Ok, I am officially tired of writing about Europe, so I thought I’d tackle the most-oft question in my thirty years of managing money: should I pay off my house?
We tell clients there are two aspects to paying off one’s home: the first is financial, and that’s where we can be of help. The second is emotional, and clients must navigate that part of the equation themselves.
From the financial side, several considerations come to the fore:
- What is the cost of your mortgage? If you are paying 5% on your loan, then you must adjust that cost for any tax benefit you receive by deducting mortgage interest. Ask your accountant about the after tax cost of your loan, or if you are facile with math and early into your mortgage, you can adjust your rate by using your tax bracket; be sure to count both federal and state rates.
- Say the loan costs you 3% after considering taxes. Compare this to what you are earning on the funds you would use to pay off the loan – are your earnings higher than your mortgage cost? Long term municipal bonds pay pretty close to 4% right now; corporate bonds pay 5% to 6%; even dividend yields are close to 3% presently. There’s no doubt about it; mortgage money is cheap. It’s quite likely that your money can return more than 3% over the life of your mortgage, unless the time frame on your mortgage is very short. And intuitively, it doesn’t make sense to pay off a home when we are experiencing the lowest mortgage rates we’ve ever seen in this country.
- Remember that paying off your mortgage puts more of your own money into the asset called “home”, and if home prices keep falling, then you have wasted capital.
- Which brings us to a fourth consideration: a home is not generally an income producing asset. Once you pay off your house, you have dented your capacity to produce income from your investments and you have made your investment profile less liquid since homes cannot be sold as easily as stocks and bonds. Hopefully without a mortgage, your expenses will be lower as well, but remember that maintenance, services such as water and electricity, insurance, and property taxes generally rise every year – in fact, your mortgage, if you have a fixed rate, is the only expense that won’t rise. To recapture the funds spent to pay off your loan, you would have to take out a new mortgage, and that can be expensive in terms of closing costs; if you are retired, you may not even qualify for a loan. Interest rates may rise, too, making the new loan more costly than the old. Alternatively you can sell the home, but you have to live somewhere.
On the other hand, paying off your mortgage is a certain “investment” – you extinguish your debt and free up cash flow that would have otherwise gone towards the house, cash that can be invested or used to support your lifestyle.
One compromise to explore is prepaying your mortgage every month. Putting an extra $100 to $500 per month towards the typical mortgage will control the amount of interest you pay over the life of the loan, and it will shorten the life of the loan so you’ll pay off the home sooner. Using prepayments instead of paying off the entire mortgage can accomplish much of what people are generally looking for when they ask about paying off the house: you can feel good about the debt declining every month; you retain your investments’ ability to generate income in the future; and your mortgage will cost you less. Here’s an example: for a $250,000 thirty year mortgage at 5%, paying just $200 per month will shorten your loan from 30 years to 22.58 years, and it will cut the interest you pay on the mortgage from $231,136 to $167,402.
If you want to test a prepayment plan on your own mortgage, go here:
http://mortgagemavin.com/fixed-rate/extra-payment-mortgage-calculator.aspx
Happy calculating!