Thursday, June 7, 2007

Never Prepay Mortgage? Housing Myths Part 1

This is the first in a series of articles on housing myths.

Should You Prepay Your Mortgage?

“Rule #1” of personal finance is to pay off debts because killing anti-savings is the best savings in terms of real, after-tax, return on investment (ROI). Unfortunately, the complexity of comparing relative interest rates with differing tax rules can confuse people into breaking this rule in the wrong circumstances.

Risk: A Bird in the Hand Beats Two in the Bush

The first problem is that people treat assumptions as if they were measurements. The second problem is that uncertainty is greater on your income side of the equation: The odds of you losing your job or seeing your stocks drop is greater than the odds that the bank will forget to collect its monthly mortgage payment.

You need to consider the risk or likelihood of an ROI. A fixed-rate mortgage has a fairly certain negative ROI. You might compare a 10-year fixed-rate mortgage to 10-years of CDs to compare contractually-guaranteed rates. Bond yields fluctuate but without anywhere near the principal-loss-risk of stocks so you might compare a 30-year mortgage to a 30-year Treasury bond.

Trade-Offs: There Is No Such Thing as a Free Lunch

You will notice that ROIs decrease as they approach the certainty of mortgage debt and it is very difficult to find similar-to-mortgage-certainty investments that pay more than mortgages cost. Risk being equal, debt will cost more than savings will earn (hence Rule #1). This must be so for a bank to make a profit (in a simplified business model).

Investments that appear to pay better than paying-off-debt usually offer possible profits in exchange for more risk, or offer short-term “teaser” rates.

Testing the "Never Pay Off Your Mortgage" Advice

Chazzman2000's comment at The Simple Dollar mentioned this article as an exception to Rule #1, because the article argued that you can make a bundle by investing in the stock market instead of paying your mortgage early. Fortunately, that article was written in 2001 so let’s see what would have happened to someone who read the article, closed on the exact same suggested mortgage that same day, and poured the extra money into an S&P500 index fund ever since (I randomly chose SWPIX, which did its intended job of tracking the S&P500, labeled GSPC in the chart):

The 2001 article claimed that it would estimate only a “mediocre” 12% annual return but SWPIX’s actual 5yr average is now 8.23% and its 10yr average is 7.70%, which is less than the 8% mortgage rate. If you had put the extra $300/mo. on the mortgage for the last 6+ years, by now you would have paid $6,569.45 less interest and have built $29,069.46 more equity than if you had made the minimum payments, for a combined benefit of $35,638.91, which is about the same as and probably better than the SWPIX alternative (if we counted every last detail).

Tax deductions probably would not rescue the SWPIX choice but I will cover tax-deduction myths in a coming article.

Update 6/19/07: My comments to The Simple Dollar did not always get published but his latest post seems to echo what I and others have been trying to say.

Update 6/22/07: The questionable 12% S&P500 promise resurfaced in a June 12 MSN/Money Central article that Mighty Bargain Hunter questioned.

Update 10/28/07: Note that I generously assumed the fictitious 8% S&P500 rate but the actual nominal growth from 3/01 was little above 0% and the real "growth" after several years probably was a negative loss.

Next: The $200,000 Blunder: Housing Myths Part 2


Q at $1 Million to My Name said...

Invest invest INVEST! I agree with -- you should invest the maximum amount you can, as early as you can.

David said...

But who was paying 8% on a mortgage in 2001? I purchased my house in 2001 with a 6 1/8 % rate and refinanced several years alter at 5.5%. Seems almost silly to prepay at that rate.

J at IHB and HFF said...


Hello. The average was about 7% so for every person like you there was another person at about 8%. I used Fool's scenario and it was Fool who picked 8% because the author was so sure (but wrong) that the S&P would leave 8% in the dust. Although recent years' unusually low mortgage rates increase the odds of borrowing to invest and staying a few steps ahead of the wolf, people should beware of facile assumptions and the Fool article is a useful example.

I have a follow-up article in the pipeline so I hope you return. Thank you.