16

Some background: I have a mortgage ($212K/$247 remaining, 3.675% APR) on a house in my previous city. Selling it was my primary goal, but unfortunately that hasn't happened. And looks like the situation won't be better for at least 1-2 years. So I am left with the option of renting it till the market improves.

As per my own analysis and interpretation, I feel the stock market is at a peak and won't gain much in next few years. So I decided to divert my investments from stock equity to pay off the mortgage and continue paying off as early as possible. My end goal is to sell the house in next 2-4 years whenever the market is better and buy another one in my area using that money.

Last week I sold all my stock equity amounting to $100K and made $60K principal payment to the mortgage. Planning to make another $40K payment this week, but I started doubting my plan this week.

I am looking for some validation that my plan is sane. I understand there are a lot of factors; but in general is this something you would advise someone to do?

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  • 21
    Remember that you will still owe some capital gains taxes on that equity sale, so if you haven't put that aside, you should plan to do so.
    – Istanari
    Aug 24 '20 at 16:24
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    Even with the risk of having to later tap into your house's equity at a later time, the amount of interest you'll save now by paying down your principal can offset whatever higher interest you'll pay later. This can be especially true if you can reset your mortgage to keep the same term and rate, but lower your monthly payment to reflect your newly lowered principal.
    – chepner
    Aug 24 '20 at 19:16
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    "til the market improves" -- aren't we currently in a seller's market?
    – Barmar
    Aug 25 '20 at 13:32
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    "whenever the market is better", "until the market improves", "I feel the stock market is at a peak". You are assuming a bunch of things you can't possibly know, because no one can.
    – Dan C
    Aug 25 '20 at 15:01
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    @user91988 mortgage is not on primary residence - rates on rentals/investments are not that low in my experience.
    – D Stanley
    Aug 25 '20 at 15:09
36

Well "sane" is a pretty low bar... It's not a terrible plan, but it's not guaranteed to work in your favor.

If you are correct that the market is at a peak, then yes, you'll be better off paying the mortgage. But if the market goes up, then you'd have an opportunity cost.

The trade-off with paying debt versus investing is risk. You are effectively "earning" a risk-free 3.675% on your money by paying off your mortgage. Could you do better in the stock market? certainly. Will you? There's no way to know. You might do significantly better, or significantly worse. Statistically the market earns more on average, and it has also always recovered from losses within a few years, so if you have a long investment horizon then redirecting to debt may just be "timing the market" which is generally not a good investment strategy.

One problem with paying off debt is that it's not easy to get back into the market if that's what you want to do. Home equity is very illiquid - the only way to get to it is to sell the house (which it sounds like you're trying to do) or take a home equity loan (typically at a higher interest rate). so if and when you decide to get back into equities you'll probably need to start from scratch, investing a little at a time as you have extra in your budget for savings.

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  • Hmm, I don't understand home equity illiquid ????? When you own a house outright, they throw HELOCs at you, right?
    – Fattie
    Aug 24 '20 at 16:56
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    Sure - for an interest rate that is likely worse than a mortgage rate. I would never recommend someone tap a HELOC to invest.
    – D Stanley
    Aug 24 '20 at 17:16
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    Trying to predict the stock market is always a mug's game. Trying to make a long term (e.g. 1 or 2 years) prediction two months before a US presidential election is even worse - not to mention the the potentially irrational behaviour of the current president, and the way COVID might play out.
    – alephzero
    Aug 25 '20 at 14:33
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    @Fattie Never forget that "financial advisers" make their money by taking it away from the people they advise - not the other way round.
    – alephzero
    Aug 25 '20 at 14:35
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    @DStanley - For me, that turned into a "do as I say/write". I bought a rental with my HELOC. $180K total inc full renovation. Borrowed a bit more for minor repairs during 1st 2 years, but TL:DR, I owe $130K on it now, and the rent is just over $30K gross. $12-15K net last yr/this year. Just sharing that. Aug 25 '20 at 15:05
17

This will depend greatly on your personal appetite for risk. From a strictly monetary point of view, you'd likely do better by investing in the market (although past performance does not guarantee future results). Paying off the mortgage gets you a guaranteed effective return of 3.675%, which is historically pretty low. Long-term investment in stocks would historically perform better than this, but there is a risk of performing worse. Over most periods of time, you'd have been better off leaving your money in a well-diversified stock portfolio rather than saving on mortgage interest.

Also consider that money in stocks is far more liquid that money tied up in a house. When you pay $100k into the principal on a house, you will not see that money again until you sell the house. You already have concerns about selling the house, so paying more into it will make that money inaccessible until you are able to sell. Keeping the money in the stock market allows you far greater access to some or all of the funds. If you have a sudden need for $10k, selling a portion of the stock is straighforward, while selling the house or taking a line of credit against the home is not as simple.

One other wrinkle to consider is PMI, which you can typically get removed from your payment once you hit 80% loan-to-value. It may be worth paying off the mortgage down to the 80% LTV amount, in order to get rid of PMI, which can be another 0.5-1% of the loan cost per year. Paying mortgage principal will normally save you just the mortgage interest rate, but paying an amount in order to get rid of PMI will also save you some extra. The guaranteed return is even higher if you are still paying PMI, making investing in the mortgage more attractive.

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    @Fattie Sure you can do that, but is it advisable? With a HELOC, you'll generally be paying a higher interest rate than you had with the mortgage in the first place. Putting $10k into a house and then pulling it out again with a HELOC is necessarily a losing proposition, putting $10k into stock and then selling it is not. Aug 24 '20 at 17:12
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    Hmm; perhaps I misunderstand HELOCs. The only time I mortgaged a property, I got, well, the same interest on the mortgage as mortgages were going for; and it took about 100 seconds since banks slaver over owned property you know. Maybe I'm incorrect or out of date.
    – Fattie
    Aug 24 '20 at 17:22
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    HELOC rates are 2-3% higher than current mortgage rates from what I see, but could just get a mortgage on the paid off house instead of the HELOC.
    – Hart CO
    Aug 25 '20 at 3:46
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    The rate you see is massively dependent on the term of the loan (lower term means higher rate). A HELOC also has the feature that the bank doesn't know what the money is buying (higher risk), or when it will be drawn down (also higher risk), which will equate to a higher interest rate.
    – illustro
    Aug 25 '20 at 11:38
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    @Jammin4CO True, but that's an entirely different question of whether it's best to live in the house, rent it out, or sell it. That decision is entirely independent of whether it makes sense to pay off the mortgage or not. Aug 26 '20 at 14:06
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By paying off the mortgage now you would be taking a "guaranteed" profit now in the form of reduced mortgage interest, but are forgoing uncertain equity investment returns

I'm going to split this answer into sections, because the topic is complicated. First I'll lay out a high level overview of the pros and cons of the options, and what I think you should do (spoiler get proper independent financial advice). Next I'll do my best to analyse each option, and provide what assumptions and simplifications I've made to get that analysis. I'll also, explicitly state what I've ignored in this analysis (primarily taxes).

High level overview

Ultimately it comes down to how much risk you are happy in taking (are you risk seeking, risk neutral or risk averse, and to what extent).

Paying off the mortgage now (or a good chunk of the mortgage) allows you to get a "guaranteed" profit by way of a significant reduction in future interest paid (because of the magic of compounding interest). It's also much less volatile profit, since your interest rate is fixed, so we can calculate with a good amount of certainty what that profit is.

On the other hand, keeping money invested in stocks is riskier, both in terms of the potential volatility of the investment, and because of the lack of certainty over what the actual earned profit will be.

You need to decide what level of risk you are happy with taking. If you continue investing in the stock market, you are taking the risk that your investment is completely wiped out, and you are left with the same mortgage and no investment. On the flip side, by paying off the mortgage early, you are taking the opportunity cost (which is a risk of sorts) of forgoing potentially higher returns from stock market investing.

Quantifying that risk precisely for you would require taking some professional financial advice (beyond asking on a "random site" on the internet), and decisions like this can potentially affect you for a long time to come.

In terms of financial advice, the type of advice I would advocate looking for, is independent, financial planning advice, that you pay a flat fee for (ie not one that has any direct input into what investments you pick, nor one that gets compensated based on the performance of your investments).

This answer is not a substitute for such advice, but should provide you with a starting point for your own research.

Introductory remarks

First off, you are right to be concerned. This is a lot of money you are dealing with, and decisions about it should not be taken lightly. I will also preface all of this by saying, get some professional financial advice on this, given the amount of money in question. Asking "the internet", even a well intentioned section of the internet like this one, is not a substitute for financial advice, though it can help inform what you ask when you are getting that advice.

Mortgage Example Analysis

You haven't mentioned how long is left on your mortgage, but, given the size of it, I'm going to assume ~20 years for the purposes of my calculations. I'm also going to assume that the 212,000 quoted at the top of the answer, was before the 60k was paid off last week (since 247-212 =/= 60). Finally, as you have clarified you are on a fixed rate with no repayment penalty, the analysis below assumes that fixed interest rate for the duration. If any of these assumptions are wrong, please let me know and I can rework the figures.

I'm also going to be rounding figures in my answer

  • If you had paid nothing off of the 212,000 mortgage, and just paid the monthly repayments for the remainder of a 20 year term, the bank would (at an interest rate of 3.675%) make ~86,000 in profit on the mortgage.
  • By paying off 60,000 last week, that profit of the bank has been reduced to ~61,500, saving you ~24,500 over 20 years!
  • If you pay off a further 40,000, the total bank profit on your mortgage (over 20 years) drops to ~45,500, a further saving of ~16,000

So, by paying off the mortgage early in the way you were planning to do, assuming a 20 year remaining term, your "profit" on that 100,000 investment is ~40,500, or 40.5%. You are taking some risks by repaying your mortgage early:

  1. By putting the money into your mortgage, you are turning a liquid asset (cash) into an illiquid one (house equity).
    • If you aren't familiar with liquid vs illiquid assets, a liquid asset is one you can access immediately and use/convert in order to pay for something, an illiquid asset on the other hand, is one that takes some amount of time to release the money for other use.
  2. You are potentially foregoing potentially higher returns in equity (stock) investments (but also not exposing yourself to the downside). This is an opportunity cost.

At the same time, you do get some benefit from this strategy. You own the house after 2-4 years instead of 20, and after those 2-4 years, any monies you were paying towards a mortgage, are instead able to be used for something else (investing or discretionary spending). Just by virtue of not having to pay the mortgage, you have increased your effective income for other uses by 20-40% depending on your circumstances.

Stock Market Example Analysis

Comparing this against investing on the stock market:

  • Investing in the stock market costs money. Fees for investing in anything but an index fund or buying and holding stocks for a long term investment can be 1-2% per annum (usually called an Annual Management Charge or AMC). This AMC is analogous to mortgage interest charges (particularly since it significantly reduces your compounded returns over 20 years).
  • Stock Markets have significant levels of volatility (that is their prices, and thus the value of your investments, can fluctuate quickly, and the declines and increases can be large)
  • Stock Market returns have historically been higher (in aggregate) than your mortgage interest rate (but you have to remember the AMC dramatically reduces your total return due to the magic of compound interest).

Lets make some assumptions, to illustrate the stock market complexities (note this is only an example and the numbers are not a prediction):

  1. Your investments do very well, and you are able to maintain a 7% investment return on the 100,000, over 20 years
  2. You are paying an AMC of 2% of your fund value to participate in this fund
  3. You don't sell the stocks for the full 20 year period, reinvesting any and all profits into the fund
  4. There are no "trading fees" on top of the AMC (there are in most cases, but this makes the illustration easier). If this assumption is incorrect (which it is) then those trading fees (eg Bid/Offer spread, stock purchase fee etc) will further reduce any profits you make.

Making those assumptions:

  • A 7% annual return, before the AMC, would have increased the 100,000 to ~387,000
  • Taking the AMC into account, the value of your initial 100,000 after 20 years is ~265,000 (Yes that "small" 2% AMC results in a drop in value of 122,000!), for a profit of 165,000.

As I mentioned, equity investments are volatile, so we need to look at a couple of other potential interest rates:

  • If instead your investments were to make a still respectible 4% return, then, after taking into account the AMC, your total investment value after 20 years would be ~148,500
  • If your investment did really bad (either because the fund was terrible, or your made bad investment decisions), and it only broke even on it's fund performance, then with the AMC your initial 100,000 investment would be worth ~66,700 (a loss of ~33,300!)

Now obviously, this sort of analysis makes wide, and pretty sweeping assumptions, but it's useful as an illustration of what can happen.

But what about Taxes?

Lastly, any gains you make on your stock market investments are, in most jurisdictions, taxable (that is you will owe tax on the gains you have made), once you liquidate the position. This will further reduce any profits you get from your investment.

On the other side of the fence, paying off your mortgage, makes you a "profit" that isn't taxable (as you simply aren't paying more interest). In certain jurisdictions, you may be able to claim mortgage interest relief (or claims the mortgage interest as a tax deduction), but that is highly location specific. If you are able to claim this relief, then by paying the mortgage off early, you forgo this "income" from the government, which has the effect of reducing the "profit" from the early repayment. From a brief check of the US situation (in which I am not an expert), given this is not your primary residence, you do not qualify for the US relief (but you should verify this yourself).

How both of these (Capital Gains Tax and Mortgage Interest Relief) interact with potential profits is highly dependent on jurisdiction (for example in the UK most capital gains are taxed at 28%, while in the US it varies from 10% - 37% depending on the particular gain, similarly, in the UK Mortgage Interest Relief is only offered on by-to-let mortgages, and only since 2017, while in Ireland, Mortgage Interest Relief is only available to first time buyers who purchased their home prior to 2012, and expires this year).

Both taxes and reliefs can also have specific limits based on your earnings from other sources, which can potentially complicate matters greatly. The effect of taxes and reliefs on your decision is something that you should get specific advice about.

So what next?

Get some proper financial advice. If I were in your situation, this is the sort of information I'd expect from a financial advisor:

  • A 5, 10, 15 & 20 year projection of the two primary options you are considering, including an indication of potential profits (after any fees etc are taken into account)
  • The assumptions required to justify those projections (and an indication of where those assumptions were sourced and how variable they could be)
  • An indication of the variance or volatility of the different options
  • How taxes and reliefs in your jurisdiction affect these options

Here is what I would explicitly not expect to get from them (if they are a truly independent financial planning adviser):

  • Recommendations on any specific investments
  • Any sort of cross selling for other services

But what if the value of my home goes down, am I not just throwing money away if I repay the mortgage early in that situation?

No, the value of your home for sale, and how much you owe, and will need to repay on the mortgage are two separate things. The mortgage is linked to how much your home was worth when you bought it not it's value now. By repaying the mortgage you are reducing your total interest paid for the property. Regardless of how much your property is worth, that amount is a "fixed" (within the bounds of variable interest rates) and known quantity.

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  • Thank you for the detailed analysis. I am on a fixed rate with no pre-payment penalty. Aug 25 '20 at 18:36
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    As far as I know, US taxpayers get a deduction for mortgage interest, so paying off your mortgage effectively is taxable, since you lose the deduction.
    – Mike Scott
    Aug 25 '20 at 20:48
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    This is a great answer, but I think the management fee estimate is way off the mark. A 2% management fee in a stock fund is extremely rare in the U.S. Most passively managed funds charge less than 0.1%, and some are even free. Most actively managed funds charge less than 1%. Aug 26 '20 at 17:19
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    @MikeScott US taxpayers generally get a deduction for mortgage interest for a primary residence, but OP doesn't live there now - that deduction may no longer be available. The ability to roll capital gains into the next house also may not be available depending on how long it takes to sell. Aug 26 '20 at 20:41
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    @jpaugh I'll have a look at doing that, thanks for the feedback.
    – illustro
    Aug 26 '20 at 21:47
2

One option is to pay down half your mortgage, but keep making the same monthly payments into the mortgage. This will shorten your mortgages greatly.

Not having a mortgage can be very good as reducing stress and opening up options. If this is life changing for you, then it may not be worth taking the greater risks of the stock macket.

0

My end goal is to sell the house in next 2-4 years whenever the market is better and buy another one in my area using that money.

If this is your plan, you can do it any time you are prepared to do it and stop trying to time both the housing market and the stock market. If the market is going to be "better" for you as a seller in 2-4 years (something you can't know for sure), and your plan is to turn around and immediately buy a different house in the same area, then you are selling and buying in the same market and any gains you make from selling will be negated when you buy. If you're right about where the real estate market is in your area right now, the opposite is true: you'll get a good deal when you buy but not when you sell. But it's still a wash if you're buying and selling real estate in the same area at the same time.

0

You haven't mentioned if you have an emergency fund. If you don't, I recommend you keep the $40k in low interest CDs or money market - the return is low because you are "parking" the money, not investing it. You're doing this with essentially zero return to insure that you can make the house payments until it sells - if you have a trust fund or parents that could bail you out, you can ignore this paragraph.

In either case, I would advise you to get a new real estate agent when your current contract is up and unload the house instead of renting it.
Houses in the $200-350k price range in my area are selling in under a week. (And yes I mean July-Aug during COVID-19 with virtual showings). Much (but NOT all) of the country is still selling houses and you need another realtor's opinion the same way you'd get a second medical opinion before a major surgery. Buying a house without seeing it in person seems insane to me - but I'm told a couple of my neighbors houses were sold that way.

When thinking about renting, remember that an irresponsible renter can do thousands in damage that you'll need to repair before selling - I know of a case where a cat caused the owner to have to replace the carpeting, and then when the smell wasn't gone... had to pull that carpeting up, replace the subfloor and put down more carpet (almost $10k).
Also, if they stop paying it can take months to evict them. This year there was a rule passed preventing evictions for a period of time no matter the circumstances, it could happen again.

0

I would suggest a third strategy for your consideration. Since you think (with good reason, IMHO) that the market is at a high point, and you have a mortgage at a fairly low interest rate, park the money in some sort of cash/money market investment and wait.

Worst case, you lose maybe 3% per year (difference between money market and what you'd save on mortgage). Best case the market does drop significantly, and you can buy back in at the low price.

-1

The stock market is overvalued right now and highly volatile. It's a trader's market not an investor's market.

I would work on paying the mortgage but keep some cash in reserve in case the market crashes.

Interest rates should be at 0 or virtually 0 for the next couple of years although I would expect them to rise faster if Trump wins than Biden.

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    Can you back up these opinions?
    – user253751
    Aug 27 '20 at 12:59
  • @user- The question is asking for an opinion but regardless the market is overvalued based on market cap to gdp or P/E ratios or anything you want to look at it. I don't think anyone knowledgeable wold dispute that. As far as interest rates, the Fed lowers interest rates when the economy is bad. Again, no one would dispute that. But, Trump has shown a propensity to push for increased rates while the Obama administration (that Biden was a part of) kept rates at virtually zero for the entire 8 years. I don't think it's a stretch to draw the conclusion I did.
    – Savage47
    Aug 28 '20 at 3:16
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    AFAIK, there is no objective "market cap to gdp" or "P/E ratio" which is considered overvalued. You think they are higher than they should be, and that's fair enough. Some other people don't. What makes them wrong and you right?
    – user253751
    Aug 28 '20 at 10:35
  • "I don't think anyone knowledgeable would dispute that" Well, every institutional investor currently invested in the stock market disputes that. Otherwise those people would have sold already, reducing demand, and thus reducing price. Assuming that your opinions are universally held and downplaying contrary opinions is a good way to lose a lot of money in investing. Remember that uncertainty exists. Aug 31 '20 at 12:51
-6

Instantly pay off the mortgage entirely regardless of your trading strategy...

Home equity is better than money in the bank.

Nothing is faster and better for a trader than having a house or two as equity.

You can instantly trade against that equity.

(I believe in the US some brokers will literally just take the house as equity, and give you an instant sort of trade-your-ass-off-HELOC against the paper right?)


Also critically, and IMO, say you decide to trade. If you have to pay for your money (say 2 or 3%) it really focusses the mind. Folks who just trade with cash sitting around treat it like college kids with a plastic card, "found money". Why not bet on Apple? My 100k is just sitting in the bank - buy Apple! Hit the button! If your 100k to trade with is costing you, it really focusses the mind on whether your great trade idea is so great.

Vague typical article on same:

https://www.cnbc.com/2018/01/24/investing-with-borrowed-money-can-win-big--for-some.html

And here's a why-you-shouldn't article

https://seekingalpha.com/article/2109003-tapping-into-home-equity-to-buy-stocks-is-a-very-risky-proposition

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  • I'm surprised by your last paragraph. I'd think on average it's the other way around- I believe generally people are more careless with borrowed money than they are with their own cash.
    – TTT
    Aug 24 '20 at 17:09
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    Borrowing money against home equity costs interest. I don't see the rationale behind taking cash, investing it in the house, then paying interest to extract equity, and finally investing in the stock market. You could have just invested the cash in the first place, without paying to access the equity. This works if the HELOC rate is the same as the mortgage rate, but it's typically higher. Aug 24 '20 at 17:24
  • I mean, every time you short, or merely trade on margin 9say the usual 2:1), you're paying for money.
    – Fattie
    Aug 24 '20 at 17:27
  • but @NuclearWang , say our OP starts this scheme "today". unless they just trade uselessly and ramdomly, they might not even put a trade on for months. over the course of the next year, say, they may only be in some wonderful trade they thought up, for weeks in total.
    – Fattie
    Aug 24 '20 at 17:30
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    Home equity is not always better than money in the bank. The home equity crisis in 2008 proved that. For almost a decade in a number of countries getting equity out of a home was difficult, and significant sums of money were lost on the value of homes for people who bought at the peak.
    – illustro
    Aug 25 '20 at 15:56

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