Continuation from the last article
This is the second in a series of articles on whether you should pay off your home loan early. In the last article, I covered the importance of considering the opportunity cost, tax consequences, and whether you have other debts to consider paying off first. In this article, I will cover specific examples to help illustrate some of these points. However, as I said before, you should consult a financial advisor who knows your situation before making a choice on either paying off your mortgage sooner or not.

The total 30 year cost of your mortgage
Assume you recently refinanced or bought a home with a 30 year fixed payment mortgage of \$100,000. I used \$100,000 for simplicity since the results shown are per \$100,000 loan. If you have a \$200,000 mortgage, simply multiply the numbers by two. If you have a \$500,000 mortgage, simply multiply by five and so forth depending on what your mortgage amount is as compared to \$100,000.

The total amount of money you give the lender over 30 years will be shown below at different mortgage rates. The monthly payment against the loan for each interest rate is also provided for reference. This payment does not include property taxes, insurance, etc. that may be included in the total monthly payment for a house beyond just paying against the mortgage debt.

At 5%, the monthly mortgage payment is \$536.82
At 6%, the monthly mortgage payment is \$599.55
At 7%, the monthly mortgage payment is \$665.30
At 8%, the monthly mortgage payment is \$733.76

The total amount paid over 30 years at different interest rates for a \$100,000 mortgage are:

Year 5% 6% 7% 8%
30 193,254 215,835 239,505 264,150

What would you accumulate by investing the monthly payments instead?
Consider what would happen if you did not get a mortage and took what would have been paid monthly toward accumulating wealth through investments.

If \$536.82 per month were invested instead of used to pay a 5% mortgage, the total 30 year account balance would be:

Year 4% 6% 8% 10%
30 372,580 539,244 800,055 1,213,475

If \$599.55 per month were invested instead of used to pay a 6% mortgage, the total 30 year account balance would be:

Year 4% 6% 8% 10%
30 416,117 602,260 893,545 1,355,276

If \$665.30 per month were invested instead of used to pay a 7% mortgage, the total 30 year account balance would be:

Year 4% 6% 8% 10%
30 461,751 668,304 991,536 1,503,903

If \$733.76 per month were invested instead of used to pay a 8% mortgage, the total 30 year account balance would be:

Year 4% 6% 8% 10%
30 509,266 737,073 1,093,566 1,658,656

How can you have a much larger return from investing than if paying a mortgage for 30 years?
When first looking at the numbers above, it makes no sense that a 4% yearly return on your investment can grow a much larger investment balance than a 5% mortgage would cost over 30 years. In other words, how can a lower rate of return on your investment grow much faster than a higher rate mortgage over 30 years?

Keep in mind that the starting point differs for both. For a mortgage, it starts with a balance due of \$100,000. Each month, only a very small amount of you payment goes toward reducing this balance with the bulk of the payment going toward interest. However, when investing, your entire monthly payment goes toward accumulating more money the next month. You also get the huge benefit of interest compounding as well. Each month interest is paid on the full payment you put in the previous month and on the total balance of the account to date. So, as your balance grows, so does the amount of interest that is paid to you each month. This is the power of compounding growth.

I wrote a four part series that goes into detail on how compounding is a key tool, if not the most important tool, most sophisticated and accredited investors use as part of the wealth building strategy.

When would you have \$100,000 to buy the house with cash instead of with a mortgage?
Consider the fact that consistently investing what would have been paid on a mortgage into investments would allow you to accumulate a balance of \$100,000 very soon. You could then buy the house with cash and still be able to continue investing each month. Here is when you would accumulate \$100,000 balance.

If \$536.82 per month were invested instead of used to pay a 5% mortgage, you would have \$100,000 by:

4% 6% 8% 10%
13 years 11 years 11 years 10 years

If \$599.55 per month were invested instead of used to pay a 6% mortgage, you would have \$100,000 by:

4% 6% 8% 10%
12 years 11 years 10 years 9 years

If \$665.30 per month were invested instead of used to pay a 7% mortgage, you would have \$100,000 by:

4% 6% 8% 10%
11 years 10 years 9 years 9 years

If \$733.76 per month were invested instead of used to pay a 8% mortgage, you would have \$100,000 by:

4% 6% 8% 10%
10 years 9 years 9 years 8 years

Opportunity cost of having a mortgage instead of investing the payments
Opportunity cost is the difference between what would have been earned by investing instead of paying a mortgage. To see what the opportunity cost is over the 30 year period, simply look at the table that shows the total mortgage paid at the different interest rates against what the associated monthly mortgage payment would have grown to had it been invested at a specific rate for 30 years.

For example, consider the 5% mortgage which had a monthly payment of \$536.82. The total you would pay for the mortgage is \$193,254. However, you could have invested that monthly payment instead for 30 years and earned from \$372,580 at a 4% yearly return to \$1,213,475 at a 10% yearly return. The 30 year opportunity cost the difference which ranges from \$372,580 – \$193,254 = \$179,326 to \$1,213,475 – \$193,254 = \$1,020,221. The range shows the significant loss of earnings that would have been realized if the money had been invested instead of spent on the mortgage. Continue this for any of the interest rates and associated monthly payment shown above over the 30 year period. The opportunity loss ranges are even more dramatic.

Consider buying a house with cash from investments
As you read earlier, your investment account could have accumulated a total of \$100,000 on average in about 10 years. If you had saved first to buy the house with cash, then from that point forward you could continue with the same saving plan to again build up your investment account for other purchases or investments. This opens doors for you to continue building your wealth without debt. You will have more options on how and when you want to retire with a paid off house and a growing investment portfolio that would grow to where the yearly returns eventually pay your day-to-day expenses in a short time.

Examples above don’t really consider rent verses owning a home
The above examples don’t take into consideration that you need to pay for some type of housing during the 30 year period of investing if you don’t buy a home with a mortgage. In that case, you would be paying a comparable amount on rent so it could not be invested. However, I wanted to keep it simple and just focus on the opportunity cost of investing verses having a mortgage. Ideally you would have started an investment plan early in your career by renting a cheap place while investing significant amounts monthly into your investment account to where a home could be bought with cash in a few short years.

The above example also do not consider the added benefit of tax deductions on the mortgage interest paid yearly, the capital gains that would be paid selling your investment to pay cash for the house, and other factors for the sake of simplicity. Again, I wanted to keep the focus on the benefits of investing verses getting a loan.

Summary
I don’t want to say that it is best to always pay cash for a home instead of getting a mortgage. I strongly advise working with a qualified financial planner early in your career to look at your long term financial goals. Then divide those goals into a workable plan of action to know what you need to do periodically over time toward reaching those long term goals. However, the information above does show that for some people, building wealth without debt can definitely have significant advantages, especially in today’s environment where credit is bringing down economies around the world. I wrote another series of articles in the past that tells how to get debt free that might also be of interest to you.

I hope these articles help you consider the bigger picture when evaluating a plan of action. Always play out the numbers over time. See what you will gain and what you will lose. Understand why the numbers are what they are. Learn how to use those differences to your advantage.

Next article in the series
The next article continues this series continues this discussion providing several scenarios for payying cash to buy your home. Other future articles in this series will explore scenarios for paying extra each month on your mortgage for faster payoff.

Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
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