Two weeks ago Dallas reader D.J., sent an interesting question. The sale of a recently inherited house would bring enough money to pay off the mortgage on his home.

His question: Should he pay off the mortgage or invest the money?

I gave a pretty abstract answer, warning of the impact of mortgage payments during a down market and suggesting it was more difficult and risky than it looked.

"This isn't a no-brainer. It isn't a slam-dunk, either," I concluded.

Well, it isn't. But you can get a better idea of what this is all about if you see it in real figures rather than abstractions.

D.J., looking backward, was thinking Vanguard Wellington fund would be a good choice.

Given perfect hindsight, it would have been. With $100,000 to invest or pay off his mortgage, he could pay off a $100,000 mortgage and enjoy freedom from mortgage payments and tranquility. At the end of 10 years he would still have no mortgage and he would still be free of investment worry.

If he had invested in Vanguard Wellington fund and had withdrawn enough money each month to make his mortgage payment, however, he would have ended the period with a lower mortgage balance and an investment account that was larger than his original $100,000 investment.

Ten years ago mortgage interest rates were much higher, with a national average rate of 7.75 percent on a fixed rate 30-year mortgage. Using Morningstar Principia software, I found that his original investment would have grown to $143,064 if he had made payments of $733.76 a month on a 30-year mortgage at 8 percent. His original investment would have grown to $155,484 if he had made payments of $665.30 a month on a 30-year mortgage at 7 percent.

Either way, he would be way ahead of the game. At the end of the period his 8 percent mortgage balance would have been whittled down to $87,725. His 7 percent mortgage balance would be a bit less, $85,813. He would have been even further ahead had he taken an adjustable mortgage at a lower interest rate because he would have enjoyed a decade of declining interest payments.

Other funds could be used as well. Vanguard Balanced Index would have ended the period with a balance of $122,711 making payments on an 8 percent mortgage, $134,347 making payments on a 7 percent mortgage. He would also have come out ahead investing in Fidelity Magellan and Putnam Voyager, two funds that have been disappointing (Magellan) or terrifying (Voyager) during the period.

In spite of superior returns for their categories, however, the strategy would not have worked for Vanguard Total Bond Index or Vanguard GNMA. Similarly, it would not have worked with two well-known international stock funds, Templeton Foreign A shares or T. Rowe Price International Stock, although one specializes in value stocks and the other specializes in growth stocks. (The results for a variety of mutual funds are shown in the table below.   These funds are intended as illustrations, not as recommendations.)

Ten Well Known Funds Working Against Mortgage Payments
Performance of 10 well known mutual funds over a 10-year period based on an original investment of $100,000 net of monthly mortgage payments at 7 or 8 percent. The percentile figure indicates how each fund performed relative to its competitive peer group, e.g. Vanguard Wellington was in the top 8 percent of "moderate allocation" funds, out performing 92 percent of its peers for the period. Fund values in italics indicate the fund value was less than the amount remaining on the mortgage.
Fund 10 Yr return Per cent tile 8% mortgage 7% mortgage
Vanguard Wellington (Moderate Allocation) 12.34    8 $143,064 $155,484
Vanguard Index 500 (Large Blend) 12.00 17 $170,752 $182,551
Vanguard Balanced Index (Mod. Allocation) 10.45 27 $122,711 $134,347
Fidelity Puritan (Moderate Allocation) 10.41 28 $109,165 $120,746
Fidelity Magellan (Large Blend) 10.16 57 $129,158 $139,608
Putnam Voyager (Large Growth)    9.10 47 $106,752 $116,150
Templeton Foreign A (Foreign Lg. Value)    8.75 57 $   67,248 $   79,422
Vanguard Total Bond Index (Int. Bond)    7.42 25 $   64,010 $   74,531
Vanguard GNMA (Int. Govt. Bond)    7.42    6 $   63,667 $   74,101
T. Rowe Price International Stock (For Lg G)    5.07 32 $   49,541 $   59,127
Source: Morningstar Principia, data for period ending 12/31/2004

Looking at these results you may shake your head and say, "Gee whiz, Burns is a worry wart."

Pick a good balanced fund and have the fund make an automatic monthly payment for your mortgage. Forget about it for 5, 10, or 15 years. Then cash in your accumulated difference when you need it.

Even so, I believe there is more risk in this strategy today than there was 10 years ago. Ten years ago, interest rates had plenty of room to come down--- and they did. As a consequence, bond investors enjoyed a decade of bull market. Ditto stocks. As interest rates fell, bonds offered less competition to stocks and price to earnings multiples rose. (And that happened entirely without the Internet Bubble).

Today, interest rates appear to have bottomed. And while stock valuations--- as measured by price to earnings multiples--- aren't as high as they once were, they are still high by historical standards.

What is missed looking backward to a particular year is that each starting year will produce very different results. Many who retired in 1971, near the top of a bull market, felt safe to make large withdrawals from their nest eggs. They were wrong. Many who retired in 1981, the bottom of a long bear market, worried even as their net worth multiplied.


Mortgage rate history