I got so carried away trying to figure out how to milk a dime out of Brian Miller yesterday, I forgot to tell you (or answer) his question. Namely:

“I have seen people take the stance that making principal prepayments on a mortgage is not the ‘smart’ thing to do, since stocks historically return about 10% over long periods of time, and mortgage interest is typically around 6% or so. But nowhere have I seen the advice taken to its extreme; that is, when your mortgage is finally paid off, take out a home equity loan and put the money in stocks. Have I just missed this advice? Or, is there some reason why it becomes no longer good advice at this point?

“And what about the fact that since stocks historically average annual returns of ~10%, and for the past few years have performed much better than that, then the law of averages says eventually stocks will do much worse than 10%. Isn’t this reason to at least place some of your investment money into mortgage prepayments?”

Maybe I didn’t answer Brian yesterday because he more or less answered himself.

To begin with, I actually tend to be one of those conservative types who think pretty highly of mortgage-prepayment as a way to save. After all, a lot of money management has to do with psychology and personal choice — how you live your life. No one should be ashamed of wanting to “earn” a risk-free 7% by paying down a 7% mortgage. It can help you sleep peacefully at night. And the mortgage-burning ceremony, when that day comes, can be one of life’s joyous milestones.

But there are a couple more things to say in response to Brian’s note.

First, if Brian really has a 6% fixed-rate 30-year mortgage — and if he’s thinking he might actually keep this property for 30 years rather than move on in a year or two — then he’s in an enviable position. The lender is on the hook to him at 6% for decades . . . while he is only on the hook to the lender until the day he decides to pay off the loan. Should mortgage rates drop to 4%, he could refinance. But if inflation roared back and mortgage rates hit 12%, he’d still be paying 6%.

It’s kind of like being an employee with a long-term stock option — but the right to “reset” the strike price if the stock price goes down. (If you have stock options, you know what I mean. If you don’t, it will just make you angry.)

So I will admit that it doesn’t always make sense on a strictly logical level to accelerate the payments on a really low, fixed-rate long-term mortgage.

But the second thing to say is that Brian is right (in my view) — this notion that stocks will always go up about 10% a year, with maybe some dips, but nothing much to worry about, has gotten a little scary. To me, anyway. So I sure wouldn’t hock my house (or anything else) to buy stocks at today’s prices — or at almost any other time, either. Borrowing to buy stocks might usually enhance your results a little, but occasionally wipe you out. Too risky.

And the final point is this. Six or seven percent may not seem like much, especially in light of the kinds of returns you could have earned on stocks (or bonds!) the last 17 years. (Long-term bonds not only paid a lot of interest over this period, they appreciated as interest rates fell — the combined returns have been tremendous.) But in a period of virtually zero inflation, that’s a “real” 6% or 7%. After tax it may be a real return of 4% or so. (The “earnings” from paying off your mortgage should be thought of as taxable, because — assuming you itemize your deductions — you only save the after-tax cost of the mortgage.)

Paying down a 7% mortgage when inflation is zero is actually a much better real return than paying down a 12% mortgage when inflation is 6%. The first way, paying down the 7% mortgage, you are “earning” 4% or 5% after tax and inflation. With the 12% mortgage you may really be saving only 7% or 8% after subtracting the value of the tax deduction. When you then subtract a further 6% for inflation, you’re really earning just 1% or 2% after taxes and inflation.

Should you pay off your 6% mortgage rather than invest in some great new business that your freshly-minted M.I.T. computer scientist son wants to start? No. Probably not. But should you pay your mortgage down rather than buy an Internet stock that’s already up tenfold since last summer? Well, maybe so.

I do think I can earn more than the 4% or so my mortgage costs me after tax, so I do not accelerate my own payments. But only time will tell whether this was smart.


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