It’s common sense, but I’m an idiot

It’s common sense, but I’m an idiot

My wife and I bought a house this last summer, and we opted not to put 20% down because well I’m not sure we had exactly 20% to put down and the interest rates we so low that I figured I would be better off investing the extra money rather than putting more money down on the house. Well this discussion (paying off mortgage vs. investing) gets debated all the time. Some people argue you should pay off the mortgage as fast as you can because it’s a guaranteed return on your money and you have that sense of security when your house is paid off and you don’t have that payment hanging over your head every month. Other people say your mortgage rate is probably only 5-8% and those payments are tax deductible so you’re likely really only paying in 3-6% and you can certainly do better than 3-6% in the stock market, so you are better off investing the money. Really in many cases its personal preference, and me being the young optimistic investor that I am decided that I was going to go the investing route vs. paying off the mortgage.

Well my main mortgage is locked in at 5.625% for 30 years. We only put 10% down at closing and took out another 10% Home Equity Line of Credit (HELOC). This was originally 5.75% but that was just an intro rate and it jumped up to something like 7% after the first few months. Well the Federal Reserve keeps raising interest rates and I’m now paying 7.75% on my HELOC (I believe that’s prime + .5%). Regardless I was always making the minimum payment on my mortgage and my HELOC, because I was a smart investor and could run the numbers and knew I could get more money in the stock market.

Now just recently I realized I am an idiot. Sure my theory of paying off my mortgage/HELOC as slow as possible and investing the difference works in theory. Only problem is I wasn’t investing the money in the stock market, I was storing up my extra cash in my ING Direct account earning 3.8%. Now it sure feels good to see that monthly statement from ING and see how much money I made in interest, but it didn’t dawn on me until last week that I was shooting myself in the foot.

I think as investors we tend to overlook the negative things and only focus on the positives. We overlook things like annual fees, trading costs, taxes, poor investment choices, etc. Instead we concentrate on our successes, like the stock we blindly picked that went up 75% in the first year, the fact that our mortgage/HELOC is tax deductible, or the hundreds of dollars in interest you were making each year in your ING account. Now granted the huge increase in interest I was earning at ING versus the normal bank surely was something to brag about, but when I finally realized that every dollar that I have in my ING account is another dollar that my bank is charging me for my HELOC it paints a different picture. Maybe I wasn’t as smart as I thought I was.

Well despite all the debating that is done in investing vs. paying off debt, it’s really a very simple common sense math equation to give you a yes or no answer. In this case it’s just as simple as:

Rate of Debt x (1 – Tax Rate) vs. Rate of Interest on investment x (1-TaxRate)
**note: the debt part of the equation is only for tax deductible debt such as HELOC/Mortgage/Student Loans, for normal debt such as credit card debt you would not multiply it by (1-Tax Rate)

So in my Case
Cost of HELOC: 7.75% x (1-.15) = 6.5875% vs. Return at ING: 3.8 x (1-.15) = 3.23%

So every dollar that was in my ING account not being used for anything was actually costing me 3.3575% or over twice the return I am getting in my ING account.

This is a perfect example of why you can’t just listen to the guy who sounds the smartest in a debate on a financial matter. You must look at your specific situation and run the numbers for yourself to find out what truly is best for you.

Just to show you that it’s not always right or wrong to pay off debt or invest, I’ll show you another example with my student loans that will paint a different picture.

Fixed Student Loan Rate: 2.53% x (1-.15) = 2.1505% vs. ING Savings: 3.8 x (1-.15) = 3.23%

In this example every extra dollar that I pay on my student loans costs me roughly 1.08%. Now if it was deciding between paying off student loans vs. investing in the stock market long term it would be an even greater disparity. Essentially I’d be an idiot to pay off my student loans early.

Anyway to my point here – Most financial decisions are relatively straight forward if you sit down and do some simple math, you can’t just rely on anyone else’s advice/opinion.

Going forward I plan on draining my ING account and using every spare penny that I have to pay off my HELOC. I can also write checks from my HELOC so I don’t have to be too concerned about putting too much money into my HELOC and not being able to pay my bills or have money to contribute to my IRAs in 2007. Essentially my HELOC will be my “savings storage” and if I need to withdraw money from the account I will just write out a check from my HELOC (once I get a replacement checkbook to replace the original one I shredded and threw away because I never thought I would use it).

  • 20BigOnes

    The argument over mortgage rates being 5-8% and paying 3-6% after taxes is a moot point. Any gains you earn in a non-qualified account (assuming Roth IRA is maxed) will also have taxation. I believe you would want to compare mortgage rates to gains you can make, without the tax comparison put in.

  • My Financial Journey

    A very valid point, I agree that taxes can cancel themselves out in certain scenarios such as tax deducation from mortgage and taxes owed on a short-term capital gain.

    However there are many other scenarios. If you have debt (mortgage, HELOC, student loans) or investment returns (IRA, 401K) that are tax advantaged you would need to take into account the tax scenarios if one side of your equation had a tax advantage and one did not.

    I essentially designed the equation that way because it will work for all cases. If taxes are involved in both sides they cancel each other out (valid point – but equation still works), if taxes are not a consideration they can be put at 0, and in cases where on side has a tax advantage and the other does not the equation will weight that side appropriatly. Also tax rates could be different if for example your HELOC would be a tax deduction at your tax rate, where a long-term capital gain on an investment could be at a lower rate.

    However as you pointed out in my example when comparing HELOC to ING account the taxes are not a consideration.

    Thanks for the comment!

  • Jmass

    Not putting a large downpayment on your house can lead to a higher rate of return on the sale of the house for a gain (if the sale occurs before the mortgage is fully paid off) since you will receive an equivilent gain with less capital invested.

  • My Financial Journey

    Jmass –

    Agreed as long as the HELOC rate is reasonable. At same time any money not earning at least my HELOC rate after taxes is not being used to its full efficiency.

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