Friday, October 9, 2009

Not all debt is scary

If you are fortunate enough to have a few extra dollars at the end of the month after paying your mortgage what should you do?

Sample Mortgage Details

  • 5.25%
  • 25 year amortization
  • $400,000 loan
  • loan payments of around $2400
  • our user has an extra $600 every month in free cash.

Option 1: Put the money into a dividend paying stock

In this scenario the user decides to pay the mortgage for the full 25 years and invest the extra $600 directly into a dividend paying stock. Our user finds a stock with an dividend yield of 6%, once the appreciation in the stock's value is included the return amounts to 7.25%.

Option 1 Results:

At the end of 25 years our user has finally paid off their mortgage and has amassed a portfolio totaling some $600K- impressive.


Option 2: Pay the loan off faster and then invest

In this second scenario our user decides instead to have their payment increased by an extra $600 and focus on paying down the mortgage. The mortgage is paid off much faster- in 17 years, and our user, over the next 8 years, takes the $600 plus what would have been the regular monthly payment of $2400 and invest the entire $3000 into the same stock as above for the remaining 8 years.

Option 2 Results:

In option 2 our user ends up at the end of the 25 years with a portfolio of approximately $489,000, some $111,000 less than our option 1 investor. To see it graphically here is what it would look like:


Conclusion:

While this may look like an incredibly simple choice to make the devil is in the details. Their are risks option 1 is exposed to:
  1. Investing in the market over 25 years our sample investor would not likely see a consistent 7.25%, their may be larger or smaller years. If the first several years of the investment are not average, or above average, the return will not be as advertised.

  2. Can't get a 25 year fixed rate. At best you could get a 10 year and hope that at the end of the 10 a 5.25% is available. Hope is not a good investment word.

  3. Is our user a good saver? A mortgage is something that you must pay, an investment account is something that you should pay. In our scenario 1 our user may be lax and not always pay the investment account. In our scenario 2 the user is far more likely to pay the bill after the mortgage is increased. Even a few missed investments in option 1 can have a substantial impact on our scenario.

So what would you do?

This article was written by buyingvalue. If you enjoyed this article, please vote for it by clicking the Buzz Up! button below.

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