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I close on my first home October 21. I've locked in a 4.330% APR on a 30-year fixed conventional mortgage and my payment will be ~$800/month. I've put the required 20% down to avoid paying PMI.

However, the $800/m isn't even 25% of my take-home income and it will be < 20% starting January 1st. This is skewed even more by the fact that I'm taking on extra contracting work that will net me an additional $1600/month before taxes.

I'm curious whether or not I should put that extra money into the principal of the home or if I would be better served putting it into a mutual fund. I've noticed quite a few mutual funds have historically had > 4.330% annual return on investment and if I was paying linear interest on the loan it would be no-brainer.

However, since I'll be putting in a small amount of money to the principle of the home at the beginning I'm wondering if I would be in a better position if I funneled that extra cash (We'll say $2000/m) toward the loan instead of investing it.

Is this a good idea?

Thanks.

Edit: Contextual Information

  • I'm 23 years old.
  • My company does not offer matching, but instead deposits 8% of my salary + cafeteria funds into my 401k at the end of the year regardless of what I do.
  • I have virtually no other debt to speak of (I just paid off my car and I keep my CC balance around $1,000 at any given time).
  • I'm not bound to this location - my reasoning for buying a house is funneling my living expenses into principal instead of having it evaporate at the end of each month.
  • I'm not particularly worried about being unemployed -- My house payment is low enough to where my unemployment check would more than pay for it and I'm in software, which means I can find a job on a whim if I needed to.
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More times than we'd like to admit in life we are faced with a situation where we could turn a profit on something if we only had initial capital to back it up. As @JohnFx (and @mbhunter) brought up, the liquidity of my assets is something to consider and (for me, personally) is very important. Although I'm not sold on mutual funds, it makes sense at this point in my life that I keep my extra income in something that I can withdraw within a few weeks notice. –  Chuck Callebs Sep 14 '11 at 4:59
    
The only thing I'd add is that you should at least go with an every two week payment. If you do end up with the loan over a longer time period for any reason just paying 1/2 two weeks early cuts down the length of the loan by years. –  Joshua Drake Sep 14 '11 at 5:17
    
October 21st? Don't worry about it -- by then we will all be experiencing fiery annihilation (businessinsider.com/…) –  Chris Burt-Brown Sep 14 '11 at 8:59
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Joshua - your recommendation is fine, it's 8% higher payment each year. But. Most banks won't accept half payments, so the OP should budget and 'envelope' that half payment each check and send full payments as they accumulate. 13 per year instead of 12. –  JoeTaxpayer Sep 14 '11 at 18:10
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buy land... i hear they're not making it anymore. –  jberger Sep 14 '11 at 19:19

9 Answers 9

up vote 20 down vote accepted

Excellent answers so far, so I will just add one additional consideration: liquidity.

Money invested in a mutual fund (exclusive of retirement accounts with early withdrawal penalties) has a relatively high liquidity. Whereas excess equity in your home from paying down early has very low liquidity.

To put it simply: If you get in a desperate situation (long term unemployment) it is better to have to cash in a mutual fund than try to sell your house on the quick and move in with your mother.

Liquidity becomes less of an issue if you also manage to fund a decent sized rainy-day fund (6-9 months of living expenses).

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I'm accepting this answer. Although most of the answers here contain excellent advice, this response brought me to my current conclusion (I'll comment on the main post). –  Chuck Callebs Sep 14 '11 at 4:54
    
This is not true in some countries, especially Australia, where most lenders allow you to redraw any extra repayments from your home loan, or have a linked offset account to the home loan which acts like a standard savings account, except it reduces the interest payable on the home loan by any balance held in the offset account. –  Victor Jul 1 '13 at 20:27

Naturally the advice from JoeTaxpayer and dsimcha is correct, every situation is different. I will get reckless, go nuts and make a recommendation!

You are young, childless for the time being. Do the following with your money:

  1. Eliminate all credit card debt or other unsecured debt.
  2. Max any matching retirement accounts at work.
  3. Fully fund a Roth IRA at $458/month (if you qualify) (and at Vanguard in a target retirement date fund if you don't have one)
  4. Save up 6 months of cash in a savings account. This is your entire monthly outflow * 6 and it will be a lot!
  5. Blow a little bit on wasteful fun and enjoy these good times in your life
  6. Take anything that remains and put 50% in an aggressive investment account (at Vanguard or somewhere cheap) and 50% towards your house.

ALTERNATE IDEA for #6

  • Save up all that cash in a heartbeat so you can refi with a credit union into a 10 or 15 year mortgage and pay off the house in half the time or less and save a boatload on interest.

Fix yourself up for the long term first, then have a bit of fun, then get out of the house debt. In that order.

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I think it is actually important to take more (SENSIBLE!) risks early when you are young; once you are married, have kids, etc, those options close –  Jeff Atwood Sep 14 '11 at 4:09
    
This is a great plan. I posted a separate answer just to suggest a slight adjustment, but overall I think the priorities above are perfect. –  NickC Sep 14 '11 at 17:25

I was going to ask, "Do you feel lucky, punk?" but then it occurred to me that the film this quote came from, Dirty Harry, starring Clint Eastwood, is 43 years old.

And yet, the question remains. The stock market, as measured by the S&P has returned 9.67% compounded over the last 100 years. But with a standard deviation just under 20%, there are years when you'll do better and years you'll lose. And I'd not ignore the last decade which was pretty bad, a loss for the decade.

There are clearly two schools of thought. One says that no one ever lost sleep over not having a mortgage payment. The other school states that at the very beginning, you have a long investing horizon, and the chances are very good that the 30 years to come will bring a return north of 6%. The two decades prior to the last were so good that these past 30 years were still pretty good, 11.39% compounded.

There is no right or wrong here. My gut says fund your retirement accounts to the maximum. Build your emergency fund. You see, if you pay down your mortgage, but lose your job, you'll still need to make those payments. Once you build your security, think of the mortgage as the cash side of your investing, i.e. focus less on the relatively low rate of return (4.3%) and more on the eventual result, once paid, your cash flow goes up nicely.

Edit - in light of the extra information you provided, your profile reads that you have a high risk tolerance. Low overhead, no dependents, and secure employment combine to lead me to this conclusion. At 23, I'd not be investing at 4.3%. I'd learn how to invest in a way I was comfortable with, and take it from there.

Disclosure (Updated) - I am older, and am semi-retired. I still have some time left on the mortgage, but it doesn't bother me, not at 3.5%. I also have a 16 year old to put through college but her college account i fully funded.

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I am single and plan to stay that way. :) –  Chuck Callebs Sep 13 '11 at 20:11
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Ok. My original question stands. :) –  JoeTaxpayer Sep 13 '11 at 20:15
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@Chuck - famous last words =) –  MrChrister Sep 13 '11 at 20:20

I wouldn't pay down your mortgage faster until you have a huge emergency fund. Like two years' worth of expenses. Once you put extra money toward principal you can't get it out unless you get a HELOC, which costs money. You're in a position now to build that up in a hurry. I suggest you do so.

Your mortgage is excellent. In the land of inflation it gets easier and easier to make that fixed-dollar payment: depreciating dollars.

You seem like a go-getter. Once you have your huge emergency fund, why not buy a few websites and monetize the heck out of them? Or look for an investment property from someone who needs to sell desperately?

Get a cushion that you can do something with.

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I wish I could accept two answers, the third paragraph is very similar to my long-term plans. –  Chuck Callebs Sep 14 '11 at 5:02

Paying off the debt is low-risk, low-reward. You're effectively guaranteed a 4% return. If you buy a mutual fund, you're going to have to take some risk to have a decent chance of getting better than 4% and change return in the long run, which probably means a fund that invests primarily in stocks. Buying a stock mutual fund is high-risk, high reward, especially when you're in significant debt. On the other hand, 4% and change is very low-interest. If you wanted to buy stocks on margin, financing stock investments directly with debt, you'd pay a heck of a lot more. Bottom line: It comes down to your personal risk tolerance.

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Other answers are already very good, but I'd like to add one step before taking the advice of the other answers...

If you still can, switch to a 15 year mortgage, and figure out what percentage of your take-home pay the new payment is.

This is the position taken by Dave Ramsey*, and I believe this will give you a better base from which to launch your other goals for two reasons:

  1. It should yield a lower interest rate (sometimes significantly).
  2. It provides better regular pace to pay off the house. You are already looking at paying off your 30 year mortgage "faster" - why not simply start with a better pace?

Since you are then paying it off faster at a base payment, you may then want to take MrChrister's advice but put all extra income toward investments, feeling secure that your house will be paid off much sooner anyway (and at a lower interest rate).


* Dave's advice isn't for everyone, because he takes a very long-term view. However, in the long-term, it is great advice. See here for more.

JoeTaxpayer is right, you will not see anything near guaranteed yearly rates in mutual funds, so make sure they are part of a long-term investing plan.

You are not investing your time in learning the short-term stock game, so stay away from it. As long as you are continuing to learn in your own career, you should see very good short-term gains there anyway.

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A 15 year mortgage typically has a .75% lower interest rate from my looking. But what's better about doing that as opposed to simply paying off a 30 like a 15? Getting a 30 and paying it aggressively means that you still pay less interest at the end of the day but if something comes up financially you have flex room. –  justkt Sep 14 '11 at 17:51
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@justkt - depends on a person's attitude. Dedicated folks can swing it, but too often a person will just pay the minimum and take all 30 years. Know thyself. –  MrChrister Sep 14 '11 at 18:00
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+1 - I'm no Ramsey fan, but anyone here who uses the phrase "JoeTaxpayer is right" gets a +1 by default. –  JoeTaxpayer Sep 15 '11 at 0:54

The mathematically correct answer is to invest, because you'll get a higher rate of return.

I think that answer is bunk -- owning your home free and clear is a huge burden lifted off of your shoulders. You're at an age where you may find a new job, business, personal or other opportunities will be easier to take advantage of without that burden.

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but wait -- precisely because he is young, he may want to move to another area, and a paid-off-in-full home will anchor him there until he can unload it. –  Jeff Atwood Sep 14 '11 at 4:13
    
@Jeff true, but theoretically the equity can move with him. Moving costs (and agent fees and closing costs) will be the same with equity or without. –  NickC Sep 14 '11 at 17:28
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@Jeff - not necessarily, as if he's renting it out to move having it paid in full allows him to flex more easily with the rental market rather than trying to cover his mortgage. –  justkt Sep 14 '11 at 17:49
    
@justkt The rental market would have to tank a considerable amount to make home rent less than my mortgage. Also, the equity can move with me, but I'm bound to the house actually selling before I can take advantage of that equity. –  Chuck Callebs Sep 14 '11 at 18:33

There are several factors to keep in mind. Before you even consider paying extra on the principal of the house, you need to have an emergency fund equal to six months' worth of living expenses.

Beyond that, you should split things up between various options...

Fully fund a retirement account to get the maximum tax benefit. Stash extra cash in a relatively liquid (ie mutual fund) investment account. Keep adding to the savings until you have about 2 years worth' saved.

The man caveat with investment versus debt is that, due to the way the interest works, your investments will have increasing returns over time, whereas paying off debt will give you decreasing returns. This isn't to say that additional money put towards debt is useless; on the contrary, the feeling of being debt free is one of the best you can experience. But each additional dollar put towards principal has a lower rate of return than the dollar before.

Investments, on the other hand, just keep getting bigger (aside from market volatility, or sudden drops like 2008 or even what happened earlier this year).

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I'm probably going to get a bunch of downvotes for this, but here's my not-very-popular point of view:

I think many times we tend to shoot ourselves in the foot by trying to get too clever with our money. In all our cleverness, we forget a few basic rules about how money works:

  1. Savings will probably help you
  2. Debt will probably hurt you

It's better to have 0 debt and a small amount of savings than lots of debt and lots of savings.

Debt will bite you. Many times even the "good" mortgage debt will bite you. I have several friends who have gotten mortgages only to find out they had to move long before they were able to pay it off. And they weren't able to sell their homes or they sold at a loss.

When you have debt, you are restricted. Someone else is always holding something over your head. You're bound to it. Pay it off ASAP (within reason) while putting a decent amount into a high-yield savings account. Only after the debt is gone, go and be clever with your money.

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No downvote, but this is really way to conservative advice for a young person. Today stocks are on sale, everything is cheap and the likelihood of recovery during his career is very high. –  MrChrister Sep 14 '11 at 3:20
    
@Phil - if friends had to move before they paid off their mortgage, what's better a paid in full house, or $250K in the bank? John's answer "liquidity" is dead on. Even if we take the "walk away" off the table, having more money saved is preferable should any life event occur. The obsession (esp from the Daves of the world) to pay off the mortgage is to a risky extreme. Some pass on their matched 401(k) deposits to do so, others maintain 10 years of living house poor to get rid of the debt, ignoring retirement savings completely as well as other day-to-day niceties. –  JoeTaxpayer Sep 15 '11 at 0:52

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