Most Profitable in the Long Term? Pay Down Mortgage, or Invest in Annuities/Bonds

Factual Questions
1

You guys are pretty good with numbers, so I am going to try for a solid answer here.

I am trying to figure out what is the best option, financially. I bought a house last year at 6% / 30 Years. The final cost was something like 116,000. I have been putting all my extra money into paying down the principal. I figure that if I just paid the monthly payment for 30 years, the house would end up costing me over 100,000 dollars MORE than the sale price. So, if I can pay this thing off in about two years, that will save me 100K. Correct so far, right?
So it seemed like the smart thing to do, and besides, I don’t like having debt! And this house is the only payment I have right now. I bought it for my mom, by the way. She doesn’t pay rent. I am just going to sell the house far in the future when she no longer needs it. The house will likely be worth more in the future, so as an investment, I will make whatever amount the value of the house increases, plus whatever I avoid paying in interest by paying it off as soon as possible. Good so far?

Just the other day, I mentioned to my friend that I have the Principal down to $80,000. And he was shocked that I was putting all my money into the house. He said that paying down principal on real estate is a bad idea right now. He says that I sould be investing all that extra money into Annuities and Bonds. He said to avoid Stocks and Real Estate!!

Wouldn’t I have to find something that would give me a return of at least 6%, though, to make the money that I will end up paying in interest on the house? And then, wouldn’t that just have me breaking even? So I need a return of more than 6% to even profit from those other investments? Is there something about interest or investing of which I am ignorant? Please help me out here!
Do annuities and Bonds routinely pay higher than 6%?

What is the best thing to do with the extra money? I plan to have the house paid off by next summer. Should I stop paying off this house and invest that $80,000 in something else?

Enlighten me, please. Thanks!

2

Can’t be certain about other countries but in the UK paying off capital is usually the best option.

After all, when you borrow money someone is making a profit on the difference between the interest they have to pay on the money they borrow to lend you and the interest they can charge you.

If you are being paid interest (whether directly or indirectly), someone is making a profit on the difference between what the interest they have to pay you on the money and the interest they can charge whomever they lend it to.

Obviously there are all sorts of caveats. I doubt if Bill Gates would be as wealthy as he is today if he’d paid off capital rather than starting MS. (If the even applies in his case.)

3

Assuming you live in the U.S, are you factoring in the Home Mortgage interest tax deduction? This can drop your effective interest rate of 6% down quite a bit, depending on your income tax bracket, which can start making other investments favorable.

The other thing you should worry about is having a large enough emergency savings bucket (6 months living expenses is usually a good figure to start with) in something relatively liquid in case of job loss or other catastrophe. Paying off the principle is all well and good, but if it leaves you with nothing in your savings account at the end of the month, it’ll be difficult to recover from any unexpected financial hit.

4

I’m no financial genius, but I’ve got some money earning low interest rates in bank savings, and was considering investing in bonds because the yields on some are really attractive. But I’ve heard from various places that the bond market is in a bubble now and is in danger of bursting at some point.

5

The S&P is up 9.5% in the past 12 months. As always, the real question is what time frame you need the money in and what your ability to accept risk is. If you’re investing for the long term I can’t see why anyone would say equities and real estate are to be avoided right now, especially equities.

First, figure out your after tax cost of the mortgage (like YamatoTwinkie said). What’s your effective tax rate? Multiply 1 minus your tax rate by 6% and that’s your real cost of debt. So say you’re really only paying 4.5%. Is your mortgage fixed or is there a risk that your cost will go up? If not then in the simplest of terms, if you can earn more than that 4.5% after tax and any costs you’d be better off investing the money than paying down debt.

Of course in reality there are much bigger questions. If you invest the money you can take it out if you need it in the future. If you pay down your mortgage you have to either sell your home or borrow against the equity in it (and pay interest on it) to get the money back. If you invest it and times get tough you can use your savings to make mortgage payments. If you pay off 70% of the mortgage and lose your job, you still have to make the payments on the last 30% every month.

I’m sure there are dozens of other considerations a financial planner could help you with.

6

Keep some things in mind.

Do you intend to live in this house for a long time?

If you buy stocks, or bonds, over long term, you will still have the market to consider in the future to know how much you will realize. If you pay off your mortgage, you will own the actual equity in your home. If your home is just an investment, that represents a negative liquidity factor. If you plan on staying there it is a capital conservation factor, since you won’t be paying rent or mortgage payments. That takes no action, incurs no fees, and compares with whatever current rents and mortgage cost the market has at the time. (Not likely that it will be a whole lot less than right now, once you figure the absence of fees etc.)

A paid off mortgage incurs no tax benefit, but that tax benefit is a reduction in an expense. You won’t have that expense, so the benefit is somewhat theoretical. If your house is reasonably insured, and well maintained it’s market value is fairly stable, and it will have personal benefits not considered by economists. You should consider those benefits.

If you are likely to move in less than a decade, then it is just a medium term investment, and one set of evaluations are appropriate. If you have no plans to move at all, then it is an entirely different value to consider. Changing homes is expensive. That cost needs to be addressed as well when comparing the investment value of your home.

Tris

7

Awesome things to consider! Thanks guys. I didn’t even think about the tax deduction thing. My taxable income last year was $32,500. This year it will be roughly $4,500.
On a normal year, it should be around $36,000 taxable income. Not sure what my tax bracket percentage is for any of those. Lil help?

Though anyone can take an unexpected financial hit, I have 100% job security–which is nice. For me to lose my job, it would take some sort of serious physical injury, and such an injury would qualify me for immediate medical retirement, so I would keep much of my income. I have 100% free medical and dental, so minor injuries or even the onset of chronic illness would not set me back in anyway. So that part is good, at least.

Also, the mortgage is fixed. The house is not for me, and I won’t be living in it at all. I bought the house for my mother. She is relatively healthy as far as I know and about 56 years. I will own the house for the rest of her life, which hopefully will be longer than 30+ years.

That should clear up the details. Are there investments that are guaranteed to be more beneficial given these details? Or do they ALL come with risk? Well, I mean, I am sure they all have some risk. But would investments returning the amount of interest that would make it worth it in my situation all come with greater than average risk?

Aren’t Bonds guaranteed at a certain percentage for a certain number of years and then they mature? Am I right on that? Are there bonds which yield a high enough interest to be worth investing in instead of paying off this house?

Thanks everyone.

8

You’ve already invested $100K in real estate, when you bought the place and took out the mortgage. That’s not going to change by paying off the mortgage.

Paying off the mortgage is NOT investing in real estate. Really, it’s investing in a bond with a return of [6% minus tax benefits; probably around 4.5-5% at the end of the day]. The only risk with this investment is the chance that you’ll decide at some point to default on the mortgage and walk away. I assume that’s a pretty low risk, compared to just about anything else you can invest in other than CDs. The only downside is that it’s not easy to get that money back – you’d have to get home-equity loan, which takes a while and probably costs a bit.

You can always find a time period where stocks return more than 5%, but you can also always find a time period where they return a lot less. Long-term, the consensus seems to be that stocks do outperform most other investments, but only by a little, and you get more risk. So it’s really your call.

9

This about sums up anything I could say, but I wanted to add…

If your interest rate is still at 6%, take a look at refinancing. If you have decent credit, you should be able to get into the 4.5% range right now, and around 3.75 if you can go with a 15 year loan. I always guestimate closing costs in the range of 2% of my loan value. Also, since your mortgage is only 1 year old, see if your bank is offering a free refinance. My mortgage was just over 2 years old, and Wells Fargo (I know, some of you hate them) called me and asked if I wanted to drop my rate from 5.5% to 5.0, with zero closing costs. Not costs rolled into the loan, but zero costs. Well duh, sure I do.

10

Thanks. Wells Fargo has my mortgage now. It changed like 4 times in the first 2 months. I will see if they’ll do a free refinance for me. My normal credit union was recently offering really low refinancing rates. I looked in to it, but when I explained that I would be paying off the house in about 18 months, she worked the math and showed me that I would be losing money in the deal. Because of closing fees. She said I would have to pay it for 5 years to break even, and then after that, it would start being in my benefit to refinance with them.
I’ll send Wells Fargo a message.

11

Caution: A lot of people assume their mortgage is tax deductible but it’s not necessarily true. It’s only true if you itemize. You said your taxable income is only $4,500 this year. You can just take the standard deduction and pay no tax at all, assuming you didn’t already do that to get the $4,500 number. If you’re not itemizing, then the tax benefit of paying mortgage interest is nonexistant.

12

I’ve never itemized. I always take the standard deduction. And, no, I wasn’t subtracting my deduction when I gave that $4,500 number. That’s the amount of my total income that was not tax exempt due to working overseas.
But only my base pay and special pays are taxable anyway. So even when I am not overseas, I only pay taxes on about 30% of my entitlements. Food and housing and some other allowances in my paycheck are not taxable income.

13

[QUOTE=Bear_Nenno]

On a normal year, it should be around $36,000 taxable income. Not sure what my tax bracket percentage is for any of those. Lil help?
[/QUOTE]

The Federal tax rate would be in the neighborhood of 12% for that level of income. Add in applicable State taxes, if any.

[QUOTE=Bear_Nenno]
Wouldn’t I have to find something that would give me a return of at least 6%, though, to make the money that I will end up paying in interest on the house? And then, wouldn’t that just have me breaking even? So I need a return of more than 6% to even profit from those other investments? Is there something about interest or investing of which I am ignorant? Please help me out here! Do annuities and Bonds routinely pay higher than 6%?
[/QUOTE]

Basically correct, but as has been pointed out, mortgage interest is tax deductible. One thing to note is that you must itemize deductions to take the mortgage interest deduction. If you do so, you may no longer claim the standard deduction. In other words, if you claim a $4800 interest deduction ($80,000 x 6%), you can no longer claim the $5700 standard deduction. So you would need to claim additional deductions in addition to the interest deduction to make it worth your while.

[QUOTE=Bear_Nenno]

Aren’t Bonds guaranteed at a certain percentage for a certain number of years and then they mature? Am I right on that? Are there bonds which yield a high enough interest to be worth investing in instead of paying off this house?
[/QUOTE]

You are confusing the coupon rate (% of interest you get on the face value of the bond until maturity) and the yield. If you buy a bond when it is first issued and then hold it to maturity, then your yield is just the coupon rate because your gain comes purely from the interest payments. But, if you buy a bond and sell it before it matures, your yield can be different depending on what you what price you obtained for your bond. Your gain/loss would then be:

(interest received while holding the bond) + (money received from selling the bond) - (money used to purchase the bond) .

As a data point, US 10-year Treasuries are yielding about 3% right now, so buying bonds that yield 6% will entail a fair amount of risk.

14

Also, isn’t the mortgage interest deduction only for a primary residence? If you’re overseas and your mother lives there, does this house qualify?

15

The short answer is that paying off debt is nearly always the best possible investment you can make. Maybe investing in equities will outperform it(at a cost of significantly more risk), but I doubt that there will ever be a situation where you can get a higher rate of return investing in bonds than you would paying off debt. Some things to consider:

  • interest income is fully taxable income. If you’re making 6% on a bond(and good luck getting that in today’s market) and you’re in a 30% tax bracket, you’re really only making 4.2% on that bond

  • Interest paid is usually paid with after-tax dollars. When this is the case, paying off debt will have no tax implications(while as I’ve just mentioned, you pay tax on interest income). This means that you usually must get a significantly higher rate of return from the bond in order for it to be a better investment than paying off your debt.

  • As people have mentioned, in their infinite wisdom the US federal government has made mortgage interest paid tax-deductible. I’m not sure exactly how the math works out but I’m pretty sure that at best, this means that the tax deductions from paying mortgage interest are a wash compared to the extra tax you pay on interest income. So maybe if you can get a bond that pays more interest than you are paying on your mortgage, you might be able to come out ahead, but:

  • The higher the rate of return on a bond, the higher the risk of default. If the company that issued the bond goes bankrupt, you could lose both your principle and the interest you were expecting. A couple of years ago everybody was getting great returns on bonds called “asset-back commercial paper”. Then they discovered that what they owned where subprime mortgages that were going into default, and the people holding those bonds lost their shirts.

  • Meanwhile, paying off debt has essentially no risk at all. As somebody else said, the only “risk” is that paying down the mortgage is wasted money if you’re going to default on the loan.
    Given all of these factors I’m definitely of the opinion that paying down debt is the way to go. Think of it this way: if you could make more money buying bonds instead of paying off your mortgage faster, your bank could have made more money buying bonds with the money that they instead loaned to you. If you want to bet that you know more about how to make money than the bank does, go ahead and buy bonds.

16

I’m no financial genius, but I say go for anything other than paying off the house. Why? Because you want to be diversified. If you invest in stocks, bonds, annuities, mutuals, etc., yes they will fluctuate over time, but will generally offer you a healthy return in the long run. To assume the present fecal state of the economy and stock market will continue is very short sighted. In fact, many people would say that with stocks as low as they are, now is exactly the time to invest.

Besides, if you dump all your disposable income into the house and need it for something else, it won’t be readily available if you’ve used it to pay off debt. Sure, your job is great, but think about random major repairs to the house, your car, or other major purchase you haven’t considered that will be a ‘must have’. Things like that tend to pop up in your life.

The best approach is, do some of both. When my mutuals are in free fall, I throw extra money towards the house, and when things have bottomed out and started to go back up, and tend to put extra money in the market.

17

That sounds like you’re trying to time the market, which is generally not a good idea. For one thing, no one knows “when things have bottomed out and started to go back up” and the biggest gains are often right at that moment. For that reason, I think it’s best to invest regularly, or to dollar cost average your investments.

18

However, long term capital gains taxes are currently 0% for the lowest two tax brackets in the U.S. (This is set to expire after 2010, at which point it’ll revert to 10% if it’s not extended)