PMI buy knocking down what you owe. I think that would be mission number one. Pay down the loan am’t, get the house reappraised when values rise and demonstrate 20% equity asap.

food for thought: The mortgage advantage disappears as the amortization progresses (interest paid will dwindle).

13

Not exactly.

Keep in mind, he’s paying at 5.75%, but he gets some of the interest back at tax time. He could figure it out exactly, but he’s probably really paying 5% or so.

Also, keep in mind that earnings on investment are taxed, so if you gained 5.75% per year, you would need to pay taxes on that.

Anyway. . .if you haven’t maxed out IRAs (or a 529), that’s what I’d do with the money, because you are relieved of the taxes, but even if you have, I’d prefer putting it in the market.

14

I should have hit this thread before Trunk, as he said exactly what I would.

I somewhat agree with China Guy: I like a 6-month cushion in liquid, non-volatile investments. Then I would look at investing as much as possible in tax-advantaged investments. You mention that you meet your maximum employee match for the 401(k), but perhaps you could increase your investments there. Section 529 college plans are also a great place to tuck money; check with your state to see if there are any additional tax advantages. NYS allows a taxpayer to deduct contributions and lower their AGI.

15

How about if you pay down *my * mortgage, instead. I’m sure you’d get that warm fuzzy feeling deep down inside.

(Although mine is at 4.75% and should be paid off within about 10 years.)

StG

16

If it was me I’d

first) Max out my yearly Roth IRA contribution (something like $3-$4K now I believe)

second) Push up my 401K contribution. Even past your companies matching point. I think you can max out yearly contributions around $20K? If you put it in the right investments you should easily average at least 8% annually.

fourth) Make extra payments to my mortgage principal.

…IMHO…

17

If you really don’t need the money, why not go for higher risk, higher return investments?

I would really be looking towards something that is income generating that can snowball quickly - later on can move towards “safer” investments.

Another option, what if you were to buy a second house? For a rental property a monthly top up of $500 would be way more than enough to make this very viable (enough if have problems with tenants). And if you are looking 20-30 years into the future then property can be a great investment.

18

Because, as we all know, step 3 is Profit!

At first it looks like paying off the mortgage below the PMI level is the best bet, because you earn 32%, but keep in mind that that rate is only for the first year and a bit. After that, the money is effectively locked into the mortgage, and is only earning 5.7%, less whatever you get back as a deduction. The effective interest rate you’re paying on the mortgage (and thus, earning on any extra payments) is probably less than 4.5%. Compare this to earning an average of 8% in the 401(k) (plus additional tax savings). Using the simplified model of earning 32% the first year and earning 4.5% after that vs. earning 8% every year, investing in the market pulls ahead in about 7 years.

Of course, the market is more risky and killing off the PMI may have some nice emotional appeal.