Invest or Pre-Pay the Mortgage?

Now I come to the point where many others have came upon: to invest or prepay my mortage?

Factoring in interest deduction, my after-tax mortgage interest rate is 3.7%. That's 3.7% guaranteed after-tax investment rate.

I need an investment vehicle that offers a before-interest-tax 5.16% APR to beat that. An equivalent investment vehicle delivering the same kind of rate guarantee is CD. Since CDs are usually advertised in APY with monthly compounding, the equivalent APY is 5.28%. A quick check at bankaholic.com showed only 7 banks offering CDs with higher APY.

The highest is offered by KeyDirect at 5.7% for 120 months (10 years). Unholy cow! But that is the longest CD term I've ever seen and is offered by a bank that I don't want to do business with any longer.

The next one is CountryWide's 5.45% but only for 3 months. Sounds good except that it needs a $10K initial deposit. But building up to $10K takes time and all the while the collected money will be sitting in lower-than-5.16%-APR accounts. The other CD offers do not seem good as well. So, it seems my mortgage gives me the highest guaranteed investment rate for now.






Let's go a riskier route: stock market (includes mutual funds). The tax rate for capital gain is 15%, so, the minimum APR to beat the mortgage's rate is 4.35%. If I invest in various low-expense-ratio index funds or ETFs like VFINX, VTI, SPY, my risk of not making more than 4.35% APR over the next 3-5 years (expecting a baby, see below) is very low. Investing it in stock market gives you the best bang for your time.

Yet, 36% of my income is already in stock market in the forms of 401k and IRA. For me putting extra money in the same basket just increases the risk needlessly. Furthermore, if we own the house, we will be less affected by a recession. That is the virtue of not putting all your eggs in one basket.

Readers who are still with me at this point would probably think, 'this guy is going to prepay'. I would have, but my better half, well, being better, she gives me a better argument.

'We are still young', she argued, 'what is youth without risk?'. We have no children yet. We can basically take as much risk as we want now. We can even be fools and go back to the 30K debt hole we came from without affecting any innocents.

I bought it. For better or worse, I liked the argument. Perhaps I'm just greedy instead of being young. For now, I am reducing the amount of pre-payment from $1500 to $1000/month. Over time, I'll move more and more to the stock market.

When our risk-equation changes, like when we have a baby, I will have to revisit this topic again.

UPDATE 2007-Dec-14: I have a spreadsheet that may help you answering that flummoxing question: should I invest or prepay.

Mortgage After-Tax APR Comparison Goggle spreadsheet.

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Formulas:
Effective APR = APR * (1-TaxRate)
APR = Effective APR / (1-TaxRate)
APY = (1 + APR/q)^q - 1, where q is number of compounding per year.

Initial 2008 Budget

$150K/year pre-tax income.
$15.5K for wife's 401k
That leaves $134.5K pre-tax or $88.7K after-tax.
$15.5K for my Roth 401k
and
$10K for our Roth IRAs.

That gives us a monthly income of $5200 which needs to be deducted by
$2800 for all bills, including mortgage. The leftover is $2400.

We are planning to use $1000 to pre-pay the mortgage, and put the rest (after food expenses) in either stock market (if the condition is good) or in high-interest saving accounts.

This is a very simple on-the-napkin budgeting. If we manage to follow this, our net worth will increase by $62.4K by the end of 2008.

Choosing Benefits for 2008

It is that time of the year again. The last call for changing our 2008 Q1 benefit is coming soon.
We are not planning to change anything much. We are keeping the HMOs, the dentals, the 401ks (of course!), and basic life insurances.

One thing that shocked us was the increase for HMO plan: from $35 to $50 months! My company is offering HRA which costs only $15/month. It is tempting, but despite attending the seminar twice, I still do not understand it. May be I am too dense, but I am not going with HRA despite its cheaper cost until I understand it completely. Isn't there an advice not to invest in something you don't understand? Isn't the health plan a form of investment on our health?

Starting 2008, my company is offering Roth 401k. I'm switching from traditional 401k to Roth 401k. Unfortunately, my wife's company isn't offering one yet.