Finance Fail: Pay off my home or invest the money?

by JT McGee

Should you pay off your mortgage or invest elsewhere.In the real world there are three things you’re not supposed to talk about: politics, money, and religion. In the personal finance blogosphere, it’s whether or not you should pay down your mortgage or invest the cash instead. There are a million differing viewpoints on the matter, and I truly don’t care which you choose. However, I do wish that you include every possible contingency in your decision.

The fact of the matter is that there are millions of articles about paying off your mortgage vs. investing, but none of them—at least none that I’ve found—have bothered to talk about bankruptcy. Maybe it’s because bankruptcy is somehow impossible if you’re perfect with your personal finances. Not true. Personal finance is too safe that it’s dangerous. I mentioned this in my post “Screw the Emergency Fund, Buy a Home.”

Most people say you should pay down your home mortgage because you’re getting a risk-free return. This is also not true. The only risk-free returns are found in US Treasuries, and only because the Treasury can, at any time, come up with the dollars they need to make good on your Treasury securities. Both home mortgages and US Treasuries are US dollar denominated, assuming you live in the United States, so the risk of a compete dollar collapse is irrelevant.

Why mortgage debt isn’t a risk-free investment

Homes are cheap where I live. They’re horrendously cheap (like, Midwest cheap!) to the point where a newer home in the best areas with one-acre lawns and with great schools don’t top $100 per square foot.

Even still, laws in my state provide for a homestead exemption in chapter 7 and chapter 13 bankruptcy of only $15,000. On a $150,000 home, for example, that means you’re allowed only 10% of it it should you go broke. If you own a $45,000 home, then you’re allowed to keep 33% of the equity, assuming its all paid off. Homes, then, are not risk-free. You can lose by paying off your home because each time you make a payment you:

  1. Own more of the home, and thus have more equity on the line should it fall in value.
  2. Own more of the home beyond bankruptcy shelters.

(For a overview of the economic dynamics of the US real estate market, see the post on home price trends.)

If the price of real estate falls and you own the majority of your home, then the loss is all yours. If the price of real estate rises and you own the minority of your home, you have as much upside as the same person who owns a majority, or all, of their home equity.

Put it simply: the more you own of your home, the more downside risk you take on for virtually zero gain.

More importantly, if you cannot pay for any reason–injury, serious long-term disability, financial hardship–you can walk away from a home and no one can force you to use your retirement assets to pay for it. It’s the way the law works.

Why you should invest the money

You should be investing the cash because the laws are telling you to do it. Whereas I get to keep $15,000 of my home equity in bankruptcy, I get to keep 100% of my 401k and IRA assets in bankruptcy.

This completely erases the argument that securities are riskier than your own mortgage because it ignores absolute failure in your life while including the possibility for absolute failure of the financial markets. If your home plummets, whatever you have in it minus the bankruptcy exemption is gone…immediately. It isn’t protected.

And hey, I know I’ll hear plenty about this but home mortgages are a two way street. You can either pay back the money, or give up the home. The Fed’s monetary policy is mostly centered around keeping rates low for this reason. They don’t want any more people walking away from a mortgage.

If you’re underwater significantly, give up the home.

Comparing and contrasting

Paying off your mortgage with cheap money doesn't make sense

How to make the most of a mortgage:

 

Never own more than 20% of my home –  If I’m protected only to $15,000, and PMI is gone after 20%, it doesn’t make sense to own more of it. Every time rates plummet, you can extract on the equity you’ve built up for further investment elsewhere, preferably one that is a bankruptcy shelter.

Never complain about bailouts –   I wasn’t keen on bailout out Wall Street, but hey, their money is worth more than my vote—I can’t do anything about it.  That said, I can’t really complain, since I’m getting a fat bailout in the form of retirement asset protection and cheap money from a home loan.

Always max out, if possible – If you aren’t yet maxing out on a 401k and IRA, then you shouldn’t be paying down your home mortgage, plain and simple. Again, Treasury ETFs through a 401k or IRA are risk-free, your home mortgage isn’t. Not that I’d advocate buying Treasury ETFs, but the reality is that there is a safehaven for you to put your cash in a 401k/IRA.

Always understand basic risk management – The spread between a 30-year fixed mortgage and a 30-year Treasury bond is roughly .3% for credit-worthy borrowers. That’s a small loss, one easily erased by the tax benefits of paying mortgage interest, and even if not erased it basically means that Wall Street thinks an individual borrower is .3% per year more risky than the US Treasury.  That’s silly, really.

Readers: Am I wrong? Notice any errors in my thinking? Do you pay off your mortgage early, or do you instead invest the money? Both? I’d like your input!

{ 32 comments… read them below or add one }

tom May 12, 2011 at 13:55

I guess I do not follow your bankruptcy argument.

If you fall into bankruptcy, why should you keep anything, but $15K of your home value? You owe money and that money is in your equity. If I were a creditor, I would be after your equity also.

So, your home buying strategy is to put 20% down, then get an interest only loan?

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JT McGee May 12, 2011 at 14:01

Bankruptcy means your home equity is gone. In bankruptcy, your IRA/401k assets cannot be taken.

So, if you’re investing in a home at 4.5% per year “risk-free,” then you’re still open to losing every dime of that money. If you’re investing in 30-year Treasuries at 4.3% via a 401k, IRA, you can’t lose any to bankruptcy. In either case, paying down a home or investing, you still live in the home, and the upside (if any) is still yours.

My home buying strategy is to purchase one, but suck equity out of it whenever possible to do so cheaply. Interest only loans are usually written as adjustable-rate; I’d want a fixed rate mortgage.

Government underwrites risk in personal finance. Make use of it.

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tom May 12, 2011 at 14:13

You’re talking retirement investments as bankruptcy protection…

Most of the mortgage vs. investment debates assume maxing out IRA and 401(k), then deciding whether or not to invest or pay off the mortgage. I think it’s popular opinion to first max out then decide.

By narrowing the scope of the debate, would you change your answer?

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JT McGee May 12, 2011 at 14:26

I’m saying that the risk-adjusted return on Treasuries through a retirement account is far safer than the risk-adjusted return on paying down your home mortgage debt.

If we change the scope of the argument, then yes, I probably would. However, there doesn’t seem to be any shortage of people who advocate paying off a mortgage even as their BK-protected accounts aren’t maxed out.

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tom May 12, 2011 at 15:30

I agree with that, treasuries would be safer. The scope of your argument threw me for a loop.

I also agree that bankruptcy laws are bailouts for Americans.

It’s ridiculous to me that you can run up debt, buy expensive houses and cars, then turn around and declare bankruptcy and pay off next to nothing (exaggerating for effect).

It’s also extremely hypocritical for anyone to be up in arms about corporate bailouts and not be up in arms about tax and bankruptcy laws.

JT McGee May 13, 2011 at 00:06

Yeah, my bad, tom.

I need to go back to the whole make a post and then have someone else read it before I post it. I can read through the most sporadic thoughts and know exactly what I mean, but I know it doesn’t make much sense to anyone else. Quality control from here on out…I’ve been getting lazy.

I totally agree with you on BK, though. I’m actually starting to worry that once my generation starts to vote that even student loan debt will become BKable again. Oh man…

tom May 13, 2011 at 08:10

You bring up an interesting point regarding student loans. I’m wondering if that can’t be mitigated by the younger voters slowly forcing higher education funding changes through Congress.

Without getting to deep into politics, Gen Y is going to make up 25% of the US population, so we have the numbers to force change.

Invest It Wisely May 12, 2011 at 14:10

You guys have fixed-rate mortgages for 30 years which I’m not sure exists anywhere else and certainly doesn’t exist in Canada. Therefore if you’re looking for financial independence there is a case to be made for paying down the mortgage especially if you believe that interest rates will rise.

If you’re not in a rush to pay down the debt then I agree with the 20% rule.

As for the treasuries, they are only risk free in a nominal, face value sense. They’re not risk free in a real, opportunity cost sense.

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JT McGee May 12, 2011 at 14:30

Definitely on the fixed-rate mortgage. The fixed rate is the necessity to this plan.

It was a relative comparison between Treasuries and your fixed-rate mortgage note. If you can borrow for a home at 4.7% when US Treasuries are paying 4.5%, then you lose .2% per year BUT your assets are entirely secure, sheltered from the whims of the real estate market entirely, and from every possible personal finance blow up. That is, like purchasing synthesized credit default swaps for yourself at .2% per year.

If you opt for riskier assets, which I think you should, then you’re sitting pretty on other people’s money.

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Ashley @ Money Talks May 12, 2011 at 14:24

I certainly want my mortgage paid off before my husband retires in 20 years. (should be on track to do that without a problem)

I would rent my house out before I included it in a bankruptcy. I can rent it for at least the costs right now, and over time that should only improve.

I pay extra to my mortgages, both my primary home and my rental property. Shoot me!

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JT McGee May 12, 2011 at 14:41

I’m assuming you have a decent rate on both mortgages; so, I can understand that you would pay it off, I just…don’t really understand.

My whole point is that it makes sense to leverage up like a moron because you can’t lose when you’re using other people’s money. Main Street is just as “bad” as Wall Street, it’s just that Main Street doesn’t like to take risks and Wall Street does. Then Main Street complains about it, even when they have the same opportunities right in front of them but don’t make use of it.

Maybe I’m just too much of a gambler :P

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Ashley @ Money Talks May 15, 2011 at 11:55

It’s not about returns, its about the security of my family. The rental property I’ll give you, that’s just money. It’s worth taking some risks on. But my children’s home? It would be irresponsible to put my kid’s bedrooms in the stock market. To make my family move, change schools, make all new friends, get settled in another place all because I wanted to make a few more percentage points on my money. That seems wrong.

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JT McGee May 15, 2011 at 12:24

Hmm, that makes sense.

I guess that’s the fun of personal finance; as some point it’s all about how finance relates to you. All things considered, I’ll probably maintain very little ownership of even my first home, pending I can accumulate enough in a Roth IRA that would allow me to withdraw my original investment without taxes to cover the home. Again, though, I am a natural gambler. :P

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Ashley @ Money Talks May 15, 2011 at 17:57

It’s totally different when you don’t have a family. If you are single person, or even married couple, moving is just logistics. When you have kids who are settled and happy in their home it’s a different thing.

JT McGee May 15, 2011 at 19:55

Well, sure–calculators don’t have a “wife” and “2 kids” button, so it’s difficult to quantify.

The only way to put that into consideration is to say how much money would be considered fair value for compensating you for the cost to deal with the logistics and happiness. If someone came to your house tomorrow and offered you twice the market value for your home or twice your purchase price, whichever is greater, would you not deal with the hassle of moving?

Everything has a price. If we decide that we can’t provide a price for something, then the laws of finance and economics cease to be important, at which point this article is worthless for both you and me and the thesis is irrelevant.

Travis@TradeTechSports May 12, 2011 at 16:08

In places like California, I dont think its realistic to only owe 20% on your house. Also, for simple numbers, if you think you house is going to appreciate the same or more than say your stock portfolio over a given amount of time, put it in the house, you get the percentage increase as well as the tax deduction.

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JT McGee May 13, 2011 at 00:03

Should you own more or less?

How do you get a tax deduction by paying down the principal?

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Jonathan Harms May 12, 2011 at 17:04

Paying down the mortgage aggressively vs. Retirement investment.

I am not so sure that a home’s value is subject to the magic of compound interest like retirement funds are. A home’s value is reflective of market inflation values but, is it a relevent point to say that for ever dollar over paid on the mortgage is a dollar you can’t put into retirement savings.

My mortgage dollar will increase in value at a rate of house market inflation, but my retirement dollar has compound interest on it’s side when I invest it for retirement. Compound interest is more valuable to me than a house’s value going up 4% each year. Besides, I think my retirement investing can return more than 4% a year anyway.

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JT McGee May 13, 2011 at 00:04

I think so too, that’s why I say leverage up to the moon.

Actually, on Monday I posted about a particular P&C Insurance stock and how buying it was essentially the same as buying Treasuries at a discount. Lovin’ it!

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No Debt MBA May 13, 2011 at 15:34

I didn’t realize that retirement assets were protected during bankruptcy. Is that true in all states or does it vary? I think the treatment of your residence varies by state, right?

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JT McGee May 14, 2011 at 11:08

I’m not sure if they are. The supreme court recently upheld a case where they would be protected, at least Federally, but since this hasn’t been upheld on the state level (Supremacy clause should mean it would be) I wouldn’t bet on the courts to automatically accept the decision.

Generally speaking, 401ks are protected more than IRAs, since 401ks are considered pension programs, which have a longer history of court decisions. In some states they’re protected to $1 million, and in some states they have limitless protection. A quick Google search for your state should give you some kind of idea.

I am not a lawyer, and this is not legal advice

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No Debt MBA May 15, 2011 at 07:39

Interesting. I would imagine that as a country we would want to move towards standardization on bankruptcy issues.A company could have branches and people paying into their 401ks in many states and the assets could be treated differently in each state. Makes the HR department’s job difficult.

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JT McGee May 15, 2011 at 12:21

Yeah, it’s the whole state’s rights thing. I largely agree that we need simplification of the tax and regulatory environment, but I’m glad that we have left some of it to the states in order to afford SOME localized control. Then again,it does make things difficult for HR, as you mention, and also for people who move across state borders and those who live near a border.

Sometimes finding common ground is just as hard as finding a solution, it seems.

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Angry Voter May 16, 2011 at 05:41

In your article you say the IRA limit is $5,500 which is incorrect.

The IRA contribution limit is $5,000 if you’re under 50 and $6,000 if you’re over 50.

http://www.irs.gov/retirement/article/0,,id=202510,00.html

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JT McGee May 16, 2011 at 09:13

Now corrected. Thanks.

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Norman May 17, 2011 at 14:32

Not paying your mortgage early is a good plan for someone your age. Totally agree with everything you state. However, there is a time in one’s life when its time to pay off the mortgage. This is the stage of life that I am. As I contemplate retirement within the next 10 years, my mortgage will definitely be PAID IN FULL before I retire.

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JT McGee May 17, 2011 at 14:48

Absolutely!

That’s one of the problems melding an institutional finance approach to personal finance; institutional finance relies on the understanding that forever exists, and forever definitely doesn’t bode well with our human existence. Though I haven’t given much thought to asset allocation and investing when I near retirement–pfft, I don’t even know what I’ll be having for dinner tonight–I know that even risk-adjusted returns stop making sense once you reach a point where a “relative forever” doesn’t exist any longer. The last thing I want to do is go broke in retirement, though I hardly have any fear of going broke right now.

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Mortgage Nerd May 22, 2011 at 21:56

It’s a good argument. Honestly I think I change my opinion every day on this topic. Some days I feel like putting everything I can to the mortgage just so that I can be done with debt. Other days I am worried about our retirement accounts. The only thing I do know is this… First, pay off high interest debts, save for a rainy day fund, and max out the 401K contribution. If there is any money left over after those things than I think people should just apply it to whatever helps them sleep better at night.

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JT McGee May 23, 2011 at 20:47

Sounds like a pretty reasonable plan. I know what you mean on going back and forth on things. It has all to do with an investor’s worst friend: recency.

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Sandy - yesiamcheap August 4, 2011 at 09:31

The whole mortgage risk thing can be mitigated by simply saving the money and the buying the home in cash or investing the money and using your returns to pay for the home. America is one of the only places where a 30 year mortgage is standard.

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JT McGee August 4, 2011 at 09:34

Yes, but I guess what I’m getting to is why pay it off at all if you can borrow against it then legally hide it? We are the only country with a 30 year mortgage, and I think it rocks from a micro view.

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PKamp3 October 15, 2011 at 12:30

JT, get out of my head!

This article is even more important with mortgage rates near all time lows (last week was lower). There are two places where consumers ignore a very interesting tax law as it relates to long term debt – student loans and mortgages. Now, student loan deductions phase out at a much lower income, so for the majority of Americans mortgage debt is the cheapest debt they can find. Take your rate, 4.25% or whatever, and deduct any interest you paid that year… in high tax states you are already likely itemizing so it’s all gravy.

Here’s my point: if you have a career in front of you, why pay it off? I’ve got an article in the works about the narrowing spread of mortgage rates and inflation, but here’s the point: you’re currently borrowing at rates (including the deduction) that approach the market’s expectation of inflation over the next 30 years. Inflation is good for a debtor (see: America, United States of).

The best arguments for paying off a mortgage are of a personal nature, especially the loss of income (childbirth, retirement, sickness/injury). Financially, holding onto the cheap debt isn’t such a bad option. However, YMMV, and the math changes when you don’t have a whole career in front of you.

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