Last week, I discussed the one best investment that a new investor could make. I advised that this investment should be a group of companies (such as my Watch List) and the small investor should move the principle between “hot” stocks.
The money invested in stocks needs to be money that you do not need immediately. This does not mean that it is not necessarily money that you will not need for 20-30 years. If you have money that you are confident that you will not need for decades, you should probably invest that money in your own home. Follow the old Benjamin Franklin saying: "A penny saved, is a penny earned."
If you currently pay 7% interest on your home loan, any extra money that you apply to your mortgage will immediately give you a 7% return for the balance of your mortgage time. Therefore, paying a one-time extra $1,000 on a 7% mortgage that has 23 years left on it, then it will result in $5,002.04 that you did not have to pay over the course of the 23 years. This is an absolutely guaranteed return – over the course of 23 years you will be over $5,000 wealthier due to that one-time investment.
Your home mortgage is the safest "buy and hold" investment that you can make! You already know that you pay a certain percentage. If you pay the loan off early, you effectively make that loan percentage as an investment return.
The same logic goes for your car loan your credit cards. This is typically more short-term debt than your home. Quick payoff on any short-term debt will guarantee you the quickest and best investment strategy. You are not spending those pennies; you save them. Benjamin Franklin will be proud of your efforts to pay off your short-term and long-term debt quickly and efficiently.
Good article! Many people don’t realize paying off debt is a form of investing, and should be a priority for new investors. I especially agree with paying off debts like car loans or credit card debt, which almost always have a higher interest rate than any investment!
But, consider the scenario of having a mortgage with a rate of 5%, which is the rate one can get today. With the tax deduction for mortgage interest, at a 25% tax bracket your “real” savings rate would only be 3.75%. Given the stock market on average should return 8% – 10% over the long term, I’d rather invest the money than pay the extra principal on my house.
Jeff – Thank you for your comment. I understand your logic.
I will stand by my statement that reducing your mortgage is a great long term investment. Yes, in any given year the stock market will produce 10% return or better but it is quite volatile. Last year, few people broke 10% returns.
The average household mortgage that is being held is about 7% right now (sorry, I can’t find that source as I type this reply). Homeowners would be wise to refinance at a lower rate (this would likely incur some charges) or if refinancing is not an option then they should be overpaying to drive down the principle.
Refinancing can be a short-term investment as many times this can reduce payments enough to pay back within a few years.
Note that overpaying needs to be long-term money. The homeowner will not see this money returned to them until the end of the mortgage. By overpaying early, the last payment will come earlier so that expense will be eliminated from the budget. If the home is sold while still in debt, the profit on the sale will be higher (which may incur a tax penalty if not handled appropriately).
If the investor needs the return earlier than the end of the mortgage, this strategy is not as appealing.
Hopefully you didn’t take my comment as being overly critical! I agree, paying extra principal provides a guaranteed rate of return. And if I had a mortgage at 7%, I’d definitely be putting as much money towards principal as I could – where else are you going to find a fixed rate of return like that? My point was if you have a new mortgage or have been able to refinance to a sub-5% rate, then it’s not quite as straight-forward a decision. As you point out, paying extra principal or investing should be with long-term money. And so when thinking long-term, one could argue that investing in a index mutual fund should provide a better rate of return than the extra principal payments.
Of course, there are a number of people who don’t like the risks and volatility of the market, and so even if paying principal provides a lower rate or return, that is still the better solution. And to lay all my cards on the table, even though our mortgage rate is less than 5%, I am paying extra principal, just because I dislike debt so much!!
I think we agree!!
I agree that paying extra towards the mortgage can be a good idea, but when you say the savings/earnings by doing so are guaranteed, I take exception a bit. The actual value of the home may go up or down over time. It used to be you only thought of them going up, but now we know for sure, down is an option. I bought my house 8+ years ago, thought we made a decent deal at the time, but I still couldn’t sell it for what I paid.
So, if it’s lost 10% over the 8 years, any extra principal I paid in lost some portion of that 10% as well, likely wiping out any gains from the interest reduction.
Not completely disagreeing, but you oversimplified a bit, and skimmed over a real risk.