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In 2004, I bought my first home. I was 23, and I thought I knew everything there was to know about finance. In reality, I had no idea what I was doing. I took out what seemed to be a huge but reasonable mortgage and decided to be aggressive with a fifteen year mortgage in order to lower the interest rate to 3.5%. At that point, I felt mentally prepared to quickly pay off the mortgage.
On paper, it made sense for me to buy a house. I had a good job, had friends in the area and had plans to stay in the DC area for the foreseeable future. Looking back now, 2004 was close to the peak of the market. Had I needed to sell the property in 2010, I would have taken a bloodbath. Luckily for me, I didn’t need to sell the house and was fortunate to stay employed during the Great Recession.
In order to afford the home, I had to bring on three other roommates. While this made for some tight accommodations at times, the rent and utilities checks more than made up for the inconveniences. Four guys in a house has all the makings of a frat house. If you are ever in this situation, write into the contract that a maid service will be coming in every two weeks. This was crucial to ensure the house never became too filthy.
In a Hurry to Pay Off the Mortgage
One of the more controversial moves that I made according to some financial advisors was paying off the mortgage as quickly as possible. Most promote investing money in the stock market instead of paying off your mortgage since historically the stock market has yielded greater returns over time.
I decided even with that knowledge at the time that I would rather lock in and pay off the 3.5% mortgage rather than taking a risk with the market. It made more sense at the time to diversify my portfolio and treat my mortgage as a bond with a guaranteed rate of return. Most financial advisors will advise against this. They say 20-somethings don’t need that much exposure to bonds. I disagree. Since I was able to pay off the mortgage in essentially half the time, I was able to reduce the amount of interest I paid by a little more than $24,500, which in turn equated to a 3.3% rate of return.
If I Had Invested the Money
So let’s say that instead of paying off the mortgage, I decided to invest that money into the stock market. Using Morningstar, if I had purchased the S&P 500 (which I talked about in a previous why I love the S&P 500 article), ticker symbol SPY, back when I bought my house in mid-2004 until I paid off my house at the end of 2012, the total return from the S&P 500 would have been 47.19% with dividends. On face value, that would have been a return of 4.65%, which obviously is higher than the 3.5% mortgage rate I was getting a guaranteed return on.
However, since I didn’t make a lump sum payment to pay off the mortgage in the beginning, I don’t think it’s an accurate measure to use the figures above. In fact, what I should actually use is a dollar-cost average to get my true return. Using the $900 that I averaged monthly paying off my house, I would have a cost basis in the S&P 500 of $92,700 with a total return, including dividends that are reinvested into more shares, during this period of $119,421. This comes out to a return of closer to 3.6% per year, which is similar to the 3.3% return on paying off the mortgage earlier or a difference of $2,781 over the seven and half years.
What about the home interest deduction? I actually LOWERED my taxes now by not paying interest on my house. The money that I was allocating towards paying off the mortgage in principal and interest is now being used to maximize my 401(k). Therefore, I am actually able to save more in my 401(k), which is growing tax-free, and by not paying principal and interest.
If you are thinking that I should have maxed out my 401(k) AND paid my mortgage payment to minimize my taxes, you are probably right. However, looking at the difference in returns of 4.65% vs. 3.3%, I feel comfortable with the decision I made. While it felt daunting to pay off the mortgage, by the end of 2012, I had reached my goal of paying for my house. Honestly, the feeling of knowing I didn’t have to pay that massive bill each month was an incredible feeling.
Have you considered paying off the mortgage? Why or why not? What would you do with your excess cash if you didn’t have to pay the rent or the mortgage each month? Share your thoughts below.