Financial Planning Blog

In Part 1 we looked at several financial objectives that should clearly be addressed prior to accelerating the payoff of your home mortgage. Once you have a handle on these priorities, should paying off the mortgage come next? Not so fast! Some legitimate reasons for not aggressively tackling the mortgage are outlined in Part 2. Although a persuasive argument for overall wealth creation can be made for maintaining a mortgage and investing that equity elsewhere, not everyone is convinced.

At Table Rock Financial Planning we understand that your personal finances are not just about math, nor is maximizing your portfolio by age 60 your sole objective. You are managing your finances not only for wealth creation, but also to minimize your family's risks. You undoubtedly place a significant value on financial security and your family's peace-of-mind.

Advantages to paying off your mortgage

• Your highest risk-free rate of return: Except for paying off other, higher cost debt, paying off your mortgage almost always provides you with the highest available risk-free rate of return.* When you pay off your fixed-rate mortgage, you know exactly what your rate of return will be. It is more than likely going to be higher than FDIC insured savings accounts and CDs, money market funds, or Treasury bills and notes. Yes, you can possibly make a higher return elsewhere (see Part 2), but you will need to take some additional risk to do so.
• Lower overall portfolio risk: When you consider the risk of your family's complete portfolio of assets, paying off your mortgage will almost always lower your overall financial risk. If the alternative to paying off your home is to invest in even a conservative, diversified portfolio of stocks and bonds, you will still be exposed to a higher level of financial volatility. And, if the alternatives are to keep holding that concentrated position in your employer's stock, trying your hand at trading options, investing in your brother-in-law's start-up company, or maybe buying some rental property, you have will have vastly increased the risk you are taking with your family finances. And, please don't assume that holding gold or other precious metals will be a "safer" place for money earmarked to pay off your mortgage. It may work out well for you, but so can a trip to Jackpot or Vegas. (Thank you Carl Richards for another helpful illustration.)
• More spending discipline: When you have the assets to pay off your house (or the cash flow to accelerate your payments), but instead choose not to do so, you may feel a bit richer. Will those funds sitting in your brokerage or checking account tempt you to spend more on going out to dinner, a new boat, or possibly an expensive vacation? This isn't to say that spending on some of these luxuries is wrong, but will the available cash tempt you to spend more than you really want, or should? Will paying off the house help you to act smarter and make better decisions?
• More investing discipline: Helping you to control expenses may not be the only way that paying off your mortgage enables you to act smarter and make better decisions. Will a paid off mortgage give you the peace-of-mind and confidence to stay invested during down markets? Not panicking and bailing out of the market at bad times, and then missing the eventual rebound, is critical to capturing favorable long term returns.
• Reducing your cash flow needs in retirement: Having your house paid off will reduce your cash flow needs in retirement. This will enable you to have a lower, safer withdrawal rate from your portfolio, and result in a higher likelihood of not outliving your retirement assets. (Granted, your portfolio will assumedly be smaller, since you will have used funds to pay off your mortgage.)
• Reducing your cash flow needs prior to retirement: With no monthly mortgage payment, your lower monthly cash flow requirement will put you in a better position to weather a financial hardship, such as a job loss or short term disability. Yes, having the money you used to pay off the house sitting in investments would also be helpful. But, consider the possibility that in hard times these funds may be invested in assets that have lost considerable value, or be tied up in tax-deferred accounts. (Also, the assumption is you have established an adequate emergency fund prior to eliminating the mortgage.)
• Funding college expenses: If you can pull it off, eliminating the mortgage before your children hit college can be an effective strategy. First, and most obvious, you free up considerable monthly cash flow to put toward tuition and other expenses. Of course, you could have been investing the money you used to pay off the mortgage in accounts earmarked for college. Saving for college, especially in 529 plans or other tax advantaged accounts, is certainly to be encouraged. However, when it comes to qualifying for financial aid, you may be better off with a paid off house (and higher available monthly cash flow), than with a big 529 plan or non-retirement brokerage account. This is because federal financial aid formulas and the FAFSA form ignore your home equity, but do consider the investment assets in the 529 plan or brokerage account. Be aware, though, private colleges that use the institutional methodology and CSS profile may consider your home equity to some degree.
• Because it feels so good: As Dave Ramsey is fond of saying, "After you pay off the mortgage, take off your shoes, walk through the backyard--the grass feels different under your feet". And, that's different in a good way, let me tell you!

Maybe these reasons don't motivate you to pay off the mortgage earlier-than-later. Maybe you aren't one of us who gets a big emotional boost from completing such a huge objective. Ask your spouse, however. Usually, at least one of you would sleep much better at night knowing that the house was paid for. Have some serious discussions on how paying off the mortgage fits into your overall financial plan. And then, if it is right for you, get after it with a passion. Check it off the list and be done--it will feel great!

--------------------------------------------------------------------------------------------------------------

*The only time this is not going to be the case is if you have an extremely low interest fixed-rate mortgage, and current interest rates have spiked up considerably higher. I'm not sure when the last time the stars were aligned like this, but I assume it was over 25 years ago.

If you have ever shared your intent to pay off your home mortgage with coworkers, invariably one of them will passionately let you know just what a stupid idea it is. It doesn't matter if you are a fireman or doctor, an engineer or accountant, this topic will continue to be debated at the water cooler--or wherever coworkers gather these days. At Table Rock Financial Planning we believe that paying off your mortgage prior to retirement is generally a wise move, and makes sense both financially and emotionally. However, as outlined in Part 1, there are a number of financial objectives that should be prioritized over accelerating your mortgage payoff. And, as evidenced by the controversy surrounding the topic, the decisions around paying off a mortgage aren't cut-and-dried. Again, this is personal finance, and the strategy that is right for you may not be optimal for your neighbor.

Reasons to go slow on paying down your mortgage

• Your mortgage leverages your housing investment: Besides being a place to live, your home is an investment in an asset which you expect to appreciate in value. (Of course, the last few years have reminded us that this appreciation is not a given, and certainly not consistent year-to-year.) Similar to buying a stock on margin, a mortgage allows you to benefit from the total expected appreciation of your housing asset while you have tied up a much smaller amount of your own capital. In a simplified example, you leverage your $50K down payment with a $200K mortgage, allowing you to purchase a $250K house. Imagine (and it takes some imagination these days) that after a few years the house appreciates 20% to a value of $300K. Although the asset gained 20%, the gain on your $50K capital investment is 100%.
• There is an opportunity cost to paying off your mortgage: Possibly you have the available funds today to pay off your home. The expected financial return to paying off the mortgage is the after-tax cost of your mortgage interest. If your interest rate is 6%, but you were able to deduct all the interest at an effective tax rate of 25%, you expect to make an after-tax return of 4.5% on your "investment" in eliminating your mortgage. Say you believe, however, that you can reasonably expect to earn 8% investing the money in a diversified portfolio of stocks, and by investing tax-efficiently you can net well over 6%. (Better yet, if you can hold the stock in a tax-favored account such as a Roth or traditional IRA.) Wouldn't it make sense to use the mortgage money to invest in the stocks? The availability of cheap after-tax mortgage money gives many people an opportunity to invest more in the market, with the hope or expectation of higher returns. If you can successfully pull this off you can build additional wealth over the long term.
• Your mortgage provides potential tax benefits: The mortgage interest tax deduction provides an advantage to some borrowers by lowering the after-tax cost of borrowing. The lower after-tax cost of borrowing makes it easier to find an alternative use for your money that has a higher expected return than paying off the mortgage. Due to our progressive tax structure, these potential benefits are greater to high income earners. Many borrowers receive a much smaller (or no) benefit to this tax deduction than they assume, simply because the standard deduction would provide almost as high of a reduction in their taxable income. The real value of the mortgage interest tax deduction is often oversold, and if Congress gets serious about tackling the deficit, it may not be around in the future.
• Your fixed rate mortgage is an inflation hedge: Your mortgage allows you borrow money today and pay it off over a long period of time--15 to 30 years. Due to the magic of inflation, the future dollars you pay back the lender are worth less in purchasing power than the dollars you originally borrowed. For example, at an average rate of inflation of 3%, the dollar you pay back in 15 years has the equivalent purchasing power of only $0.64 in today's dollars. In 30 years that dollar is worth only about $0.41. Of course, the interest rate you pay compensates the lender for a level of expected future inflation. However, the long term fixed interest rate mortgage provides the borrower with a significant hedge against unexpectedly higher inflation. If inflation is higher than expected, the borrower wins by having locked in the low interest rate over the long term mortgage. If inflation is actually lower than expected, the borrower has the option pay off the mortgage or refinance at potentially reduced interest rates.

These are some pretty persuasive arguments for going slow on paying down your mortgage. Of course, some people take "slow" to the extreme, and never get around to actually owning their own home. Maybe that is a reasonable strategy that works for them. However, most Americans consider paying off their home a critical part of their financial plan. In Part 3, we'll examine a number of good reasons to pay off your mortgage.

In the meantime, those inclined toward scholarly economic papers might enjoy this research brief, Should You Carry a Mortgage into Retirement, from the Center for Retirement Research at Boston College. The author's bottom line is that it's a good idea for most people to pay off your mortgage prior to retirement. Here is the conclusion:

The above analysis indicates that retired households are, in theory, better off repaying their mortgage. In addition to this theoretical conclusion, there is also a very practical argument against borrowing to invest. If a household with a mortgage mismanages its investments, or over-estimates the rate at which it can decumulate those investments, it risks losing the house, its only remaining asset.

One argument that is sometimes cited in favor of not repaying the mortgage is that retaining a mort­gage increases the household's liquidity, and enables it to better cope with sudden unexpected expenses. But households that retain a mortgage need to con­sider what they would do if the bad event actually hap­pened - i.e., how they would maintain their mortgage payments once their financial assets had been spent.

Where should paying off your mortgage fit in your financial priorities? This is a question that should be on any mortgage holder's mind as they sort through the myriad of competing financial objectives. Like a number of personal financial topics, this is one where reasonable people may come to different conclusions. And this should be no surprise, after all this is personal finance--where math and economic theory often take a backseat to emotions, behavior, and relationships.

For starters, let me state my general opinion on the topic. Yes, you want to get your mortgage paid off--certainly by retirement, hopefully sooner. Paying off your mortgage has significant advantages in lowering the overall financial risk in your life and managing your post-retirement cash flow. For most people, but maybe not everyone, there are also exceptional emotional benefits to being totally out of debt. However, before you rush to make that extra payment, realize that a number of other financial priorities should take precedence over paying off or down the mortgage on your home. Don't let a good thing become a bad thing by doing it at the wrong time.

Things to do before paying off your mortgage

You've established a foundation of spending less than you earn, and now it is time to start putting those "excess" funds toward your top objectives. Some of the objectives that should clearly come before accelerating the payoff of your mortgage are:

• Pay off other debt first: Credit cards, auto loans, and other consumer debt are usually at higher interest rates and not tax deductible. It makes absolutely no sense to pay any extra on your mortgage when you should be aggressively eliminating these higher cost loans. Although eliminating student loan debt may be lower on the priority list than consumer and auto loans, you should generally still place it at a higher priority than attacking the mortgage.*
• Establish an adequate emergency fund: Things happen, and someday you will undoubtedly need quick cash for something unplanned or unexpected. Financial advisors almost universally suggest maintaining a savings or "emergency" fund of somewhere between 3 and 12 months expenses in a safe, accessible interest bearing account. The right amount varies from family to family, depending on numerous factors--job security, health, other funds to access, and risk aversion to name a few. The key here is to be able to handle the financial crisis without accessing credit--credit which may not be available to you when you really need it.**
• Regular savings earmarked for planned major purchases or other requirements: With a minimum of forethought and planning most of us can anticipate approximately when we will need to purchase replacement vehicles, and estimate how much this will cost. By saving for this major purchase up front, we avoid the need to take out a car loan. It makes absolutely no sense to accelerate paying off your house if it means you will not have adequate funds left to purchase your next vehicle. The same is true for vacations, weddings, furniture, appliances, and other major purchases. You should be at a point in your life where all major purchases are made from savings before you consider paying off your mortgage.
• Investing for retirement at an adequate rate: The concept here is that you should be investing sufficient funds in tax-advantaged accounts (traditional or Roth IRAs, 401Ks, etc.) to put you on-track to accumulating sufficient assets to fund a reasonable retirement. Of course, what is sufficient, on-track, and reasonable differs from family to family. If you are fortunate enough to have a generous defined benefit pension plan, you likely don't need to be as aggressive in your personal retirement savings. If you are like the majority of Americans in private sector employment without pensions, you need to fund this objective at a high rate for a long time. If this is your situation, figure you (and potentially your employer) should be putting at least 15% of your income into tax-favored retirement accounts before accelerating the mortgage payoff. It's not that putting your resources toward the mortgage isn't a good thing--it is. However, you will likely have a better long term outcome if you can multi-task--investing enough for retirement, even though it means taking a few years longer to pay off the mortgage.
• Adequate insurance to protect your family: The key motivation to paying off your house is to lower your overall risk profile. Don't make the mistake of under-insuring your family against key financial risks in order to accelerate the elimination of your mortgage. Certainly, you want to be a smart consumer of insurance, and avoid over-insuring for risks you can assume. However, make sure your have adequate term life insurance and disability insurance to protect your family from the loss of a key breadwinner's income. Also, maintain sufficient medical, automobile, homeowners insurance to protect yourself from devastating losses and liability claims.

Don't take this somewhat long list of priorities as a reason to give up on paying off your mortgage. At Table Rock Financial Planning we believe having an objective to pay off the mortgage, sooner-than-later, should be part of most everyone's retirement plan. In Parts 2 and 3 other thoughts and issues regarding the decision to pay off your mortgage will be considered. In the meantime, here are two other takes on the subject from Ron Lieber (New York Times) and Liz Pulliam Weston (MSN).

------------------------------------------------------------------------

*There are situations where it would make sense to pay off a mortgage before student loans, but these are certainly not the norm. It depends on your loan (student and home) balances and terms (interest rates, payments, length of term, etc), your tax situation, and your potential fit for a federal student loan forgiveness program.

**Paying down (or off) your mortgage does increase your home equity which is theoretically available in a financial pinch. However, it is usually somewhat time consuming and expensive to access this home equity in an emergency. Some financial advisors suggest establishing a home equity line of credit (HELOC) up front, before you need it in an emergency. Personally, I prefer having a sizeable emergency fund that I control, as opposed to counting on the access to credit via a HELOC.