In the world of personal finance, you can always generate a good debate if you talk about paying off your mortgage early. The argument usually boils down to something like this:
If your interest rate is 4%, then paying extra towards that mortgage will earn you 4%. If you think you can earn more than 4% elsewhere, then don’t pay off your mortgage.
However, when it comes down to if YOU should pay extra towards YOUR mortgage, the above statement is an oversimplication. As Einstein is credited with saying, “Make everything as simple as possible, but not simpler.”
Since I am faced with this decision myself, let’s address the implied assumptions in the sentence above and all the other little details that go into the decision.
Warning: This is a braindump post and thus rather long and detailed…
Assumption #1: Your mortgage interest is 100% tax-deductible.
- In order for paying off your mortgage at 4% to get you the same net return as an investment earning 4%, the assumption is that your mortgage interest is 100% tax-deductible while your potential investment is to be taxed at your ordinary income tax rate. That way, the taxes cancel out.
- Mortgage interest is only tax-deductible if you itemize. However, the standard deduction in 2013 is $12,200 for married filing joints and $6,100 for single filers. This is the amount that anyone can deduct. Let’s say your mortgage is for $250,000 and the interest rate is 4%. That’s $10,000 in interest annually. So far, the married folks have no tax benefit at all! You would need a lot of other deductions like state income tax, property tax, and charitable contributions to push you over the hump. For example if you have $7,200 in other deductions, then only $5,000 of your $10,000 in mortgage interest is actually saving you anything extra in taxes. I call this 50% deductibility.
- In addition, as you pay down your mortgage over time, your interest paid will decrease and make it gradually harder to itemize.
- On the flip side, if your investments are stocks, then your long-term capital gains tax rate may be lower than your ordinary income tax rate.
- The ability to avoid some taxes and thus increase your effective return is also why it is generally advised that you shouldn’t pay extra towards your mortgage unless you’ve maximized your tax-advantaged accounts (401k, IRA) and definitely any 401k employer match. An employer match is often a 50%-100% instant return, so you definitely can’t leave that on the table.
- Bottom line: People think their mortgage interest is saving them lots of money in taxes, but it often isn’t. Each person should add up their other deductions and figure out their own percentage of deductibility.
Assumption #2: You’ll won’t refinance or sell the house before the end of the mortgage term.
- Let’s rewind and just assume that paying down your mortgage will effectively earn you 4%. Hmmm… 4% for 30 years, that’s too low for too long! I would point out that the current yield on a 30-Year Treasury bond is about 3.2%. Not impressed? Me neither. How about the fact that people rarely keep their mortgage for 30 years. Let say you sell your house or refinance in 5 years. Now you earned 4% a year guaranteed over just 5 years. A 5-year bond only earns about .90%, and the top 5-year bank CD only earns about 1.5%. Now things look better!
- “But wait, my mortgage payment stayed the same! How did I earn 4% over 5 years?” As you make additional payments, more of your monthly payment is applied toward the principal and less towards interest. You just got moved forward in your amortization schedule. When you sell or refi, you’ll get your money back and realize that return.
- Bottom line: Your mortgage holding period matters.
Assumption #3: You can handle the additional leverage.
- “Whatever, stocks will earn so much more than 4%, who cares?!” Now, if you asked me if stocks were going to return greater than 4% over the next 30 years, my answer would be yes. Would I bet with even money odds? Sure. Would I bet my life on it in order to win a Twinkie? No. I think the odds are good, but not a sure thing. It’s always hard to compare a guaranteed fixed return with a highly volatile return.
- What I’m trying to get to here is that intentionally putting even more money in stocks while effectively using borrowed money is called leverage, which amplifies both potential gains and losses.
- Let’s say your house is worth $250,000, your mortgage is for $200,000, and you have $100,000 in stocks. Now let’s say you had a $100,000 windfall and instead of paying down your mortgage, you put it in stocks so now you have a $250,000 house, $200,000 mortgage, and $200,000 in stocks ($250,000 net worth). If the stock market went up 50%, you’d be up $100,000 (40% increase in net worth). But if the stock market went down 50%, you’d be down $100,000 (40% drop in net worth). If you’d just paid down the mortgage, your swings would have been only 20% of your net worth. Trust me, that’s a lot less Pepto Bismol. Sure, those swings may work out in the end, but it may take a decade or more. Can you handle the wilder ride without asking to get off?
- Again, holding period matters. Over a 30-year period, I like my odds of the stock market averaging being better than 4%. Over a 10-year period, I would like the odds a lot less.
- Bottom line: Leverage increases risk and stress. It may be worth it, but consider it carefully.
Assumption #4: You’ll invest properly.
- I don’t think it’s a coincidence that if you look at most US households, their largest asset is often their home. A mortgage is quiet, regular, “forced” savings. You can’t sell your house with a few mouse clicks. Real estate transactions are expensive, so people tend to buy and hold for relatively long periods. Nobody on the TV is yelling at you to SELL SELL SELL your house and BUY BUY BUY the other house across the street. This is a good thing.
- Some people will indeed put the money that could be tucked away for a 4% guaranteed return and put it in the stock market for decades and get a higher return in the end. But the behavioral component certainly isn’t guaranteed, as there is an entire financial industry out there trying chip away at your money.
- Bottom line: How’d you do during 2008 and 2009? Did you buy MORE stocks? If so, you may have the proper make-up for investing. If you quietly switched to bonds, you need less risk.
Detail #1: Inflation hedge!
- “Isn’t a mortgage a great inflation hedge?” Yes, if inflation goes sky-high (over 4% in this example), your monthly payment will effectively decrease over time. Inflation tends to be good for debtors. However, like other forms of insurance, hedging costs money. What if inflation is tepid, just meeting the market expectations of 2-3%? Are you willing to pay the premium for this insurance?
- Alternatively, take the wait-and-see approach. As long as you have a mortgage, you’ll still have some inflation hedge. If one day interest rates rise high enough and you can earn more than 4% (or whatever your rate is) with equally safe investments, then by all means do so and stop paying extra. I have some 10-year CDs at 5% APY that I view as a “mortgage offset” holding. Sure, I could cash them out and pay down my mortgage, but why not pocket the higher rate as it’s FDIC-insured?
Detail #2: Cashflow
- When you pay off a mortgage completely, you go from a required chunk of money every month to nothing but property taxes and homeowner’s insurance. This can be useful if you are at a point where you may be dependent on a pension, annuity, or other fixed income.
- If you’re not paying down your mortgage and putting money in stocks instead, you might be in a bear market when you want the house paid off. You don’t want to be forced to sell low.
- For this reason, I like the idea of timing your mortgage payoff date to the date of your retirement, or a date where you want lower monthly recurring expenses (“semi-retirement”). If you plan on retiring in 10 years, then try and get your house paid off by then. If you are a long ways off from your retirement, then you have many working years left and don’t have to worry much about cashflow.
- Paying off your house is saving for retirement. Without a mortgage payment, you’ll need less income and thus a smaller portfolio.
Detail #3: Home Value Exposure
- I occasionally read that paying down your mortgage gives you too much exposure to real estate. This always confused me as you are fully exposed to changes to the value of your house whether or not you have a mortgage.
- The exception to this is if you want to be able to walk away from your house in the event that your home becomes worth less than your mortgage (short sale or strategic default). In this case, you would make a minimal downpayment and keep as little home equity as possible to minimize your downside risk. I’d make sure you live in a non-recourse state as well.
Detail #4: Bond Replacement Therapy
- Often, the focus is on stocks vs. mortgage. This is because it is quite hard to find any bonds that safely yield as much as your mortgage interest rate. However, another option exists. These days most investors have embraced at least little bond exposure in their asset allocation. Well, why not simply decrease your position in bonds and put that money instead towards paying extra towards a mortgage? Right now the Vanguard Total Bond Market Index Fund only yields about 1.7%. Wouldn’t you rather yield 4%?
- There is a loss of liquidity. A bond mutual fund or bond ETF can be sold nearly instantly for cash, and you can just sell a small portion if you want. You can’t do that with a house. HELOCs are an option but have their own costs. However, if this is your retirement portfolio, how much liquidity do you really need? My 401ks and IRAs are also less liquid, but I still like them.
- As long as you don’t replace all your bonds with mortgage payments, you can still rebalance between asset classes.
- This method will force you do to some mental accounting when the stock market drops, remembering that you have money tucked into your home equity.
I hope you agree that there is no clear answer to this question. The devil is in the details. It’s a mix of math, balancing future probabilities, and personal “sleep-well-at-night” risk tolerance.
Let me know in the comments if there are even more details that I forget to mention (quite likely).