• “If you won the lottery, what would you do with the money?”
There’s the usual responses like buying a fancy new car, going on a shopping-spree, taking an exotic vacation, that thing you always wanted, etc. But after all you filter out all the fun responses, most people come to two very sensible responses:
• “I’d use the money to payoff my house”
• “I’d invest the money”
Although not all of us will be winning the lottery anytime soon, we make much smaller-scale decisions along these lines all the time. For example:
• Every paycheck when your money goes into a 401(k), have you ever considered if putting it towards your house was the better option?
• Have you ever got your income tax refund, a profit-sharing check, or an inheritance and thought if one was better than the other?
So let’s dive into this question and take a look into the factors that make one option more favorable than the other.
Let’s design this example using some very simple assumptions. For starters, we’ll say you suddenly have $150,000. At the same exact time, you’ve decided to buy a house where the mortgage loan would also cost exactly $150,000. The mortgage for this house would be a term of 30 years and at a fixed rate of 5.00% with no points. Under these terms, your fixed monthly payment (principal and interest) would be $805.23.
A mortgage of these parameters would cost the following:
Going back to our two sensible options above, we must chose between:
• Option A – You could payoff the entire balance of the mortgage right now. From that point on, you could take the $805.23 each month from your income that you would normally use to pay your mortgage and invest it.
• Option B – You could hold on to your $150,000 and invest it right away. From that point on, you’d then make your standard $805.23 mortgage payment each month using your income.
Here’s some fun knowledge to impress your friends with. Using the same interest rate as your mortgage, 5.00% in our example, which option gives you the higher future value of your money?
The answer? They’re the same!
You see, this is one of the fundamentals of your mortgage. When you borrow the money for your house (in our case $150,000), the monthly payment is a calculation that is based on what the future value of that $150,000 would be in 30 years at a fixed 5.00% interest rate. Notice that your monthly payments do NOT equal $670,161.65 divided by 360. This is because your monthly payment is based on the property of compound interest (click here to read my post about how compound interest works). Basically, each time you make your $805.23 payment, you add on the incremental increase of 5.00% interest. Over time, this will equal $670,161.65; the same thing as if you had just invested the original $150,000 in the first place.
Another way to look at it:
• Your mortgage is similar to an investment where you earn the same rate of return as your mortgage interest rate.
Remember though – your mortgage is debt (money you owe someone) which is different from what you would traditionally think of as an investment (money that is yours and that you have access to).
By the way: You can use Microsoft Excel to figure this out pretty easily. Open Excel, click Help from the menu bar, and type “PMT” in the help box. PMT is a built-in function in Excel that will help you calculate loans (such as fixed rate mortgages). Excel will provide you with information and an example on how to set this up.
So although this example is helpful, it does not answer the question. In Part 2, we will dive back into our question and explore the factors that influence which decision is better.