• Michael Cocozza

Should I Pay off my Mortgage?

Who doesn’t like the idea of owning their home free and clear? But is it your best financial choice?

Should I pay off my home?

Who doesn’t like the idea of owning their home free and clear? But is it your best financial choice? Whether to pay off a mortgage or not is one of the most common questions advisors receive. And as with most financial questions the answer is, “it depends”. One-size-fits-all advice is great for quick articles, but it does a disservice to the person asking the question. Let’s get into the details.

Firstly, if you are asking the question, congratulations! You have either amassed enough money or have a high enough savings rate to pay off your home, or make extra principal payments. But should you? Whether or not YOU should pay off your home depends on your unique circumstances.

Much of the advice I see on the Internet focuses primarily or solely on the reduced interest that one pays when paying off a loan early. But it is important to see the bigger picture. There is an opportunity cost of payoff off debt. It is important to consider what the money would have been used for if not being used to pay off the debt.

Let’s consider what it means to pay off a home, in dollars and cents. We will use a couple of overly simplified example to explain:

Bob and Ann are 50 years old and have 200k and 15 years left on their mortgage. They also have 350k in the bank and are conservative, shunning stocks and bonds for the safety of CDs and money markets. Their mortgage carries a rate of 4.5%, and their savings is earning 1%. If they decide to pay off their mortgage, they will be saving about 3.5%, the difference between what they are currently paying in mortgage interest, and what they are currently receiving in savings interest. The saved mortgage interest over 15 years if they paid the mortgage off is over $75,000. The amount they would have earned on their 200k if left in savings (and savings rates remained low) decreasing over time as payments were made, would have been $15,450. A difference of about $60,000 over 15 years.

Another example:

Lisa and Jim are both 35, recently purchased a home and 30 years left on their mortgage at 4.5%. They have a moderate amount in savings for their emergency fund, but Lisa recently received a raise at work and they suddenly have an extra $500 in income each month, and are trying to decide whether to pay down the mortgage or invest in a mix of stocks and bonds.

Additional Payments - If they made additional $500 payments, the loan would be paid off in just over 18 years, instead of 30 years. Cumulative interest expenses would have been $59k less than if they had not made additional payments.

Invest - If they invested and received an annual return of 7.5% (using historical rates of return on an aggressive portfolio), their $500 monthly investments would have grown to just over $230,000 in the same timeframe. The remaining balance of the mortgage at that time would be $167,000. If they were so inclined, the loan could then be paid off with $63k remaining leftover*. Of course, they could have lost money during the time period as well, market returns are uncertain.

In both of these examples, we are looking at the mortgage rate as a “hurdle rate”. The question is, can you do better with your money than what you are paying in interest, within your risk tolerance? That last part is important. Because while Bob and Ann could do better than 4.5% a year, they aren’t going to, at least any time soon. And if they aren’t willing to take the risks necessary to earn a rate better than 4.5%, then they should strongly favor paying off the mortgage. Lisa and Jim, on the other hand, are younger, have a longer time horizon, and may be more risk tolerant. They can grow their wealth using the loan to their advantage if they can earn a higher rate.

It is important to note that each additional dollar of principal paid off is essentially invested at the mortgage rate for the remaining term. Paying $100 off of a 4.5% mortgage with 30 years remaining is like buying VERY long-term CD at 4.5% (assuming you were going to keep the loan until it matures). This can help put things into perspective when making a decision.

We often suggest retirees or near-retirees who are on track for a successful retirement (determined by our financial planning forecasting tools) to pay off their mortgages to eliminate uncertainty and earn a guaranteed rate of return on eliminating that debt. Especially since retired investors are more likely to be conservative at this stage of their investing cycle.

Ultimately, there are no guarantees. If you are comfortable taking some risk for a higher expected return, investing is the choice. If you prefer a sure thing, the payoff is for you.

Additional considerations:

1. One of the most common reasons for paying off a mortgage is the psychological benefit of the payoff. This is understandable, and sometimes, even if it doesn’t necessarily make financial sense, the peace of mind is more valuable.

2. We are in a relatively low interest rate environment right now. A long-term loan that you can payoff at your discretion can be a powerful tool. Think about how much you’d be kicking yourself for paying off a 4.5% loan if we landed in a hyperinflation scenario like the 80s when loans were in the high teens and savings rates were in double digits? You could be borrowing at 4.5% and saving at 10%. As Warren Buffet once said, “A 30-year mortgage is "the best instrument in the world. Because if you're wrong and rates go to 2 percent, which I don't think they will, you pay it off. It's a one-way renegotiation. It is an incredibly attractive instrument for the homeowner and you've got a one-way bet."

3. Cash is king – or can be. You can lose flexibility when paying off a home. A lost job, retirement, or other life changes can put you in a position where you want to re-establish an amortized loan, but can no longer qualify.

4. Tax considerations – we don’t mention the tax considerations, and obviously, there are important ones.

a. Interest on mortgages is often tax deductible, so making additional payments could be reducing that deduction.

b. Some people don’t itemize their deductions, and therefore aren’t receiving an additional deduction for mortgage interest, and may find it more advantageous to accelerate payments

c. *Investment profits are taxable, and would reduce the after-tax net gains discussed.

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