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Pay Off Mortgage Early Or Invest- The Complete Guide

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Key Ideas

  1. Why some people may want to pay off their mortgages early — and how to do it.
  2. Includes a comparison of early payoff pros and cons.
  3. A detailed discussion of the math and the emotions involved to determine what option is best for your situation.

Should I pay off my mortgage early or invest?

You will inevitably confront this question in your pursuit of financial security.

The problem is the answer is far more complex and confusing than generally understood.

The intuitive response is to get out of debt. We all want the security of owning our castle free and clear with one less expense to deal with. The prospect of making monthly payments for the next 30 years is antithetical to freedom.

However, there are times when intuition and finance disagree.

The decision to pay off your mortgage early isn’t just about getting out of debt because complicated equations involving return on investment, time-value of money, and inflation are involved.

Remember, this is finance. You can end up with “Alice in Wonderland” scenarios where debt is the cheapest solution and a dollar paid tomorrow might actually be preferable to debt freedom today.

Curiouser and curiouser…

In this article I pull back the curtain exposing the many dimensions to paying off your mortgage early. The objective is to balance your intuition with financial savvy so you can make a smart decision.

The correct answer is not cookie-cutter but must be custom fitted to your personal financial situation.

Let’s explore how this complicated process works…

How to Pay Off Your Mortgage Faster

If you decide to pay off your mortgage early there is no shortage of advice on how to get the job done. Unfortunately, it all boils down to the same three little words – “pay more principal”. There is no magic secret. The only real difference is form, not substance.

Paying mortgage principal early is a powerful money saver because small debt reductions compound dramatically over the life of the loan thus eliminating many times the payment in interest.

For example, this mortgage payment calculator shows you that a 30 year, $100,000, 6% mortgage has a monthly payment of 599.55 with only $99.55 going to principal in the first month.

If you add just $100 to that monthly payment you literally double the principal paid in the beginning, eliminate 108 payments over the life of the loan, save $39,900 in interest costs, and shorten the payoff time from 30 years to 21 years.

Not bad for an extra $100 per month…

Payoff Mortgage Early Infographic

You can embed this infographic on your own site – just copy/paste this code into your post or page.

 

If that sounds appealing then here are the various strategies for early mortgage payoff starting with the simplest and moving toward the most complex…

  • Add Principal to Your Current Monthly Payment: Assuming your mortgage doesn’t have a prepayment penalty (check first) the simplest early payoff strategy is to just add principal to your monthly payment. You could try a one-time lump sum where you put the proceeds from selling a boat, motorhome, or unused jewelry to good use. Alternatively, you can add a little extra every month by sending your raise or bonus directly to the mortgage company. The concept behind this strategy is you got by just fine without the money before so you’ll never miss it if you never see it.
  • Biweekly Payment Schedule: Rather than make one mortgage payment per month, try making half the payment every two weeks. Since there are 52 weeks in 12 months that causes 26 half-payments or 13 full payments instead of the usual 12 – one extra payment per year. Depending on your situation this can cut up to 6 years off the life of your 30 year loan. Check out the details first because some mortgage holders offer this payment schedule without charge and others will hit you with a fee. I suggest you try using this bi-weekly mortgage calculator with extra payment capability to test both this early payoff strategy and the previous one to see how fast you can be free and clear!
  • Refinance to a Lower Interest Rate: Another strategy is to refinance to a lower interest rate mortgage while keeping the term (pay off date) the same. The key is to not take any money out or extend the term when you refinance. Your new loan should offer a lower payment due to the reduced interest cost so that when you keep making the same payment as before all the extra will go to principal payoff. The nice thing about this strategy is it doesn’t require any additional money out of your pocket to achieve the desired result (unlike the two previous alternatives) because all the savings comes from reduced interest costs.
  • Refinance to a Shorter Term: Rather than pay over a 30 year amortization try reducing the term to 15 years. The monthly payments will be higher but the interest rate is usually lower thus offsetting some of the monthly outflow. Another variation on this theme is to keep your 30 year mortgage but make your payments as if it were a 15 year amortization. You won’t get the reduced interest rate of a 15 year term, but you also won’t pay refinancing costs either. Some people prefer this variation for its increased flexibility and reduced cost while others prefer the enforced discipline of the required monthly payment. Either way, you can use this mortgage payoff calculator to estimate the monthly payment required to be free and clear for any date you choose.
  • Downsize to a Lower-Cost Home: Changing homes isn’t for everyone, but I would be remiss as your financial coach to exclude this strategy. You could move to a lower cost area or buy a smaller house in the same area. The smaller mortgage principal means you can be debt free faster using the same monthly payment.

The key point to notice about all these early payoff strategies is how they aren’t mutually exclusive. You can combine them in various ways to turbo charge results.

For example, you could downsize your home while financing that less expensive home at a lower interest rate on a biweekly mortgage. Then you could sell that boat and jewelry you never use putting those lump sums toward the mortgage while also dedicating this year’s raise to additional monthly principal payments.

You will be amazed how fast you can get out of debt following this prescription.

The only limit to how fast you escape the bondage of mortgage debt is your creativity and dedication to this noble cause.

Pay Off Mortgage Early – The Pros…

Now that we know how to pay off your mortgage early let’s look at the benefits to following this strategy…

  • Save Money: The first and most obvious reason to pay off your mortgage early is it can save you tens of thousands of dollars in interest costs.
  • Peace of Mind: The second reason is peace of mind from owning your own home. It gives you a warm-fuzzy to know you have a secure place to live and you won’t be put out on the street at the first temporary setback in employment.
  • Reduced Cost of Living: For most people, mortgage payments are your biggest monthly expense after taxes. Without a mortgage payment you can save more, work less, or take that dream job you always wanted but couldn’t afford because of the lower salary.
  • Get Rid of PMI: When you accelerate paying down principal your home equity will reach a threshold where PMI should no longer be required. This saves you money long before the mortgage is paid off and allows you to accelerate the principal pay-down while still making the same monthly payment.
  • Asset Protection: Many states have laws that protect home equity in the event of lawsuit or other legal proceeding. Homestead rules can provide substantial home equity protection. Also, retirees sometimes use home equity as an estate planning strategy to protect assets for the surviving spouse should one partner consume all available resources in a prolonged illness or nursing care facility. In short, there are many situations where home equity can represent a more secure asset with special legal privileges when compared to other investments.
  • Retirement Planning: A free and clear home takes on additional significance for near retirees. If you are entering retirement with a fixed income (Social Security, pension, fixed annuity) then it can be a real benefit to pay off all debt rather than put money in fluctuating investments. This allows you to reduce financial variables and more reliably match forecasted income to expenses. Additionally, after retiring, that mortgage payment can require pulling money from tax deferred accounts when that money would be better off left to grow. Finally, if your taxable income is reduced in retirement it can reduce the benefit of the mortgage interest tax deduction tilting the equation in favor of payoff.
  • Guaranteed Return on Investment: With the stock market and real estate going up and down like a roller coaster, it is comforting to put your money toward your home and know with certainty what the ROI will be. You get the imputed rental value of a place to live and the immediate return of eliminated interest expense. The certainty of this return stream is a huge benefit for investors who feel beat-up by unreliable financial markets that supposedly will pay more… but may not.
  • Achievable: Paying off your mortgage feels more motivating than most financial goals because it is concrete. It is big enough to get excited about yet tangible enough that you can wrap your head around it. It is achievable and will make a significant difference in your life. Contrast this to retirement planning which feels more ethereal and hard to grasp for most homeowners.

In short, there are many benefits to paying off your mortgage early – and some are very compelling!

Payoff Mortgage Early – The Cons…

Before you break out the champagne and burn your payment book it is important to consider the downside to paying off your mortgage early. This isn’t the slam-dunk decision it appears at first glance because of some complicated financial issues…

  • Lose the Tax Break: I start with the tax break issue not because it is the most important but because it is the most commonly cited and misunderstood. Yes, mortgage interest paid is generally deductible on your tax return if you itemize, but there are some important “caveats” to this deduction worth considering: (1) The rules are complicated and may cause you to lose some of the deduction you thought you were getting. (2) In certain circumstances you may get as much value by taking the standard deduction as by itemizing deductions meaning your mortgage interest payments merely replaced the standard deduction and provided no real savings. (3) Even if you get the deduction you are still paying $1 to get a 35 cents (or comparable) tax break – not a very good deal. (4) And the effective value of the deduction diminishes over time as the loan matures and you pay less and less interest with each payment. In short, there are many tax rules and situations where you won’t be able to fully utilize the mortgage interest deduction. The rules are complicated so talk to your tax professional if this issue is important to your decision.
  • Low Return on Investment: A home mortgage is likely the cheapest money you will ever borrow – and the interest is usually deductible further decreasing the effective cost. For example, if you are in a combined state and federal tax bracket of 35% then a 6% mortgage could have an effective cost under 4%. This means two things: (1) Higher cost, non-deductible debt should be paid off first and (2) long-term investment returns will likely provide a higher return on your capital as evidenced by Ibbotson and Associates research showing a diversified portfolio returning in the 8% range.
  • Savings Are in Cheap Dollars: A key point to consider is how all the savings you are expecting only come after the mortgage is paid off meaning those savings must be discounted for inflation. For example, let’s assume you pay off your mortgage in 25 years instead of 30. Using this present value calculator you’ll see that $1,000 saved 25 years into the future is only worth $375.12 in today’s terms at a 4% inflation rate. In other words, you have to discount all savings by inflation because the payments you avoid will be in depreciated dollars. This is quite important.
  • False Sense of Security: You’re not going to like this idea, but you never really own your property – even if it is mortgage free. This is a throwback to feudal times where the king (“royal = real” relating to the latin for “king” connecting real estate to royal estate) was the owner of all land and received “tax” for the right of possession. Today, our local governments are the modern equivalent to feudal lords who collect property tax annually. In other words, you always pay rent to someone whether the bank is out of the picture or not. If you are not completely clear about this truth just stop paying property tax for a few years and see what happens. The truth is your monthly payment is merely a question of degree and to whom – not whether it exists or not. This ugly truth makes the idea of true mortgage freedom an illusion.
  • Lost Diversification: This one is “the biggie” so pay close attention… Most investor portfolios are denominated in their domestic currency and thus carry the risk that inflationary government policies will depreciate their investment purchasing power over time. A residential real estate mortgage is the only practical way for most people to short their domestic currency and hedge against inflationary economic policy.
  • Interest Rate Below Expected Inflation: Given record low mortgage interest rates as of this writing, it is entirely possible that the interest rate on a fixed rate mortgage (forgetting the fact that it might also be deductible) could turn out to be lower than the inflation rate. If that ended up being true (nobody has a crystal ball) then a bizarre financial situation is created where you are literally paid to borrow money in real terms (after inflation) even though you are paying interest every month. In other words, you make more by owing than by owning. Strange but true. When you prepay your mortgage you give away that financial advantage.

In other words, the way mortgage financing works is you borrow (short) your currency and use the proceeds to buy an inflation adjusting asset (real estate).

Few people understand how conventionally financed real estate is little more than a leveraged play on inflation. That is why it’s such a powerful wealth building tool more than 90% of the time, and it blows up horribly when the rare deflationary event strikes (i.e. 2008).

When you pay off your mortgage you are unwinding your short currency hedge. This means you lose the ability to be short today’s more valuable dollars and repay them with depreciated dollars in the future.

The importance of this financial fact cannot be overstated given today’s record government indebtedness and overt government policy directed toward creating inflation.

I repeat… this is a HUGELY IMPORTANT factor in deciding to pay off a mortgage early or not! It is critical.

But don’t trust me on this issue. Consider these two facts…

  1. This inflation calculator (which likely understates inflation’s true impact) shows you how the Federal Reserve has destroyed more than 95% of the U.S. currency’s purchasing power since they began monetary policy. If that time period is too long, then look at various 30 year time periods (the life of a mortgage) for similarly dismal stats.
  2. In a February interview with CNBC, Warren Buffett called mortgaged real estate “as attractive an investment as you can make”. He further stated, “If I knew where I was going to live for the next 5 years or 10 years, I’d buy a home and I’d finance it with a 30 year mortgage. It’s a terrific deal… If I had a way of buying a couple hundred thousand single-family homes… I would load up on them. And I would take mortgages out on them at very low rates…”

Did you get that? Read it twice! Warren is a pretty successful investor who has some clue on these matters so strong statements like this are worth listening to.

He’s telling you about the value he sees in locking long-term, low cost interest financing on an inflation adjusting asset. The last time this strategy paid off was in the inflationary 1970’s when the Savings and Loan industry went bankrupt for being on the wrong side of the transaction and homeowners literally laughed all the way to the bank with ridiculously cheap mortgage payments on appreciating real estate.

Are you going to be able to do the same on this next time around?

When you prepay your mortgage you give away that advantage so tread carefully on that decision.

What’s important to note about this entire list of negatives is how they aren’t intuitively obvious. 

The list of positives to paying off your mortgage discussed earlier are easy for anyone to see, but the negatives require a fair degree of financial sophistication – from esoteric tax strategy to long term inflation effects, short hedges on currency, and discounted present value equations.

It is heady stuff – financial geekism – yet it is every bit as valid to your bottom line as the more intuitively obvious reasons for paying off your mortgage early.

That is why there is so much misinformation on this subject. The concepts are complex and sophisticated once you get past the obvious reasons for wanting to get out of debt.

In short, the decision to pay off your mortgage is an intellectual battle where the emotional-intuitive desire to be debt free is matched against the intellectual realities of modern finance.

Unfortunately, this makes the decision process complex…

How Do I Make the Right Decision for My Situation?

mortgage early image

If you are somewhat confused right now then you are in the perfect spot. You get it, and that is a good thing. The confusion results from the tug-of-war between emotion and intellect trying to sort through the complex factors explained.

The next step is to give you a structured way to sort these issues so you can make order out of chaos and formulate a well-reasoned decision whether paying off a mortgage early is the best decision for your situation – or not.

The key is to realize there are two steps to this decision process…

  1. Personal Finance Considerations: This is a decision between paying off your mortgage early or taking care of other personal finance issues first that better reflect your personal values. This decision is prioritized ahead of any investment considerations.
  2. Investment Return Objectives: This is a decision between paying off your mortgage early or investing the difference. This decision only comes into play after the personal finance issues in the previous step are satisfied first.

Let’s take each of these steps one-by-one…

The First Step Is to Figure Out What Is More Important Than Paying Off the Mortgage

I’m a firm advocate of getting your financial foundation in place before pursuing more advanced financial strategies. Your wealth can only grow as high as your financial foundation can support (similar to how a skyscraper’s height is limited by the depth and strength of its foundation).

Below is an order of priorities for building your financial foundation that may take precedence over paying off your mortgage…

  • Guaranteed 50% Return: Many employers still offer 401(k) retirement plans that include employer matches – typically 50% of every dollar you put in up to 6% of annual pay. This guaranteed 50% return on investment is pretty hard to beat so it usually makes sense to make sure you are maximizing this benefit before prepaying your mortgage.
  • Maximize Tax Deferral: Even if your company doesn’t offer a 401(k) plan it may make sense to maximize tax deferred and tax free retirement savings before paying off your mortgage. Granted, tax issues are complex and vary based on individual circumstances so it’s impossible to make a blanket statement, but every tax deferred savings opportunity you don’t use is lost forever and can never be recovered because annual limitations apply. In other words, use it now or lose it forever. The investment math often tilts in favor of maximizing every tax deferred investing opportunity available… before paying off the mortgage.
  • Pay High-Interest Debt First: Even after maxing out all your retirement savings options it still may not make sense to pay down your mortgage early when you have other debt. The reason is most other debt will be at a higher interest rate – particularly credit card debt where the interest is much higher and not deductible. Use this debt snowball calculator to figure the fastest way to get out of debt. The order of precedence is to pay off the highest interest/non-deductible debt first followed by low interest/deductible debt (i.e. mortgage debt) last.
  • Financial Stability: Once you’ve maxed out your retirement plans and paid down your high-interest, non-deductible debt you may want to consider building a 3-6 month cushion should unemployment strike. Some naysayers claim a home equity line of credit serves the same function making this step unnecessary. The thinking is that mortgage prepayments increase equity thus providing a positive return while you don’t need the funds but can still be withdrawn through a line of credit should you fall on tough times. Either way, developing a safety cushion for difficult times is a prudent step in building your financial foundation.
  • Insurance and Financial Security: One of the main goals for paying off your mortgage early is financial security, but there are many dimensions to financial security beyond just being out of debt. For example, medical bills are a primary cause of bankruptcy so does it make more sense to increase your medical insurance coverage before paying off your mortgage? That’s a tough question because each choice manages risk – but in a different way. Similarly, the Council for Disability Awareness claims you have roughly even odds of being disabled for 3 months or more at some point during your career with 1 out of 7 workers being disabled for 5 years or more. Would disability insurance give you more financial security than prepaying your mortgage? Again, an interesting question to consider…
  • Kids College Funds: Do you have kids? Then funding a 529 college account, prepaid college tuition, and/or Coverdell IRA are additional ways to maximize tax deferred savings that should probably take precedence over paying off your mortgage.
  • Underwater Mortgage: If you are upside-down on your house (owe more than it is worth) then really think twice about throwing good money after bad. I’m not going to get into a big discussion about strategic defaults here, but suffice it to say there may be more secure assets for you to invest in than a house that is underwater.

Should I Pay Off My Mortgage or Invest?

 Once you’ve built your personal financial foundation (maximized tax deferred savings both for college and retirement, paid off high interest debt, and properly insured) then the question becomes, “should I pay off my mortgage or invest?”

Notice how this question only becomes relevant after the prior issues are handled.

The answer to the “pay off mortgage or invest” question is actually quite simple – whatever gives you the highest after tax return on your money is the right decision.

Financial advisers will quickly point to research showing long-term historical returns for a low cost index portfolio around 8% (+ or – depending on assumptions) and match that against much lower mortgage rates (as of this writing) and proclaim immediate victory… but it’s not that simple.

Investment returns are highly variable with periodic “lost decades” where even pathetic mortgage interest rates represent a superior return over a traditional investment portfolio.

The problem is the future is not the past and returns vary, but mortgage interest saved is a bird in the hand. With that said, you would be hard pressed to find 20-30 year periods (the life of a typical mortgage) where an investment portfolio would not provide a higher return than recent mortgage interest rates.

The problem with any investment return comparison is nobody has a crystal ball. Unless you have a direct connection to the Higher Power then you are stuck right back where you started with a decision between a guaranteed (but low) return for prepaying your mortgage versus an unknowable but potentially higher return for investing.

In other words, you are left deciding between the certainty of mortgage payoff versus the uncertainty of investing. While financial science provides a relatively clear answer (investing should provide the higher return over the long term), this is really an emotional decision about your risk tolerance, confidence in the future, and belief in the science of investing.

It is why so many prefer to get out of debt despite the relatively compelling math.

Final Thoughts – The Human Variable…

With all that said, there is still one very important element missing from this conversation…

Life doesn’t usually go as planned. We humans are not computers who implement our brilliant plans with mathematical precision. Life throws obstacles our way, plans change, stuff happens, and that is just the way life works.

It is foolish to make long-term plans in an intellectual vacuum that fails to account for the random nature of life.

With that in mind, below are some fun ideas worth adding to this discussion…

  • Flip the Logic: If you choose to invest instead of paying off your mortgage then consider this question – would you be willing to refinance the equity out of your mortgage (thus increasing your debt) to add to your investment accounts? If not, then you are logically inconsistent. (By the way, I write this with a wry smile because it is describing me perfectly – see below…)
  • No Discipline: For every 10 people who claim to be making the minimum mortgage payment and investing the difference I would hazard a conservative guess that more than half fail to follow through on the investment part of the equation. The road to financial mediocrity is paved with the best intentions. In other words, an optional savings program that requires self-discipline is frequently no savings program at all. Contrast this with someone who places a 15 year, biweekly mortgage on their home thus creating enforced discipline. One happens with certainty regardless of life’s wrinkles… the other is optional.
  • Expect the Unexpected: Nobody expects to lose their job, have a major medical problem, become disabled, or invest in a fraud; yet, over the course of a 30 year mortgage the odds that you will experience one or more of these admittedly rare and unfortunate events are far greater than you would like to believe. When your home is paid off it is easier to weather these storms with a minimum of personal adversity. Plan for the unexpected because eventually it will happen.

Conclusion:

I suppose the best way to conclude this lengthy analysis is by sharing what I’ve chosen to do with my own mortgage(s).

The truth is I used to be in the pay-off mortgage early camp. I hate debt and have a high value on freedom. In the late 1990’s I paid off my mortgage only to watch my investment portfolio double the next year while all that capital was tied up in my house.

Ouch! That was expensive…

Admittedly, things could have worked out very differently. I could have paid off the mortgage in 2007 instead and seen a decline in investment values the following year.

However, in general, my investments outperform mortgage interest so it generally makes sense for me to prioritize investment capital.

With that said, I also find that I’m not fully rational on this issue.

I would never refinance my home and invest the equity to pursue those higher returns. From a pure logic standpoint that makes no sense: I’m not willing to liquidate investments to pay off the mortgage, and I’m not willing to increase the mortgage to fund investments.

Hmmm…. I guess I’m not as rational as I would like to believe.

The truth is the decision to pay off your mortgage is quite complex.

Fast forward to current times and I’m several years into a 30 year mortgage on my current home that, prior to writing this article, I would have refused to pay off. The interest rate is pathetically low, tax deductible, will likely end up below the inflation rate over the life of the loan, and it gives me some measure of inflation protection with a small short position against the dollar.

So I’ve been at both extremes – pay it off fast, and never pay it off – only to now end up somewhere in the middle of the road going forward.

I now firmly sit on both sides of the fence as follows…

  • Because my retirement and kid’s college are fully funded I don’t need to prioritize those accounts.
  • I have no debt besides the mortgage so no issue about paying more expensive debt first.
  • I have all the insurance I need.
  • Which means the discussion literally comes down to paying off the mortgage or investing.
  • The math is clear that my highest return is with investing, but I’m also emotionally connected to having no debt and love the freedom of minimizing my cash flow needs. For that reason, my decision is to funnel a portion of increased revenues from this business toward prepaying the mortgage even though it is technically irrational from a return on investment perspective.
  • In summary, I’m not willing to dedicate any of my investment capital to paying off my mortgage, but I’m also not willing to leverage my house to increase investment capital. This is irrational, but it is the honest truth where I stand on mortgage vs. investing. Regarding new income production, I’m fine with dedicating a portion of the revenues from this business toward paying off the mortgage rather than perpetually building investment capital while retaining debt. I guess the logic is that I’m getting a diminishing emotional return on more investment capital when compared with less debt. For economics geeks, it means I have a higher marginal utility on debt reduction than capital increases.

I would like to declare this a balanced perspective in that I’m comfortable with my portfolio “as is” so I’m willing to “diversify” and lower risk by paying off mortgage debt with extra income, but in the end I know the truth… it is my emotional desire to be debt free and reduce risk that is driving the decision. I know the math and I should be investing – exclusively.

So there you have it – I’ve personally lived at both extremes of the decision and now stand firmly in the middle. The decision doesn’t have to be either/or: you can pay a little to debt reduction and save for investing at the same time.

Like everything in life, happiness is often found in the balance. I guess paying off your mortgage early is no exception.

So now that you know my situation, where do you stand?

How has this analysis helped you sort through the decision and what conclusion did you reach? Which issues hold the greatest sway in your decision? Please share in the comments below…

89 comments
jusbrand
jusbrand

Just heard you speak about this post on The Wired Advisor Podcast. Very comprehensive post. Similar issues apply in Australia, although the tax considerations are different. The income tax breaks offered by saving into a retirement fund often outweigh the interest savings in paying down the mortgage, but people are usually more comfortable focusing on getting rid of debt. 

TIMCC
TIMCC

So Todd if I have a 200k LOC HOME EQUITY ACCOUNT and I am ready to retire and start drawing on my IRA which is earning 15% right now I could use the LOC to live on for a while until SS kicks in at 66 (I'm 63). That way my LOC (prime + 1/2) is cheaper than using my retirement funds they can continue to grow and when I am supplemented with SS the draw on the IRA will be less. GOOD POINT! BTW my mortgage is paid off.

richGETricher
richGETricher

I've a simple way to answer this article.


If your mortgage loan is less than $12,000 in interest and you have extra cash sitting in bank.

Go and pay more towards your mortgage principle. 

Why I said $12,000 ? It's not a magic number. This $12k is coming from fed/state tax break.

Married household automatically gets $12k tax break. So, if your mortgage interest is only $8000 a year, you are still getting $12,000 tax break. If your mortgage interest is more than $12k, lets say $14k in interest, your tax break is $14k. Get it ?


So why pay $8000 in interest to bank, when you are still getting $12k tax break?



KarlHungus1
KarlHungus1

Excellent article, and I am with you on both sides of the fence. I would like to see if you or others can answer a couple of scenario based questions:

Currently, I (40 Years Old) have 2 investment houses, which is my way of investing in my kids education as I all pay for the living, along with a small 529 investment and Gi Bill, and the kids can take care of the rest. I max out 401k and IRA's and invest another $1k a month or so. recently purchased a new home (272K, 3.5% 10%down, no PMI (VALoan)), which I am not sure I will be in forever. No other debt


If we really want to hunker down, my wife and I can pay off the house in about 7 years, while still maxing 401k; IRA may take a bit of a hit though.


Would you do it? The way I see it, I am not going to make all that much investing in 7 years, and with the market as shaky as it is, If the Fed stop printing $ and the market takes a huge hit, if not deflates....  I would imagine the economy would be more stabilized at that point (cross fingers) I can then invest a significant amount more each month, in just 7 years, while having a house free and clear.


But if the market is stable over the next 7 years....


any opinions?

debt debs
debt debs

Whoa... now you've got me a bit conflicted.  We would have been mortgage free this year, but added on to our mortgage for HELOC and other debts, extending it 4 more years from now and that is paying it at a quite aggressive rate.  My husband is 61 and so I would like him to be able to retire in 4 years.  I don't feel he can retire while we still have a mortgage.  On the other hand we have some room in our retirement accounts that it would be nice to max out.  Maybe I need to rethink this and put some to both.

Scott Simpson
Scott Simpson

Great guide. Some of the points are US-specific, but you covered pretty much everything I was considering.


And even after all that, I'm still on the fence, but leaning toward pay-it-off.


The situation I'll be facing: my wife will die. I will get a life insurance payout. Bank/invest it, or pay off [most of] the mortgage? The majority of me says pay it off, get rid of that giant bill, then invest/save/smartly spend income as it comes in. Part of me says to keep the money as money or at least invested money.


Thanks for the insight you've provided.

freepursue
freepursue

Thanks for posting an informative analysis AND including the realities of our predictably  irrational selves. It is so important to weigh the financial pros and cons along with what our comfort level and behaviour is as human beings. We are not computers. Emotions play an important role in our short term and long term view and decision making.


Though I understand the benefits of leveraging the potential for a low-interest mortgage for investment purposes, being mortgage-free is by far my preference (despite paying property taxes in perpetuity).


Another angle to consider as well is the size of the mortgage itself. I find people are buying homes that are too large for their real needs. The delta between a $400K home and a $200 or 300K home would mean and extra $100-$200K in money available to invest. Reevaluating housing needs from this perspective can be more powerful than any other consideration. 

tutone
tutone

Really informative and well written article. Thank you! Let me add one additional method for paying off the mortgage early. Simply match the principal each month and you will convert a 30 year mortgage into a 15 year mortgage. This method has a couple of advantages.

1. Flexibility. If times are tough then just don't add extra principal that month.

2. It's cheaper up front. Over time as the principal portion of the payment increases so will the amount extra that you pay each month, but inflation reduces the value of those dollars and hopefully your income will also have increased making it easier to afford the higher payments.

GlenCraig
GlenCraig

Awesome guide!  I love that you aren't hardcore on either side.  You understand there's clear economic logic as well as emotional comfort that can make the issue a bit cloudy.  But you make great points for holding off on extra payments if you have the discipline to use the money in better ways.

TYJACK
TYJACK

Wow, thanks ... it appears that my strategy in retirement is just about right!

Boomerst3
Boomerst3

This explains perfectly the tug between emotional and rational decision making. I refinanced my mortgage at 3% a year ago rather than pay it off. I wanted that money in the market. I recently bought a second home and decided to pay cash, but have to admit a big part of me wants to have a mortgage and put that money back into the market. Part of the reason is the added costs involved with getting a mortgage, such as title insurance for the lender, and because I am on a lake, having to get expensive flood insurance. But I still wrestle with the choice. As you say, it is personal.

Finishedat50
Finishedat50

Great post Todd. I'm wrestling with this decision right now, so I certainly appreciate the info. I'm a new subscriber, and am rapidly consuming all of the information on your site- nothing has disappointed so far- please keep the great/valuable info coming. I also purchased a paperback copy of your "How Much Money Do I Need To Retire" book. It arrives next week, and I'm really looking forward to reading it. Take care.

NateFancher
NateFancher

Wow that's a great post. I'm new to your blog. Found out about you through Jesse Mecham's YNAB podcast. Great episode by the way!

 

I've been thinking a lot about this issue of paying down my mortgage sooner, but now I'm going back to the drawing board with all that was said here. In fact I may go back and read it again!

RaymondWickham
RaymondWickham

I found this article to be fairly complete in the analysis of the different options and reasons for and against paying off a mortgage sooner. I do have an additional thought to the information found at the end of your article.

Just as a thought and a possible topic for future articles that write, what are the benefits and drawbacks to tax deferred investments. If we look at tax rates, they are at a fairly low point in history, and most would agree that taxes are going up. So why would we not pay taxes now on an investment only to pay taxes later if we believe if they are going up.

 

Also in regards to 529 savings plan, what would possible downsides be. In my opinion they are good for a portion of college savings, but they do not have flexibility. If you have a student that does not go to college then there are large penalties to remove the money. Or if you have a student that gets a full-ride then the penalties still apply. What alternatives are available to help pay for college while still giving flexibility and access to cash.

 

Thank you for your well written articles.

rbeck
rbeck

...and the longer you wait to pay off the mortgage, the higher the effective "bond" coupon rate rises, because you are paying less "face value" to get the same "return" every month (your mortgage payment amount).  So it gets more compelling as time passes.

davethecanuck1
davethecanuck1

I was a little late reading this, but it is an excellent article.  I like that you highlighted the cognitive dissonance involved in this question with regards to your aversion to borrowing more to invest.  It's important to acknowledge that we, as human beings, can be irrational.

 

I am debt free (aside from my mortgage), my kids college accounts are funded, I have maxed out my 401K for many years, and I have recently increased my cash reserves from sale of another property.  I have a little less than 30 years left on my 4.15% mortgage, and could use about 25% of my current retirement savings (taken from my cash reserves) to pay it off all at once.  I am 40, so have no intention of carrying the mortgage to full term, so I'm inclined to just get it over with now.

 

Put another way, if I was offered a 30 year bond with a 4.15% rate of return, I'd be happy to put 25% of my investment portfolio in this, assuming the rest of the portfolio is equity based.  The US 30 year is currently offering about 2.9%, so the mortgage payoff equivalent seems like a good deal.  Is my logic flawed?

 

Yes, there are taxes to be considered, but I figure the taxes on this hypothetical bond, and the mortgage deduction (I don't get the full deduction) are roughly even, so I think it's an apples-to-apples comparison.

 

So, whaddya think?  

 

 

AndyDawnNagy
AndyDawnNagy

This is extremely helpful!  Thank you for this informative and not overly technical explanation!

We have a mortgage with a 6.25 interest rate and 30k left to pay.  PLUS four boys needing college funding (one very soon) and PLUS an opportunity to invest in our 401K with an employer who is matching up to 17K JUST THIS YEAR.  (he evaluates yearly on how is the business doing)

We have 30k that needs to go somewhere other than a savings account.

We also are thinking of moving to another neighborhood. 

No other debts at all.

 

It seems wise to take advantage of the 401k matching up to it's max and put the rest into the mortgage, but we really do want to get rid of that mortgage payment.  However, we really wanted to get rid of that mortgage!  I wonder if we could pay off the mortgage and get a rock bottom rate home equity loan?  We have never even looked into such things and dont' know the rules.

 

OR, move to another home with a lower interest rate mortgage.

 

Still a little confused, but much less than I was before.

DeboJAdebayo
DeboJAdebayo

Hi Todd, great article here. I was actually looking for a comprehensive article on this point. I have a few points to raise that I hope you can answer

 

1)You mentioned that having a mortgage is a way of hedging against the home currency in case the resident government undergoes policies which are inflationary. I wondered whether this was correct? If the government underwent inflationary policy, surely that would mean that all asset classes including property would increase commensurately, so the decrease in "purchasing power" which you mentioned with regards to an investment portfolio would only be with regards to the "cash" and "cash equivalents" aspect of the portfolio. You seem to confirm this later on when you said your investment portfolio doubled but you had all the capital tied up in your house which you paid off. It appears that the real issue here is the opportunity/cost i.e. paying off your mortgage at the expense of investing in your portfolio 

 

2) Following on from the previous point. Wouldn't that also put more money in your pocket as the value of your house has increased and you have no debt (granted that gain would only be realised after selling the property).

 

3) As you said, there is the risk of inflationary policy, but there also is the risk of deflationary pressures, with the economic uncertainty would it not be better to pay off your mortgage to reduce your risk to uncertain economic policy and market forces?

 

Would love for you to give your take on my questions

Thank you very much, I look forward to your reply.

 

Regards 

Junior

spruce815
spruce815

Hi Jon,

 

I'd love to offer my opinion, but I need some additional information first:

 

1.  Are you upside-down?  If not, what is your LTV (loan-to-value) ratio?  In other words, divide your mortgage balance by the current appraised value.

 

2.  Do you like the house, and would you like to live there?  This question leads to many others, but it is a starting point in determining what you should do.

 

3.  How did you get a 37 year mortgage?  This must be an old mortgage.  Have you checked to see if you can refinance?  Regardless of LTV, there are government programs that can help without going into default.  The Home Affordable Refinance Program (HARP) has no LTV limits.

 

Hope this helps,

Spruce

newworldnow2
newworldnow2

My take (on my own finances) is this:

 

1. I pay only the interest (unless the payments hurts my cashflow. In such a case I amortize to bring down the cash outflow to a comfortable level).

2. I use the cash left over to invest.

 

As far as I see it, if you pay the interest on your debt and those payments you do make does not hurt your finances (i e you still have disposable income afterwards) then don´t amortize at all. Let it be. As long as you keep the ship floating along.

 

At the same time, I do also like being debt free so I do have the same feelings you wrestle with:). I guess we all have (i e all people with debts to pay).

Dave Waldschmidt
Dave Waldschmidt

Agreed ... no razor blades! I guess my point is that most individual investors aren't financial analysts or statisticians ... rather they make financial decisions based on how they feel about pending events ... or based on the opinion of how others feel about pending events ... the question they ask themselves is "do I take opportunity or do I protect? Even when presented with a complete statistical analysis ... most decisions are made based on how the recipient "feels" about the analysis - hence my position that many if not most financial decisions are emotion based. The the ability to review the outcome (benchmarking) and adjust based on the expected outcome is critical. Fun stuff! Thanks for sharing your thoughts too ... good stuff.

FinancialMentor.Com
FinancialMentor.Com

Facebook Yikes! Keep the razor blades away when reading thatJ. To answer your question, it depends what you mean by “traditional actuarial approach”. I would definitely stay away from correlation dependent approaches but there are other methods beyond the scope of Facebook updates which remain valid.

Dave Waldschmidt
Dave Waldschmidt

I agree in the case where actuarial data is relevant. In our current economic environment, we've got chaos in the European markets (Greece on the edge of default & bailing from the EU), unprecedented ramp-up of national debt in the US, a real estate market where 25% of the sales are short sales or banked owned (with still many homeowner's underwater), inflation is hiding in the corner just waiting for the opportunity to come out, more talk of another middle-east war/engagement (what ever you want to call it) and an unemployment rate that is at or near 16% (depending on who you believe) and is at best unstable - all pushing our economy in the direction of another recession. With so many significant stresses and unknown outcomes to near future events, isn't it difficult to conclude that a traditional actuarial model would be appropriate to use?

FinancialMentor.Com
FinancialMentor.Com

Facebook Hi Dave. Thanks for sharing your thoughts. The solution is mathematical expectation. You take an actuarial approach to your decision process no different than an insurance company or a casino. When you operate with a statistical advantage your profits become simply a matter of sample size. Hope that helps.

Dave Waldschmidt
Dave Waldschmidt

One of the best written articles on debt vs. investment I've ever read. It's interesting to note your thoughts that economic decisions are not just mathematical ones ... they're emotional too. Since my crystal ball is a bit fuzzy and I can't see into the future (how about yours?) our financial decisions are almost entirely made by "gut feelings" and not imperial evidence. We simply won't know the outcome of our decisions until our decisions are a thing of the past. The key then, is how we adjust (and make subsequent decisions) when we learn the outcome of our decisions.

spruce815
spruce815

Regarding this topic, this is by far, the most informative article I have read.  Thank you!

 

Everyone's situation is unique, and I'd like your thoughts on mine.  I'll try to be brief.

 

In 2009, I was on the verge of collapse - over $65,000 in revolving debt, mortgage at 250% LTV, and a job which only helped me get by.  Luckily, I was promoted at the end of 2009 to a job paying nearly double.  I have since paid off all of my revolving debt, established a 6 month cash emergency fund, have maxed out my 401K in 2010, 2011, and 2012 (yes, I'm already maxed out for this year), and have established an investment account with equities and mutual funds totaling approximately $60,000.  I have no children, and I've worked at the same company for 14 years.

 

I put together a plan last month for paying off my mortgage.  I have slowly reduced the principal over the past few years, but I haven't gone "all in."  I wanted to take care of the above mentioned items first prior to taking on the task of the mortgage payoff.

 

Under my most aggressive plan, which requires tremendous personal austerity along with very little additional investing with the exception of my 401K, I can have my $144,000 mortgage paid off by November 30, 2013.  My house is currently worth approximately half that.

 

Since my time horizon for payoff is more short-term than your examples, and by paying it off, I not only achieve the emotional financial security, but I also put myself in a position where I can actually move, do you think this idea is wise?  I have battled back and forth for over a year, but I made a commitment last month to do this.  I have the means to do so, and once completed, I can easily get an additional $800-$1000 rental income on this property when I move to a new house.  I'm 32 years old, so the long term benefits of the projected rental income and increase in property value outweigh the short term benefits of doing a short sale - at least in my analysis.

 

I look forward to your comments, and your article was fantastic!  Thank you again.

stannius
stannius

Thanks for this excellent writeup. So many people can't get past the "debt is bad" mindset. And most of the rest have a tendency to ignore the time value of money.

HonoluluAunty
HonoluluAunty

Aloha Todd,

 

This was such a timely article for us since we had just refinanced our home, our last child graduated from college, freeing up a our monthly budget with more discretionary funds, and I was wondering what to do. 

 

I also was sitting on the fence, but after your very good arguments pro and con, I'll go the con route and go "all in" with investing.  Once I commit to investing (even taking out more HELOCs if needed), those funds are working for us, and we have the option to cash in the investments if need be.  However, if we use our discretionary funds to pay down the mortgage, the only option we have to cash out is to refinance again or take out HELOCs. 

 

Mahalo for your wisdom!

 

Aunty

Jason_Tucson
Jason_Tucson

Great article, but I don't think your position of not paying extra but not extracting equity is at all irrational.

 

Extracting equity typically involves significant transaction costs, in terms of both time and money. So it can be perfectly rational to not pay extra on an existing mortgage, but not take out a new or second mortgage just to free up equity for another investment. In the case of equity harvesting, the return on the invested funds must compensate not only for the mortgage interest down the line but the transaction costs involved in obtaining the mortgage in the first place. Those costs are in current, "expensive" dollars. This is typically 2-3% of the amount financed, but if you still have a significant balance on the original mortgage (otherwise - you'd have nothing to pay extra on for very long) the amount you will free up to invest is only a portion of the amount financed. Say it's only 50% of the amount financed - now you have to earn an extra 4-6% on the amount invested just to cover the transaction costs.

 

I'm in exactly the position you are in, with the exception that my local real estate market has attractive investments. I'm not paying extra on my personal residence mortgage, I'm not doing cash out refinancing either. But I am financing the purchase of cash flow rental properties, thus increasing my short position in dollars. I consider my decisions in this matter to be fully rational.

 

 

Shavis
Shavis

Todd, that was the clearest, most unbiased, honest assesment on the subject I have ever read. Obviously, you have been there and done it, as it comes out in your writing. I am sorta-kinda in a related field, have paid off my mortgage and have no debt, so I can sooo relate to the question... I've been talking to myself for over a year now and am solidly on both sides of the fence, as well.

Keep up the good work... looking forward to following along in the shadows.

Joe

Ben Boyle
Ben Boyle

very good summary. I'd make more explicit (it's there) the fact that the avoided payments due to any equity in the home are post tax, in addition to adjusting for inflation and time value, for those who are analytically inclined. One should also use observed investor returns, not advertised; investors rather significantly and systematically lag the indexes in reality due to many factors (ranging from fees to timing to weighting to behavioral finance related errors and more).  Also implied but not fully described is the fact that the steadiness of the imputed cash flows have a huge (and very difficult to compare  vs return from investments w/ unpredictable time series) positive on portfolio return. Since we can't realistically describe the market sequence of returns this can't be handled explicitly, by one can approach it conceptually by looking at the benefit of other stable returns on portfolio strategies (e.g. adding bonds to a stock portfolio, using actual realized returns).  Lots of pubs on that, it's clear there's a port bene from the regularity that is dependent on the actual time series that one experiences on the "riskier" investments, but it's not trivial.  The benefit of a mortgage in an long term currency devaluation, which Reinhardt and Rogoff indicate nearly always happens, is a huge plus that is not well understood by many and is confused with appreciation.  Lots of research also indicates this downturn is likely to be quite extended and one should factor that in to one's personal strategy as well.  I find it conceptually helpful to think of one's home as a rental with an exceptionally reliable renter (no vacancy, no nonpayment, no litigation), and then it's merely a matter of choosing the finance strategy for that rental property. As a "renter" it's still simply an expense to you to minimize. As a landlord, you want to finance it appropriately for your overall situation and strategy (all the issues cited in the column).  Those w/ day jobs or other regular cashflows may sensibly lean towards carrying favorably termed debt somewhat more than those whose life stage includes reduced  or unreliable or non-cash income.  Great writeup, probably the best I've seen so far.

Financialmentor
Financialmentor moderator

@GlenCraig Thanks for your support, Glen!  Yeah, this was a fun one to write. I really appreciate you stopping by and sharing your feedback. .

Financialmentor
Financialmentor moderator

 @Finishedat50 Glad you are getting great value from the site. I hope you enjoy the book. Make sure to leave a review on Amazon so I can see your feedback. I read every review. Thanks for all your support.

Financialmentor
Financialmentor moderator

 @RaymondWickham Thanks for the good questions. The simple answer on your last question is Coverdell IRA's although the downside there is they are limited to how much you can sock away. Hope that helps.

Financialmentor
Financialmentor moderator

 @davethecanuck1 The best choice will only be known in the fullness of time. The scientific answer is "whatever gives you the highest after tax return". The emotional answer is "whatever provides you the greatest emotional satisfaction". In the end, it is a bet on an unknowable future. If inflation rises you will prefer to have a short position (mortgage) in your currency. That, of course, is the opposite of a bond in your analysis. If deflation continues than you will be glad to be debt free. There are also risk management considerations to take into account (lowering your  monthly cash  flow needs). As I said, it is a complex equation. Simple answers don't honor the reality of the situation which is multi-dimensional. In the end, it is as much a personal situation as a financial. Hope that helps.

Financialmentor
Financialmentor moderator

 @DeboJAdebayo Hi Junior, let me clarify...

 

1: The inflationary advantage of a home mortgage comes NOT from the asset purchased, but the short position in the home currency by borrowing in today's valuable dollars and repaying in future cheaper dollars. In other words, there are two sides to the equation - the asset and the debt. The asset rises in value to offset inflation, and the debt declines in value as inflation grows. It is the combination that is powerful.

2: True, but it is only half the equation. See #1 above.

3: True, and it depends on your objective. What you are addressing is risk management. You are definitely lower risk without leverage which would be better in deflation. However, you've actually increased your risk of purchasing power loss during inflation by not using leverage (debt). The problem is real estate historically lags inflation on the upside (due to rising interest rates holding back values). Leverage offsets this lag because (using a 50% mortgage in this example to keep it simple) you get 2 units of inflationary increase for 1 unit of purchasing power loss on invested capital. 

 

Hope that helps!

Financialmentor
Financialmentor moderator

 @spruce815 You're heading into the area of personalized financial advice which I can't give on these pages. I also chose to sidestep the issues involved in strategic defaults (as stated in the article) because the issues are unique to each situation and do lend themselves to an article designed to serve every person's needs. In short, the answers to your questions can't be correctly addressed in a comment. It is the wrong venue and would require personalized financial advice. Hope that helps.

Financialmentor
Financialmentor moderator

 @Jason_Tucson Thanks Jason. I see the logic in your point. I wasn't factoring in the transaction costs so much as making a point about how the reflexive logic worked and poking fun at myself in the process. With that said, where I'm actually being "rational"(IMHO) is when it comes to realizing what has a higher marginal value to me - regardless of the pure math.

 

Thanks for pointing these ideas out and adding to the conversation!

 

Financialmentor
Financialmentor moderator

 @Ben Boyle Thanks Ben. You make several excellent points. As a writer, I'm always in a battle between completeness and making something unreadable due to excessive detail. I try to strike the balance and appreciate you bringing up these points. Volatility of returns and actual investor returns vs. theoretical are both excellent points that open the door to entire articles in themselves. Thanks for adding your insights!

NateFancher
NateFancher

 @Financialmentor Yeah man! Your site needs to be seen by more people. I'm dedicated to spreading the word from my end!

davethecanuck1
davethecanuck1

 @Financialmentor Your argument about using a short position on the currency as a hedge is compelling.  I'm guessing that inflation will rise over the coming decades, which favors the short bet (mortgage).  But the risk management aspect may end up winning out in my case.  

 

Having a lower monthly cash outflow could be crucial in a 'black swan' life event.  Perhaps instead of thinking of "highest after tax returns" I should be analyzing this like I would an insurance policy.  I.e. Clipping my maximum gains in exchange for reducing my maximum risks.

 

I'll let you know in 2042 how it's all worked out for me.

DeboJAdebayo
DeboJAdebayo

 @Financialmentor Hi Todd, 

 

Thanks very much for your reply. In response to your answers  I would say this

 

1) This appears to be a further advantage of holding property that isn't your own, you are able to amortize the debt over a period of say 30 years with rent. Inflationary pressures would mean that rent prices would increase, the debt would decrease and the value of the property would also increase and in deflationary pressures you can maintain the mortgage repayments with the rent until property prices increase again. Is this sound logic? 

 

2) Further in response to your answer on "risk management," would the right answer be not to necessarily be adamanat to hold no debt at all but to be mindful of your debt in relation to your equity? 

 

Thanks again for the reply

 

Regards

Junior

 

 

davethecanuck1
davethecanuck1

 @Financialmentor  Inflationary (buying power) risk is certainly a major long term consideration, but in my case "market crash risk" (a type of black swan) is a bigger immediate risk.  I work in the financial/trading industry (tech side) so a market crash could  wipe out (temporarily at least) a good chunk of my savings, and also could cost me my job.  Basically I have correlated risks between savings and cash flow.  In a bad crash, I could be left with no income, and insufficient savings to pay off the house, though I could hopefully have enough left over to make mortgage payments with what savings I am left with.

 

Paying off the mortgage could be thought of as an investment in an asset who's value is somewhat uncorrelated to the market crash risk.  

 

Fun stuff indeed.

Financialmentor
Financialmentor moderator

 @davethecanuck1 The thing that always makes this discussion complex is what risk you are reducing: risk of inflation wiping out purchasing power (keep the mortgage) or risk of black swan making reduced cash flow needs desirable (pay mortgage off). Again, this decision is so much more complex than most people understand. Fun stuff!

Financialmentor
Financialmentor moderator

 @davethecanuck1 I really like what you said here. I think that is the core of my confused analysis at the end of the article. I have diminishing returns on increasing assets and increasing returns on diminished risks due to the incredible risks built into our economy. In my situation it isn't really about maximum return on capital as much as minimizing risk of getting knocked backward should a black swan even rear its ugly head. Paying off a mortgage makes zero sense in my situation from an ROI perspective, but is quite appealing from a risk reduction/cash flow perspective.

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