To Pay or Not to Pay? The Drama Around Paying Off a Mortgage

In working with clients who have achieved a fairly high level of financial security, often times it is assumed that paying off the mortgage is a “badge of honor” as it relates to personal finance. More specifically, not having to write a check to the bank every month sounds very enticing and may even engender a feeling of security.  However, if we ignore the mental satisfaction of not having a mortgage payment for a moment and look only at the financial nuts-and-bolts, I believe paying off the mortgage could actually cost families money and may not in their best interest.   Why?  Because in my opinion, that feeling of satisfaction or security can be expensive and is more than offset by the advantages for income taxes, liquidity, growth opportunities and interest rate / inflation protection.  This especially applies in today’s environment of historically low interest rates.

Let’s consider an example to illustrate.  Let’s say the Smiths are a married couple of about 45 years old earning a nice income of about $150,000 and have saved diligently over the years amassing $250,000 in a taxable account (i.e. not in retirement accounts).  In addition, let us suppose the Smiths have a $200,000 mortgage balance and they are trying to decide between paying off their mortgage or refinancing the balance with a 20-year fixed-rate mortgage at 3.625% (a real-world rate on a bank website this week).  The 20-year mortgage was chosen by the Smiths because they do not want to have a mortgage at their targeted retirement age of 65.

Doing the math on the principal and interest of the mortgage results in a monthly payment of about $1,173, which excludes homeowners’ insurance and real estate taxes.   Writing the check to the bank every month for the next 20 years certainly puts a dent in the monthly budget and it seems to make perfect sense to just pay off the balance of that mortgage with the available funds then invest the amount of the payment each month.  In addition, the supposition is a home-owner would save substantial amounts of interest expense by not having a mortgage and in a personal-finance-vacuum, not paying interest to the bank is an open-and-shut case:  No mortgage = no interest expense.  (Note: I estimate that over 20 years, the couple will pay the bank total interest expense of about $81,500, certainly a large sum).  However, nobody I know lives in this personal-finance-vacuum, which is why we need to consider a family’s financial lives in a holistic manner.

So we have a captured the advantage of not having to pay the monthly bill and not having to pay the mortgage interest – but how does that stack up against what I think are advantages?  Let’s take it one-by-one.

1)      Not all interest expense is created equal:  As most people know, mortgage interest on all but the highest mortgages is fully deductible and has no phase-out for high earners.  For a high-income family, this could be one of the few tax deductions actually available to them if they itemize their deductions.  Assuming the 28% marginal income tax rate (at $150,000 of taxable income) this deductibility of the mortgage interest effectively lowers the annual interest rate on the mortgage from 3.625% to 2.610% (3.625% x (1 – 0.28)).  So now we’re really paying 2.610% to borrow this money.  Back out 1.1% of annual inflation (as measured by the Personal Consumption Expenditure index average for 2013) and in “real” terms, we’re borrowing this money at 1.51% (2.610% – 1.10%).  Relative to historic rates, that is very, very cheap money for a fixed, 20 year period.  And if inflation were to revert to around 3% or higher, we would be talking “free money” in inflation adjusted terms.

 2)      Liquidity:  Using the example above, if the Smiths chose to pay off their mortgage balance they would effectively take $200,000 of funds and “trap it” as equity in their home and would need to borrow for cash if there was an immediate need for several big-ticket items such as buying a car, funding an emergency medical procedure or handling a large home-repair expense.  Sure they could always have a home-equity line of credit to tap but most banks only offer variable rate loans (usually tied to the prime rate, presently 3.25%) which exposes the borrower to the specter rising interest rates.

 3)      Opportunity Cost: Instead of using that money to pay down the mortgage, the couple could take a conservative investing approach for the long term and invest in a low-cost mix of index funds which could average ~6% per year over 20 years (5% after backing out inflation). Of course, there is no guarantee of this type of performance and it will fluctuate so there is an element of risk here.  However, in this case, I estimate this investment would result in the Smiths having around $71,000 more after-tax (even assuming 20% capital gains tax rate) in their investment accounts after 20 years if they prudently invested that sum, rather than paying the loan balance back to the bank all at once. To clarify, this is $71,000 MORE for a family’s net worth and assumes the interest expense is paid for the 20 year term.

 4)      Interest Rate and Inflation hedge: Finally, the best part about the fixed-rate mortgage in such a low rate environment means that even if interest rates double or trip from here, your mortgage payment stays the same for the term of the loan.  Again- this assumes a fixed-rate mortgage.  This means the bank cannot “call” your loan and charge you a higher interest rate going forward.  Conversely, if for some reason interest rates decline, a family can simply re-finance their loan at the lower rate assuming they do there is NO pre-payment penalty clause in their loan, which for most loans is pretty standard.  On a more esoteric note, leveraged real estate also acts as an effective hedge against rapidly rising inflation as someone who has $50,000 of equity on a $250,000 house will usually see that house value increase with inflation on the $250,000 amount, not on the $50,000 amount.  This means if inflation spikes to 7% per year, real estate as an asset class would theoretically move in a similar direction.  So a family’s “balance sheet” would benefit from exposure to leveraged real estate in this scenario, which is why I factor in people’s homes when evaluating their complete financial picture.

To wrap up, I wouldn’t be surprised if I get a lot of push back on this from those that continue to value the “security” of paying off their home.  That’s a personal decision and if a client did want to move forward with that strategy due to the value they place on that piece of mind, I can’t argue against that or make that value call.  However, it’s my job as a holistic financial planner to analyze and diagnose all the angles then make a recommendation so that my clients can make a fully informed decision and they know the effective “price” of their decision.   It’s also another reason for taking situations such as home mortgages into consideration is why I believe the best way to help families plan their financial lives goes well beyond recommending stock and bond funds.

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