Pay the Mortgage or Invest?

An interesting discussion has sprung up over at the Diehards in response to one reader's question: Should he take out a loan on his debt-free home to invest the assets?

My take on this is simple: Unless you have a very good risk/return opportunity combined with a high propensity for risk, 1) don't go back into debt and correspondingly 2) pay off your mortgage before investing in taxable assets.

# 1 is pretty straightforward.

Most folks just do better without the loadstone of debt hanging over their head. Just about anyone will agree that high-interest credit card debt makes more sense to pay off before a mortgage. Even at 10%, credit card debt isn't deductible, and so just about any other investment will pale against a 10% post-tax rate of return.

# 2 gets more tricky.

Folks who have adjustable rate mortgages now, by and large, realize that the days of cheap credit are coming to an end, and therefore their rates will (or are) much higher than historically.

For those with fixed debt, I still maintain that a 6-7% post-tax guaranteed rate of return is almost impossible to beat.

Livesoft over at the Diehards points dissents, pointing out that his 4.875% mortgage can be arbitraged with a 5.1% FDIC-insured money market account.

I still say: You are making 22.5 basis points (5.1% minus 4.875%)... assuming all of the following:

1) You fully itemize on your federal taxes (half of folks don't, the rest don't get the full value of their itemization)
2) You aren't dinged for state taxes (5.75% in my state)
3) You aren't hit by AMT
4) There are no inactivity, transfer or low-balance fees
5) There is no "lost interest" during transfers to and from your bank
6) You are guaranteed that rate for a set period of time... or at least can easily move the money out if the rate is lowered

There's probably more, but you get the point.

In this example, if you pay $1,000 a month in interest and have no fees or "waste", you can gain the princely sum of $27/year (calculated as follows):

$12,000 interest x (5.1% - 4.875%) = $27

The bottom line is this: Pay off your debts first, then invest.

And yes, I know I've neglected matching funds from employers. I'll hit that in my next post.