Financial Planning Blog

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.