OMDG asks:

We've recently purchased a house — yay! I'd always planned on paying it down quickly, but I've recently heard advice that given the low interest rate on our mortgage, we would be better off putting the $ in an index fund, since the gains in the market are expected to be higher than we would have to pay in extra interest if we were to pay off our mortgage early. However… as with all things, whether this is good advice depends on the trajectory of the stock market remaining as it has been for the past several years. In the absence of perfect information and me being a risk averse person, I decided instead to split the difference, i.e. half my extra $ to principal on the mortgage, and half in an index fund. I should also add that we are maxing out our 529 and our tax advantaged retirement savings already. Does this seem like a reasonable approach? What would you do differently?

Disclaimer:  We are not professionals.  Talk to a certified no-fee financial planner or do your own research before making any major money decisions.  (We could be totally wrong!)

Congratulations on your purchase!

We know a little bit more than when we last tackled this question.

If your interest rate is in the 2-4% range, it is unlikely that the stock market will be less than that over the period of the 15 or 30 years that your mortgage will last, even with risk adjustments etc.  Even if you're planning on only being in the market for a very short term, the stock market is likely to come ahead when there are really low interest rates.

Currently inflation is high, but not for reasons that make sense in terms of interest rates.  Inflation is high now because of supply shortages.  Still, the federal reserve board sounds like it will be increasing interest rates in the spring, which should cool down the stock market some, but also make your bank money worth more.  It is quite possible that interest rates could continue going up sometime in the next 15-30 years to the point where putting your money in a CD could net more than pre-paying your mortgage if you have a low interest rate loan.

If your interest rate is above 5%, then it makes more sense to pre-pay the mortgage because when you risk adjust things, the stock market isn't likely to do as well as paying down the mortgage.

Mortgage companies can also provide some protection against insane HOA if you ever get into a bad situation where the HOA wants to take your house.

It is also really important to note that OMDG is maxing out their 529 and our tax advantaged retirement savings-- you can always pre-pay a mortgage, but you get a limited amount of space for tax-advantaged retirement savings each year.  If I could go back, I would max out both our 457s back when we had them and not put any of that money in mortgage pre-payments or 529s.  (Being honest, I would probably still round up the mortgage payment to a round number for irrational psychological reasons, but that was never a huge sum.)

That said, there are some other things that could make it more attractive to pre-pay the mortgage.

  1.  Early pre-payments are worth more than later pre-payments because of how mortgages are structured.  They are not revolving debt.  You're basically paying mostly interest with your regular payments at the beginning of the loan and mostly principal at the end of the loan.  Any pre-payments go directly to principal which can cut quite a bit out at the beginning.  I really like this GRS amortization spreadsheet for calculating what effect pre-payments will have on the lifetime of your loan.
  2. If you are expecting to get any sort of financial aid from colleges, it can make sense to turn taxable assets (like taxable stocks, but NOT retirement stocks) into home equity because they assume you will sell stocks to pay for college but not that you will sell your house.  That is, home equity is not generally included in college financial aid decisions.
  3. If you are EXTREMELY risk averse, or if having the money in stocks makes you more likely to spend it rather than save it and you want to save it, or if you have other emotional kinds of things dealing with not wanting debt.
  4. If you just want to not deal with the hassle of paying a bill every month (and if it's less effort to pay property taxes once or twice a year instead of having the mortgage company handle that).

After we asked, you noted that your mortgage is 2.75% for 30 years.  With a mortgage rate that low, if your incomes are high enough to not qualify for financial aid, I'd probably just pay the minimum to the mortgage and not split the difference.  YMMV.  There's not really a wrong answer, so long as you're saving/investing the money in lower risk assets (stock market indexes aren't low risk in the short term but they're pretty good in the long term).

Grumpy Nation, how do you handle mortgage pre-payment vs investing?

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