3009: When to Prepay Your Mortgage Instead of Investing by Chris of Keep Thrifty on Financial Risk Tolerance

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[00:00:50] This is Optimal Finance Daily. When to Prepay Your Mortgage Instead of Investing by Chris of Keepthrifty.com. We had a toast-worthy moment last week. Our outstanding mortgage balance finally came under the $100,000 mark. We're officially in a five-digit mortgage. Much of our momentum on paying the mortgage down can be attributed to the prepayments we've made, and we're officially in a five-digit mortgage. that's going to be introduced to $10,000 worth of money on MCOs.

[00:01:20] A reflect on the trips and masculin income. We played a nicequal amount on compliment. We'reround a few months in two weeks. We've had a lot of commitment for us to do as far from our financial mortgage to zero, roughly 17 years ahead of our original mortgage term. I've posted frequently on mortgages in the past, and I often get the following question. If you've got a 15-year mortgage at 2.75%, why would you prepay instead of just investing that money in the market? You're pretty much guaranteed to make a better return.

[00:01:48] A good index fund usually gives 8% a year. Given the big milestone in our financial freedom journey, I thought this would be a great time to celebrate our progress with a detailed answer to that question. The math. The first thing to tackle in this question is what the math says about the return rate. The biggest difference between prepaying and investing is a guaranteed return with prepaying

[00:02:15] versus a volatile return with investing. I know that if I prepay the mortgage, that I'm going to get a 2.75% return rate on every dollar I put in. Putting a dollar in the stock market today, however, could yield pretty wildly varying results depending on the amount of time I'm investing over. How can you profile what you're likely to get in returns to figure this out? My approach. Replay the market.

[00:02:46] While past performance of the market is not a perfect predictor of future performance, you can certainly use historic stock market data to get a sense for how the market behaves in general over different spans of time. With our current mortgage balance and the $1,000 per month prepayments we have planned out for the future, we expect to pay off the last $98,000 of our mortgage in 54 months. That's just four and a half years.

[00:03:15] To see what this would look like if we invested that $1,000 instead, I created a spreadsheet that models out performance of investing $1,000 a month for every 54-month period from 1871 to the present. In other words, I can tell you from the sheet what $1,000 per month invested from January of 1871 through June of 1875 would turn into,

[00:03:41] what February 1871 through July 1875 would be, and so on all the way through the period of September 2011 through March of 2016. Just to make it fun, I even put in taxes on short-term and long-term capital gains and losses where applicable. By putting all the scenarios together, I can pose the question this way. If the next 54 months of the stock market

[00:04:09] behaves like one of the other 54-month periods in history, what are my possible outcomes? How likely am I to be better off investing versus prepaying? Pretty awesome, right? Okay, yes, I'm a huge nerd. Interpreting the results. Based on playing out the scenarios, I ended up with a pretty fancy chart. The x-axis shows the different possible outcomes if I invest.

[00:04:39] If the number's positive, that means investing was the better call by that amount. If it's negative, it means that prepaying was the better call by that amount. The results are pretty interesting. The best case scenario for investing is that I can pay off the rest of the mortgage after 54 months and have an extra $55,000. Um, yes, please. The worst case scenario for investing is that I fall $33,000 short

[00:05:08] of paying off my mortgage after 54 months. Yuck. If I were to invest, I've got a 50% shot of being able to pay off the mortgage and have at least an extra $7,000. But here's the big one. Investing was better than prepaying in 76.6% of the scenarios. Wait, what? Wasn't this supposed to be a post about why I'm prepaying instead of investing? I just told you investing is better

[00:05:38] over three quarters of the time. You can probably guess by the fact that I haven't changed the title to this post that I'm sticking to my guns on prepaying. Why? The mentality. For my personality, the analysis above does a great job of showing the numbers in absolute terms. But there's a relative value of these scenarios that only you can assess based on your personal risk profile. Let me try to explain with an example.

[00:06:07] Let's make a bet. We've each got a 50-50 shot of winning. If I win, you give me $33,000. If you win, I give you $55,000. Would you take that bet? It's certainly a better deal for you than me. But are you really ready to shell out $33,000 if you lose? You'd probably take it if the stakes were $0.33 and $0.55 instead. Why?

[00:06:35] The relative downside of losing is pretty low. You can part with $0.33 and not bat an eye. But $33,000? To me and many others, that feels life-altering. For my risk profile, the relative downside or pain of losing $33,000 is more impactful than the relative upside or gain of getting $55,000. Based on that, I wouldn't take either side of that bet.

[00:07:04] Back to the mortgage example. It's a bit more complex. We don't just have two possible outcomes. We have a ton, ranging from big losses to big gains and everything in between. When I look at the numbers and consider the relative downside and how much I'd be kicking myself if I ended up $5,000 or more worse off, prepayment feels like the better option. As much as we think that everything can be handled by logic and math, much of investing

[00:07:33] is about your personality and how you'd react to the different scenarios. Is prepaying right for you? Prepaying your mortgage, like most investment strategies, is largely a question of risk tolerance. You've got to decide what downsides you're willing to risk in order to have a shot at the upsides. If you like rolling the dice or just have a lot of money already, investing certainly has an upside. That said,

[00:08:02] don't assume that the 8% return of the market is a sure thing. Over shorter periods of time, it can vary quite a bit. Before you make any major financial decision, do the math and know your mentality. You just listened to the post titled, When to Pre-Pay Your Mortgage Instead of Investing by Chris of KeepThrifty.com. You sign up for something, forget about it

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[00:09:28] That's rocketmoney.com slash OFD. Rocketmoney.com slash OFD. This article highlights the age-old question, should I invest or pay off my mortgage? This continues to be an ongoing debate because the answer is going to be unique to your preferences and circumstances. If the interest rate on your mortgage is less than 5%, you'll likely make a higher return on interest from investments

[00:09:57] than the money you would save in interest by aggressively paying off your mortgage. And while I do think Chris makes a compelling argument here, the trouble I'm having with his logic is that he's looking at investing over a short period of time and I'm a long-term investor. However, many people feel peace of mind by owning their house outright, especially if it's the home they plan to be in when they retire. I personally have chosen not to pay off my mortgage early

[00:10:26] for a number of reasons. Firstly, I don't look at my primary residence as an investment and I don't want my money held up in a tangible asset. I prefer the liquidity of stocks. The argument for peace of mind in being mortgage-free doesn't appeal to me because my mortgage is $600 per month. So this is an expense that's easily met, especially because I don't have a car payment or any other debt. If you have a high monthly mortgage,

[00:10:55] I can see the peace of mind of not having a mortgage being more attractive. I also don't know how long I'll live in this house, but I do plan to keep it and rent it out after I move on. So why not let the tenants pay the mortgage? I like the advice from my friend Frank Vasquez over at Risk Parity Radio who recommends to not have more than 10 to 20% of your net worth in your residence so that you can put the bulk of your money into income-producing assets.

[00:11:25] This debate also makes me think of an OFD listener who reached out to me asking if I thought she had enough money to retire early. While she had over a million dollars, a large majority of that was in her house, so she couldn't really live off that in retirement unless she sold the house. And that's a wrap for another show. I'll be back tomorrow where your optimal life awaits. Thanks. Thanks. Thanks. Thanks. Thank you.