The Daily Dow
Thursday, August 21, 1997
by Robert Sheard
LEXINGTON, KY. (Aug. 21, 1997) -- In yesterday's column, I wrote about a feature story that made me nervous. The subject of the story was a young couple who borrowed $50,000 on a home-equity line of credit to get into the stock market through mutual funds (in addition to their primary fixed-rate mortgage). I felt this pushed the envelope of responsibility a bit since the interest rate on the home equity line is a floating one and already at 9%. The risks in a market downswing and in an environment where interest rates soar are just too high for my taste.
That does not mean, however, that I believe you should try to pay off a fixed-rate mortgage quickly in lieu of investing the money you'd use to pay off that mortgage early. Let's look at two scenarios to demonstrate why I'd prefer to keep paying the mortgage.
In both scenarios let's assume a 30-year fixed rate mortgage of $100,000 at 7%. The monthly payment on the mortgage is $665.30.
Now if the happy homeowners of this newly mortgaged property suddenly come into $100,000, would they be better off paying the entire mortgage down and investing the monthly "payment" of $665.30, or would they be better off paying the mortgage out over thirty years and investing the windfall in the stock market? The value of the house is irrelevant since in either case, they'll have it free and clear at the end of the thirty years.
If they pay off the house early and invest the $665.30 monthly "payment" into the stock market at an after-tax rate of 15% (possible with the Dow Approach), they'll have $3.7 million (and the house) at the end of thirty years.
If they decide to invest the $100,000 and pay the monthly amount on the mortgage as planned, even if they never invest another penny in the market, they would have $6.6 million (and the house) at the end of thirty years, assuming the same 15% annual after-tax return. So clearly, investing a lump sum up front and letting it grow is more profitable than paying down the loan early. Besides, for now anyway, the interest on the mortgage each month is still tax deductible, another advantage for paying the mortgage out over thirty years.
Let's say, however, that our homeowners didn't come into a quick $100,000, but they can swing a little extra each month, say $1,000 total payment each month. Should they pay the extra $334.70 on the mortgage or invest it?
If they paid $1,000 a month on the mortgage, it would be paid off after 12 years and 7 months. Then if they put the $1,000 a month from then on into the market at 15%, at the end of the 30 years, they'd have the house and $888,316.
But if they decided to sock away the extra $334.70 a month for the whole 30 years and not pay the mortgage off early, they'd have the house and nearly $1.9 million by investing the extra cash.
In either scenario, then, paying off a fixed-rate mortgage with a relatively low interest rate isn't beneficial over the term of the 30-year loan. Whether it's a lump-sum payment or monthly "extra" cash, under these conditions, your total net worth at the end of the 30 years is considerably enhanced by investing early and extending the loan over its full term. Some debt is "good" debt.
(c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool. ________________________________
Stock Change Last -------------------- T - 5/16 39.94 GM - 7/16 62.94 CHV - 13/16 78.94 MMM -1 3/4 91.50
Day Month Year
FOOL-4 -1.02% 2.85% 8.93%
DJIA -1.59% -4.00% 22.42%
S&P 500 -1.52% -3.07% 24.88%
NASDAQ -1.35% 0.81% 24.45%
Rec'd # Security In At Now Change
1/2/97 153 Chevron 65.00 78.94 21.44%
1/2/97 179 Gen. Motor 55.75 62.94 12.89%
1/2/97 120 3M 83.00 91.50 10.24%
1/2/97 479 AT&T 41.75 39.94 -4.34%
Rec'd # Security In At Value Change
1/2/97 153 Chevron 9945.00 12077.44 $2132.44
1/2/97 179 Gen. Motor 9979.25 11265.81 $1286.56
1/2/97 120 3M 9960.00 10980.00 $1020.00
1/2/97 479 AT&T 19998.25 19130.06 -$868.19
CASH $1009.44
TOTAL $54462.75