Is it irrational to make principal payments on a mortgage?

Question

Since historic stock returns are greater than after-tax mortgage rates, why ever pay principal on a mortgage?

Perhaps risk-averse investors might want to pay off their mortgage. However, shouldn't young investors (who can tolerate some risk) avoid paying down principal on their mortgage?

Shouldn't young investors take an interest-only mortgage and put all their savings into the stock market?

If so, why does everyone seem to believe that building home equity is a good thing? Building home equity seems like a bad idea to me because paid off principal earns no return and also you lose some mortgage-interest tax deduction.

Answer 1

Because the ability to save $1,000 EACH MONTH is very enticing.....us little people dream of having 90% of our income go where WE WANT IT TO GO.......

Once my home is secured......I'd love to invest......but not while carrying a huge mortgage and monthly payment.....

With NO monthly mortgage payment......we could actually do what we want for a living....not what pays the most.....very enticing......

Answer 2

I think it's about the level of security that people feel comfortable with. Some people don't like to take risks with thier money and prefer something more stable.
You can also borrow against the equity in your home if you need to, so the more equity you have, the more borrowing power you have. You are wrong about one thing though, Paid off principle does earn a return. Housing values have been going up every year and they typically outpace the inflation rate.

You do have a point however and I think that it's the same old addage, diversify! People do need to view thier home as part of thier investment portfolio. Would you put 80% of your investment into a fixed income security at the age of 30 or even 40? IF you did your advisor would tell you that you are being too conservative. If you are still young, instead of making an extra principle payment on your house it may be better to take some or all of that money and make an extra contribution to your IRA or 401K if you can.

Answer 3

It's an interesting question, but often the 'interest only' payment isn't terribly less than the entire principle and interest payment. The first five years of a mortgage are almost all interest anyway. If you look at a 30 year ammortization schedule, you'll see that the amount of the payment that goes toward principle increases every year. If you simply pay interest, your payment stays the same and you have zero equity.

There is validity to your points certainly. Even someone who hovers paying interest only will likely gain equity simply due to increasing real-estate prices. A $200,000 house, after 30 years, may be worth $500,000. Even if you still owe the original principle there is a large chunk of equity. Then you have to consider things like TVM and inflation.

It's a very complicated decision, but personally, I think the smartest investment anyone can make is real-estate, and specifically a home.

Answer 4

I know what you mean. I've tried to convince people to pay down their 18% credit cards before making additional mortgage payments... with no luck! All I do now is mention maff class when I stumble accross illogical decisions like that.

A few exceptions might be:

1) The house was bought during the real estate boom and is in danger of losing value in a price decline. The owner will have to have enough equity to hold the property - or lose it.

2) If you have less than 20% equity, your deal might slightly suck. I'm sure that 18% credit card is nailing you harder, though.

3) Savings on paying down a mortgage are assured, while money invested in stocks is not. If 15% government bonds become available any time soon, I would definitely trade equity for that, but stocks? Maybe BRK... err naaaaah....

Answer 5

Let me take a stab at this. You want your house payment to not be burden if something happens to you and your source of income. Also, if you get your payment so that a somewhat appreciable portion actually goes to equity rather than everything else that is a real plus. Can you imagine how much you can sock away if you did not have a house payment?
The principal that you pay on your house does draw some appreciation most of the time and in some markets it can be appreciable so home ownership is a real plus. A 150,000 home appreciating at 4% goes up 6k a year. Some of this also depends on your income tax bracket and if you can itemize. The interest is itemized and can save you 35% if you are in a higher bracket. The capitol gains on an investment you also may be paying 35% in taxes on it.
Then you have the whole scenario that your home interest should be the lowest interest rate you are paying. So if you do not have credit card, car loan, etc interest then pay off some of the home principal. Get as short of a loan as you can easily afford. Try to get the home loan paid off about 5-8 years before you retire so you can do some real saving. Another thing is to be really aware of what is going on in Wall St. If it is going up like a rocket(pre 2000) maybe get a home equity loan and buy stock. But you have to be aware enough to know when to get out.
The best advice I can give you is to make sure you pay yourself and diversify enough so that you never get hurt too bad. It is like Cramer says on CNBC, "Bulls make money, Bears make money, Hogs get slaughtered."
I have done the home equity loan trick and made good money in the short term. I also borrowed on margin to buy a stock that I made good money on only to be nailed by Black Friday.
The only other kernal of advice I can give you is to get rid of every broker you have and do your own research and planning. Make it so that the only person making money off what you do is you. Brokers only make money when you BUY OR SELL.
Good luck!

Answer 6

OK. Lets start the the tax deduction myth. If you pay $10,000 in interest this year, your taxable income get reduced by $2500, assuming a 25% tax rate. Not a fair trade.

Interest only... why not just pay rent and avoid the maintenance.

Answer 7

The money you put on the principle stays essentially your money. The money you pay on the interest is the bank's. You will always have to pay the montly interest amount (or lose your home), but the more you put on the principle the more you are paying to yourself.

Answer 8

I have battled that question with myself. I like to invest and know that I get a good return (well not in 2000), but when I paid off my house it was mine, and I didn't have to worry about it any more.

Answer 9

That's an excellent observation, so I think you already have the answer to your question. Most people don't think though and live their lives like a flock of sheep.