Pay Down vs Invest

22 Replies

I currently have enough money to pay down 65% of a California townhome I plan to live in, but that money could easily buy several investment properites in other parts of the country.

My uncle is a real estate agent who owns a property management company. He told me if I decided to buy property in his area he could put me in contact with a birddog and set me up with some nice investment property.

My question is, should I go ahead and pay down my house or buy rental property and let that pay my mortgage?

I have an article for you to read reguarding your EXACT situation...Whats your email?

I think the file is to big to post on here and i dont have it hosted! If anyone would like to host it its a PDF, great article!!!

Anyways...LEVERAGE your money!

Mike

I'm going to simplify things a LOT...

Look at your mortgage. What is the interest rate?

Now look at your target REI market(s). Can you earn a higher rate of return than your mortgage? If so, then invest. If not, then pay down the mortgage.

Check out our tool on this site if you need help understanding ROI.

I'm willing to host it at least until we can find a better spot to leave it online. I may or may not decide to keep it up later, but I promise to keep it up there until at least 10/31/06. Feel free to contact me and we'll get it set up.

Anyone have any comments on this article? I just finished it, and I have to say it reads like an advertisement for a mortgage company. At first blush, I have some problems with some of his assumptions. First, he talks about "risk free" but then ignores the risks involved with "Brother B"'s investments (which, apparently, make 8% a year). 8% not unrealistic, but it's certainly not guaranteed or risk-free, especially over the short term such as the 5 years before the hypothetical job loss.

There also seems to be some finagling with the tax savings calculations (which result in a lot of "Brother B"'s money to invest). First, the author seems to pretend like the standard deduction doesn't exist and that "Brother A" would continue to itemize deductions even though he would have less tax owed under the standard deduction (I think it's $10K/year for a couple, but I'm not sure). Worse, though, is how the author calculates the tax savings over the course of the entire loan and then averages it over that time, and uses the difference of this average as an amount Brother B can invest every year. This gives a much greater (and unreal) cash advantage to Brother B earlier than he would actually have it, and thus gives him more investment return than he would really get.

Let's assume Brother A (whose interest payments never exceed the standard deduction) instead chooses not to itemize but to take the standard deduction every year. Brother B's only tax savings is the amount above the standard deduction that he paid in interest. In reality he's only saving $109/month in taxes (for 15 years). Add that to the lower monthly payment and you get a net after-taxes difference in mortgage payment of $317/month (not $428).

So, what does this get you? Remember, he's getting 8% return, but we have to assume that he means before taxes. Presumably he's paying captial gains tax on this investment. Say capital gains is 25%, so he's really only getting 6% after tax return. Thus, in 15 years, Brother B's extra $317/month will be worth $92,189 and his original $30K will be worth $73,622, for a total of $165,812. He has paid off only the initial $10K of his house (it was interest only for the first 15 years). Brother A, of course, has paid off his entire house. After 15 years, Brother A's net assets are $200K (the value of the house) and Brother B's net assets are $175K. But I bet his mortgage broker got a pretty sum.

Now, it's at 15 years, Brother B still owes his mortgage and will be paying on it for the next 15 years. Brother A, who already has higher net assets, will have no debt obligations and can invest every dime that Brother B will be paying in interest and principal for the next 15 years. He will skyrocket way out of the reach of Brother B in terms of assets.

I've discarded the spurious distraction of Brother A paying an additional $100K/month on the mortgage and Brother B investing an extra $100K/month just to show what the real difference is between paying off your mortgage vs. borrowing on your house to invest. All of this also assumes that Brother B really did get his 8% return.

I also disagree with two over-riding points:

(1) I don't agree that most Americans are trying to own their home outright. If anything, Americans are more in debt (including their homes) than at any time in history (I can't back that up, but I think it's correct).
(2) I don't believe him when he says that paying off your mortgage puts you at greater risk of foreclosure. It certainly seems to me that all the evidence points to the opposite. Again, I can't back this up, but I would love to hear others' opinions on this subject.

I'll confess that these numbers (especially the standard deduction and the tax rates) are off the top of my head, and these are quick calculations. Also, taking the standard deduction also gives up savings in RE taxes and other deductions, but also note that the standard deduction has increased recently and any additional increase over the next 15 years would be to the advantage of Brother A. I'd like to hear what others think about this.

I guess my bottom line is:
(1) I still think it's better to pay off the mortgage
(2) The standard deduction is the dirtly little secret the mortgage-lovers tend to ignore when they do their calculations and
(3) Don't forget to look at the "after tax" return on the invested difference.

mgoddo really liked it so I am happy to let everyone here share with the resource that he's found. It appears to have at least gotten your brain thinking about the possibilities! 8)

8% not unrealistic, but it's certainly not guaranteed or risk-free, especially over the short term such as the 5 years before the hypothetical job loss.
A very good point. As I stated earlier you need to be able to earn ROI from other investments that is greater than the rate of interest on your mortgage. This is certainly not guaranteed, but 8% is quite reasonable.

First, the author seems to pretend like the standard deduction doesn't exist and that "Brother A" would continue to itemize deductions
This is somewhat true. There are a lot of things that go into each person's tax return so it is hard to say whether you would itemize or take the standard. You might already have large medical expenses to itemize so this argument would then be moot. But yes, if you take the standard deduction then you gain no tax benefit from higher interest on a personal residence.

Worse, though, is how the author calculates the tax savings over the course of the entire loan and then averages it over that time, and uses the difference of this average as an amount Brother B can invest every year.
I agree 100%. You can't invest what you don't have. :D

Remember, he's getting 8% return, but we have to assume that he means before taxes.
This isn't necessarily true. I can invest in tax-exempt bonds or I could put my savings into a Roth IRA. In fact this is what I do personally and it is a good choice for some people. So your argument of taking away 25% for capital gains tax is 1) too high for our current rate system and 2) not even relevant if you can get tax-free returns. It is quite possible for Brother B to invest the difference @ 8% and actually have more net assets than Brother A after 15 years. Plus let's not forget... Brother B has LIQUID assets, but Brother A's assets are not liquid. If he has to sell that house quickly... then he finds me and I buy it at a discount of, say, 30% :mrgreen:

(1) I don't agree that most Americans are trying to own their home outright. If anything, Americans are more in debt (including their homes) than at any time in history (I can't back that up, but I think it's correct).
I don't have facts to prove this right or wrong, but I would love to see some.
(2) I don't believe him when he says that paying off your mortgage puts you at greater risk of foreclosure. It certainly seems to me that all the evidence points to the opposite. Again, I can't back this up, but I would love to hear others' opinions on this subject.
That's not exactly what the article says... read it again. It says that Brother B has more cash in his pocket and can make his mortgage payments from his savings while Brother A can't get a loan and needs to sell his house (to me for a discount of... oh, never mind :wink: ). No one ever went bankrupt with a ton of cash sitting in the bank!

Not only that, but Brother A's house is worth more to the bank in the case of foreclosure. They already have received a lot of Brother A's money and now they're going to sell the house and make a nice profit. If they try to sell Brother B's house they're going to realize a loss so, but if Brother B can work out his loan then the bank can continue to profit from his interest payments.

(1) I still think it's better to pay off the mortgage
Sometimes this is the right choice! Sometimes not. I will say it again: compare the rate of return you can make on investments with the interest rate of your mortgage.
(2) The standard deduction is the dirtly little secret the mortgage-lovers tend to ignore when they do their calculations
A very good point, but not 100% clear cut for everyone.
(3) Don't forget to look at the "after tax" return on the invested difference.
Another good point, but there are ways around this. As an example municipal bonds are very liquid and they are tax-free.

This ad isn't as crazy as it looks on first glance, but it is quite different from the conventional way of thinking.

Actually the biggest problem that I have with the article is this: most Americans don't save. When they have extra cash on hand they decide to spend it rather than save or invest. A person with a "frugal" mindset is better off acting like Brother B, but if he's a free spender then he should follow Brother A's example and hope for the best! :idea:

Originally posted by "juzamjedi":

Remember, he's getting 8% return, but we have to assume that he means before taxes.
This isn't necessarily true. I can invest in tax-exempt bonds or I could put my savings into a Roth IRA. In fact this is what I do personally and it is a good choice for some people. So your argument of taking away 25% for capital gains tax is 1) too high for our current rate system and 2) not even relevant if you can get tax-free returns. It is quite possible for Brother B to invest the difference @ 8% and actually have more net assets than Brother A after 15 years. Plus let's not forget... Brother B has LIQUID assets, but Brother A's assets are not liquid. If he has to sell that house quickly... then he finds me and I buy it at a discount of, say, 30% :mrgreen:

Well, I don't know of anyone that would advise paying off a mortgage before you had maximized all tax deferred/exempt retirement options. Even the ever-outspoken and anti-debt Dave Ramsey doesn't advice that. So I agree wholeheartedly with the roth IRA (or any other option like 401K, 403b, etc), but that hardly seems to be what this article is talking about, and that's not a very liquid asset (big penalties for trying to get the money early).

I'll also admit that I know nothing about municipal bonds, but I had no idea that they could give low-risk, tax-exempt returns in the 8% range (I had always thought of them as 4%-ish types of investments).

Originally posted by "juzamjedi":
(2) I don't believe him when he says that paying off your mortgage puts you at greater risk of foreclosure. It certainly seems to me that all the evidence points to the opposite. Again, I can't back this up, but I would love to hear others' opinions on this subject.
That's not exactly what the article says... read it again.

Well, it says exactly "To reduce the risk of unforseen foreclosure, keep your mortgage balance as high as possible."

I understand your point that if the invested money really is there, and it really is liquid, and it really did pay off what was anticipated, that the person would have some money to get through hard times. But lets look at the 15 year point. By my scenario, Brother A has paid off his mortgage and has no debt. Pretty low chance of foreclosure. Brother B, following the article's advice to maximize his balance, has only $10K equity, is paying 7.42% interest on a $190K loan and has total invested assets of $165K earining him what I would argue is probably 6% after taxes. Call me crazy, but I think Brother B is at a much higher risk of foreclosure than Brother A at this point.

Originally posted by "juzamjedi":
Actually the biggest problem that I have with the article is this: most Americans don't save. When they have extra cash on hand they decide to spend it rather than save or invest.

Amen. No question that this is the real problem. The person with disciplined spending will come out like a rose in either scenario, the one who spends more than he makes is doomed for disaster.

I'll also admit that I know nothing about municipal bonds, but I had no idea that they could give low-risk, tax-exempt returns in the 8% range (I had always thought of them as 4%-ish types of investments).
I'd be happy to talk with you off-board about municipal bonds as I don't think it's really appropriate to this forum discussion. Also you are right that IRA's are not liquid although there are a few exceptions.

Well, it says exactly "To reduce the risk of unforseen foreclosure, keep your mortgage balance as high as possible."
Pretend that you are in loss mit for a bank and you're trying to maximize the value of non-performing loans. What are your options?

1. Get the borrower to catch up on the payments (plus penalties)
- Brother B has more cash on hand from savings so he *should* be able to do this. Brother A will have less liquid assets, period.
2. Get a new home equity loan
- This is an option for Brother A, but Brother B will be SOL here. However, even if Brother A does this he could theoretically have the same LTV as brother B (90%), but now he's paying a higher interest rate for the HELOC whereas Brother B was earning interest on money that he invested.
3. Work out new terms for the loan
- Either brother can do this, but you will be more likely to work out with Brother B because you have more at risk (i.e. Brother B's high loan balance)
4. Work a short sale with a 3rd party
- This is probably what Brother A ends up doing unless he gets a new job
5. Send the property to foreclosure
- This is what happens to either brother when they've exhausted all other options. Definitely the last resort, but if you notice that Brother A has a lot of equity then you would love to foreclose on his property as quickly as possible!

Suppose for a second that you're right and Brother A actually has more equity in 15 years. Here's the problem: Brother A's net worth is all wrapped up in his house and he cannot touch it unless he sells the house (or start over with ANOTHER loan!). Most likely he could sell for a profit, but he'll have to move into a less expensive home. So you've got to add in moving costs, closing costs, etc. and all of this reduces the equity that you have (maybe 10% of the selling value). On the other hand Brother B has liquid assets and he doesn't have to spend much at all in order to get full value for his investments ($9.99 with some online stock brokerages).

My KISS answer to this problem is: "Can you earn a higher ROI than the mortgage rate on your house? If so, then save and invest the difference."

Originally posted by "juzamjedi":
My KISS answer to this problem is: "Can you earn a higher ROI than the mortgage rate on your house? If so, then save and invest the difference."

But you also need to think about risk. You are taking on the full risk of the investment but only getting the marginal difference (and providing a guarnanteed rate of return to the bank). In the scenario presented in the paper, and assuming that he's getting 8% after tax return: he's going to guarantee the bank 7.42% and take on the full risk of an 8% after-tax-return investment to net himself 0.58%. Personally, I wouldn't bet my house on it, but others may.

I have to admit I didn't read the entire article but I got the gist of it by reading the first several pages. I think some very valid points were made and there is a benefit to carrying some debt on your home as mentioned in the article but here were my 2 concerns:

1. As someone else mentioned, tax savings are purely speculative based on many individual factors. Once you hit (I think) $150k AGI per year, you can start kissing part of your mortgage deduction goodbye and if you get into AMT annually like I do, then your mortgage deduction benefit really fades fast.

2. Since this is a real estate investing board, I was taking the leap that Brother B very well might be encouraged to put his excess cash into... well... more real estate! Obviously this is reading between the lines and is a big assumption but if indeed Brother B follows this course, this makes him no more liquid than Brother A and in fact in worse shape potentially as he may struggle to get much money out of *any* of his holdings in a pinch.

I guess also as someone mentioned, my concern with most people is that the extra money would in essence be "wasted" rather than put into a solid investment. I use the term "wasted" loosely because buying a boat or a BMW for example is not "wasteful" if it brings pleasure but it certainly isn't going to return 8% on your money put in either. Building equity is a method of forced savings that unfortunately many people require.

To summarize, my opinion is that while indeed leverage is a valuable tool, using too much of it or using it carelessly can get you in trouble. I prefer to have a decent amount of equity in my properties so that if/when I need to sell, I'm not bringing more money to the table just to get a property off my hands.

Building equity is a method of forced savings that unfortunately many people require.
Very wise, and very true. I tried explaining this to my GC one time and his eyes just glazed over :lol:

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