Contrasting Paying Off Second Mortgage with S&P 500 Investing: A Visual Example

by Kevin on July 29, 2010

In my last post I happily shared that we recently paid off our second mortgage! At the end of that post I made a promise to show what would have happened to our cash had we invested it in the stock market rather than paying our mortgage down with it.

Methodology for Mortgage Versus Investing Calculations

You should never accept what a blogger, journalist, or talking head gives you. You have no reason to believe any of the data I am providing you. I think it is very important to understand the methodology that was used to come to the conclusion that person makes.

That having been said I am going to list out the methodology I used to come up with my figures. If this makes your eyes glaze over, stop. Read it again. It’s important stuff.

Or you could just skip to the pretty chart at the bottom.

Note: I didn’t use a perfect methodology for my calculations. This was to save time; even so this took a bit of time to put together. Express your concerns in the comments.

Nonetheless, here are the steps I took:

  1. Picked a investment index to track. I went with the S&P 500 since it covers a broad section of the market.
  2. Took S&P 500 weekly data from Google Finance for September 3, 2007 to July 16, 2010. This was roughly the time period of when we first purchased the house to paying off the second mortgage.
  3. Picked days to theoretically invest in the S&P 500. I decided every three months — that is, quarterly — would serve my functions well while reducing calculation time. I removed the rest of the data.
  4. Kept only the date and closing amount. I removed the opening, high, low, etc. data.
  5. “Invested” $1,500 on each investment day. I pretended that on the 13 individual days that I purchased however many shares that $1,500 would provide me (including fractional shares). For example, the first date of September 7, 2007, I “bought”  1.032 shares at $1,453.55 for $1,500.
  6. Calculated total investment into the portfolio and value of total shares on each date.
    1. Total investment was easy: $1,500 per day that I invested (13 total) for a total of $19,500.
    2. Value of the shares was calculated by multiplying the total number of shares on that date by the closing price. For example, on  12/07/07 I would have 1.032 shares from my 09/07/07 purchase plus 0.997 shares from that days purchase. That gives me a total of 2.029 shares @ $1,504.66 for a portfolio worth of $3,052.74.
  7. Compared portfolio worth to total investment. In the above example I would have a portfolio worth of $3,052.74 and had invested $3,000.00. That’s a return of $52.74 or 1.76% as of 12/07/07.

And I continued that methodology for the entire investment period.

The results of all these calculations are in the table below.

DateCloseSharesTotal SharesTotal InvestmentInvestment Worth on DateInvestment Return %Mortgage Payoff Return
09/07/071,453.551.0321.0321,500.001,500.000.00%8.125%
12/07/071,504.66.9972.0293,000.003,052.741.76%8.125%
03/07/081,293.371.1603.1894,500.004,124.07-8.35%8.125%
06/06/081,360.681.1024.2916,000.005,838.69-2.69%8.125%
08/29/081,282.821.1695.4607,500.007,004.59-6.61%8.125%
11/21/08800.031.8757.3359,000.005,868.41-34.80%8.125%
02/13/09826.841.8149.14910,500.007,565.07-27.95%8.125%
05/08/09929.231.61410.76412,000.0010,001.87-16.65%8.125%
07/31/09987.481.51912.28313,500.0012,128.85-10.16%8.125%
10/30/091,036.181.44813.73015,000.0014,227.02-5.15%8.125%
01/22/101,091.761.37415.10416,500.0016,490.15-0.06%8.125%
04/23/101,217.281.23216.33618,000.0019,886.0210.48%8.125%
07/16/101,064.881.40917.74519,500.0018,896.35-3.10%8.125%

Results: Is Investing or Paying Down Your Second Mortgage Better?

At the end of the time period I used investing in the S&P 500 ended up losing me 3.10% of value. Compare that to getting a constant return of 8.125% on our second mortgage. That’s a huge difference. (Remember thats -3.10% compared to 8.125%, not 3.10% positive to 8.125%.)

Here’s the chart:

Chart contrasting investing in the S&P 500 and paying off your mortgage

(Click on the image for a larger version.)

I’ll take paying off the second mortgage every time. Even if my mortgage was smaller — say 5% like a traditional first mortgage — paying off the mortgage still came out ahead.

Things to Note Regarding My Calculations

  • I didn’t take into account investment fees incurred by investing in the S&P 500. At bare minimum you would have expense ratios eating away at your return every year on top of your investment gains/losses.
  • I didn’t factor in the “after-tax cost” of a mortgage. That’s because most people don’t get any tax benefit from a mortgage alone.
  • I didn’t factor in the cost of getting the money “out” of either investment.
    • You would need a home equity line of credit or to sell your house to get at the equity. You could potentially lose additional principle if you sell your house at a loss.
    • You would need to liquidate your investment (and potentially incur additional investment charges) to get it out of the S&P 500.
  • I didn’t factor in the benefit of eliminating a debt from your budget. This isn’t an investment factor, but freeing up that additional cash flow each month was really great for us.

    Crying? Here’s Your Tissues

    Some of you may be crying into your broker’s shoulder with something like this: “But, but, but… you picked a massive market crash and recession to use for your numbers! That’s not fair! The market traditionally returns (make up percentage here) per year!”

    Right, I did pick a horrible market to pretend to invest in. Here’s the lovely kick: I got to actually experience this market, too!

    I’m just trying to show you that paying off your mortgage isn’t a terrible thing to do. Especially in this economy when portfolios can experience 33% losses in one year alone.

    Sure, your home may lose that much value, too… at least in once hot real estate markets like Las Vegas and Miami. But here’s the other kicker: you can live in the full house even though the value has gone down.

    You can’t exactly live in your portfolio.

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    Finance Nerd July 29, 2010 at 6:51 am

    I think your scale is wrong, as your mortgage was 8.125% per year, but the -3.1% was over three years. This is actually more like -1% per year.

    More importantly, I don’t think the S&P data you pulled includes dividends, which would increase the return. You do need to account for that as well.

    In this particular case, it might not change the answer, but making those two corrections would narrow the gap considerably.

    Kevin July 30, 2010 at 8:19 am

    Excellent points. I figured the math wasn’t 100% perfect. My overall point was that it paid off better in the end, AND if you had been investing the same dollars in the S&P 500 over the past 3 years, would you have the gusto to continue to do so when down 30+%? Most people wouldn’t have.

    Kevin July 30, 2010 at 9:44 am

    And as others have mentioned I was trying to keep the calculations simple… I could have factored in the after-tax results for both the mortgage and the investments, when I withdraw the funds, interest saved over the life of the loan compared to potential estimated investment returns, etc.

    But that would be realllly complicated. 🙂

    Barb Friedberg July 29, 2010 at 1:28 pm

    I enjoyed the story, and the prior one; liked the charts. Even if the calculations weren’t “perfect.” The point was wonderful and congratulations!

    Kevin July 30, 2010 at 8:19 am

    Thanks Barb!

    Sam July 30, 2010 at 8:15 am

    First, let me say that I’m in the ‘pay off your mortgage’ crowd. I feel the a roof over my head trumps the mathematics of investment returns. That being said, I believe your analysis is flawed in its time horizon. By paying off your mortgage early, you are avoiding the interest over the 30 year life of the loan — similar to investing that money over 30 years — not simply the period of time you take to pay it off. Sure it amortizes, so the time period is a little less than 30 — but it is not 3 years. You’d need to wait and see what returns you could have gotten over this time. (Although I suspect that, at 8+%, you will still be ahead with paying it down). One other item, it was appropriate to exclude taxes but not for the reasons you mention — just like the mortgage interest is tax deductible, the investment returns would be taxable. (while the cap gains rate might give a bit of a different answer, a pre-tax analysis makes sense)

    Kevin July 30, 2010 at 9:40 am

    Right, but since I wanted to write a post today and not 25+ years in the future I didn’t think it made sense to try to guess what my investment returns could have been. I could have figured out the interest costs with a mortgage calculator.

    You’re right on the taxes. I meant to include that in the post and forgot.

    Rob Ward August 17, 2010 at 5:44 am

    Couldn’t agree more Kevin. As soon as our first car loan is paid off, the 2nd mortgage will be next!

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