Why Paying OFF A Mortgage Is NOT Necessarily Smart

6 Replies

This is why, if you are like Ben leybovich, you write "interest or more" notes, which is a cross between your options B and C, but with a built-in option to if, when, and how to exercise amortization.  Constant is lower month to month interest only, but there is option to amortize at Ben's choice of timing and amount...

Investing is about having options.  But it is also about discipline.  Most investors on BP would likely be better off  amortizing notes fully :)

Great stuff, Wendell. 

Thanks for posting, Wendell. This is some very interesting stuff. I hadn’t heard the term “Loan Constant” before and it’s an interesting tool to consider the true cost of borrowing.

One (minor) observation of the post is I think for consistency the first example (401k) should be calculated like the interest only example further now rather than amortizing over 3 years (since the assumption was no amortization).

Thanks for sharing :)

Interest rates are generally higher over longer amortization periods and especially for interest-only. As a result the loan constant may be lower for interest-only but may still produce a lower yield when compared to an amortizing loan.

Suppose we modify the example with options for a 3% rate over 10yrs vs. a 4% over 20yrs or a 6% IO (maybe a bit harsh on the IO rate increase vs. 20 yr rate, but for the sake of this example bear with me). The loan constant still looks best for IO, however the 20-year loan would provide a 10% higher annual rate of return. Of course you still have to consider do you want more money today or tomorrow?

As Ben brought up, the flexibility of interest only with option to paydown is a huge bonus factor to consider (and an ideal financing situation in my mind so long as the interest isn’t too much higher).

Notes & Assumptions: 

Assumes no appreciation over the 5 years & CAP rate stays constant throughout.

† Final value defined as = [Down Payment] + [total cashflow] + [principal paydown]

*The ROR formula breaks down when you have negative cashflow since you can't pay the negative delta along the way with the equity you only realize after selling (or refinancing). In this case you’re essentially adding another $5k to your initial investment thus reducing the 5YROR to 37%.

@Wendell De Guzman    Thank you for posting.  What is unmeasured is easier to justify lol.  Got it, so having a built in buffer is good, paying it off is not as wise of a financial decision.

Originally posted by @Christopher Covell :

Interest rates are generally higher over longer amortization periods and especially for interest-only. As a result the loan constant may be lower for interest-only but may still produce a lower yield when compared to an amortizing loan.

Suppose we modify the example with options for a 3% rate over 10yrs vs. a 4% over 20yrs or a 6% IO (maybe a bit harsh on the IO rate increase vs. 20 yr rate, but for the sake of this example bear with me). The loan constant still looks best for IO, however the 20-year loan would provide a 10% higher annual rate of return. Of course you still have to consider do you want more money today or tomorrow?

As Ben brought up, the flexibility of interest only with option to paydown is a huge bonus factor to consider (and an ideal financing situation in my mind so long as the interest isn’t too much higher).

Notes & Assumptions: 

Assumes no appreciation over the 5 years & CAP rate stays constant throughout.

† Final value defined as = [Down Payment] + [total cashflow] + [principal paydown]

*The ROR formula breaks down when you have negative cashflow since you can't pay the negative delta along the way with the equity you only realize after selling (or refinancing). In this case you’re essentially adding another $5k to your initial investment thus reducing the 5YROR to 37%.

 Awesome analysis...same conclusion: IO is best option. Thanks!

In theory interest only is great, that theory kind of popped in 2008.  Without some decent equity guys with 200 to 300 houses worth millions went broke.  Why pull more cash out?  Why not pay down as much as possible every month.  When you need money for the next purchase use the equity you have built up by paying your loan down.  If you put it in the bank you earn maybe .25% interest in savings.  If you did loan pay down you saved yourself 5% interest on the principal you paid down.  Interest only is nice but fast loan pay down makes you more money in the long run.