Issues Not Usually Addressed When Discussing Paying Off Home Debt

Here's a piece from Money magazine's series from The Mole, a financial planner who gives the inside scoop on what planners usually recommend, and what he sees as the right answer instead. In the latest edition, he advises people to pay as much as they can on their homes -- having as little debt as possible -- and implies that we should pay off our homes as soon as we possibly can. His main thoughts:

Financial planners also sometimes try to argue in favor of debt, the argument being that the less money you put down, the more investment gains will be magnified.

If some financial advisor gives you this line, say "no thanks" in no uncertain terms. These other investments will bring other risk, a ton more in fact. The only thing we know for sure is that the advisor and the mortgage broker will make more money.

My advice is to be your own banker when possible and minimize debt.

His argument above is one that many people don't really consider, myself included. We've talked a lot about whether or not people should pay off their homes early or instead just pay the monthly mortgage and invest any extra. During these discussions, we've noted that paying off the mortgage is a guaranteed return, but we haven't addressed the issue that it's much less risky than investing in stocks. Yes, there's a big expected return difference, but there's also a big risk difference.

BTW, he also notes that while paying mortgage interest will get you a tax deduction (making the cost of a mortgage lower), if you invest in stocks in a taxable fund instead of paying off your mortgage, you'll pay taxes on your gains, thus lowering the amount they generate for you.

Comments

[SB]

I think people need to be very careful in considering whether to payoff your mortgage early. The world is not on an honest monetary standard... gold. If the central banks were to restrict money growth to the same rate that gold production increases (i.e. be responsible in creating money), house prices worldwide would dramatically collapse. A nuclear accident or attack or other manmade or natural disaster could reduce the value of your property to zero. Nobody should ever assume that our government will be there to protect you - Katrina is a reminder of how effective our government really is. If you are in a situation where you have $50K, outside of a 401k, sitting in bonds, other currences, precious metals, etc, and you owe $50K on your mortgage, does it really make sense to put all your eggs into one basket and payoff the house leaving you with nothing remaining? While I agree it is good to pay off all debt, it is better to be balanced and protect yourself. Don't let the house own you, let you own the house and be able to protect yourself, not your house/banker, from real financial disaster.

[GeekMan]

SB makes a very valid point, and one I wholeheartedly agree with. Paying off a very large secured debt (a home) is not always in a persons best interest. To me, the only time it makes sense to fully pay off your mortgage is if you meet two requirements;
1) You plan on staying in the home for more than 20 years AND
2) While paying off the mortgage you will still have AT LEAST 6 months living expenses IN CASH.

Meeting those two criteria means that paying off your mortgage, or buying a home for cash, would not tie up almost all of your money in a single, non-liquid asset. Having a high credit score, a large retirement account and a fully paid off home doesn't matter much if the month you finally pay off your mortgage you lose your job or have an expensive medical problem crop up and you have no liquid cash reserves to fall back on.

As SB implies, a person with $50K cash in the bank and $50K in mortgage debt who suddenly loses their job is most likely in far better financial shape than someone with no mortgage and no cash reserves in the same position.

[Robocop]

I need some clarification about SB's comment about gold. In the case of a nuclear attack, how does having gold protects people any better than having cash (or a paid off house, for that matter)?

[MonkeyMonk]

Also, doesn't the interest rate on your mortgage factor havily into this? I put down 25% on my 5/1 ARM a few years ago and got a fantastic rate of only 5% on the remainder of the loan. I came into a little under $60K last year but I didn't put anything extra down on the mortgage -- instead I put the entire amount into my investment vehicles where it's been earning a solid double to triple the rate of my mortgage. I realize that nothing is a sure bet but I can't imagine paying off that 5% loan makes good financial sense. It's debt I'm happy to have (and the only debt I carry at all).

Note: We're planning to move next year sometime . . . a full 12-18 months before the ARM kicks in.

[Lord]

One can view a mortgage as a risk management device and something to have when your risk is too low or too exposed to inflation. It is a way to turn steady incomes into equity investments. Risk is not something to be avoided but something to faced to make dreams reality and retirement possible.

[J at Home Finance Freedom]

Hello. "Expected" return is the potential banana peel on the floor so MoneyMonk's return of double the mortgage rate worked in hindsight but the financial salespeople show such confidence because they make their money off you whether you win or lose.

Examples:
Never Prepay Mortgage? Housing Myths Part 1
“Savings” Pitch Tricks You into Overspending
Inflating Leveraged ROI Can Ruin You

[kitty]

"As SB implies, a person with $50K cash in the bank and $50K in mortgage debt who suddenly loses their job is most likely in far better financial shape than someone with no mortgage and no cash reserves in the same position"

This is true if one has absolutely no reserves and no income at all. But a person who doesn't have to pay mortgage may be able to live nicely even on unemployment benefits. Still, I wouldn't recommend repaying the mortgage with one's last saved penny. But putting some percentage of savings towards a mortgage or using some of the capital gains may makes sense.

Interest is definitely important. A few years a friend of mine got a 30 year fixed mortgage at 4.5%. Currently, one can get a better rate on a CD. So with this rate, it doesn't make sense to pre-pay the mortgage, you can just be ahead by leaving the money in a bank. But for someone who got a loan in the 90s for 7% it may make sense to pay off the mortgage. One can refinance too, but one needs to factor in refinancing costs.

Another issue is age. If you are 50 year old and is contemplating retirement, you may want to own your property outright; especially if your retirement income isn't going to put you in the same high tax bracket you were in when you worked.

If you 20-something, have a steady job and a low interest rate, you may want to keep the mortgage.

I wouldn't count on stock returns as a sure thing, though. Some of my stocks are still worth much less than during internet boom. I also was around in 1987. I only had a little of ESPP stock then that lost a third of its value. I was young, had a secure job, so while pretty upsetting it wasn't the end of the world. But imagine loosing both your job and money at the same time while still having to pay your mortgage. It happened with a lot of people in 1987, and it happened with a lot of people after the internet bubble burst. At least if your home is paid, you have less expenses so you can survive longer on the money you have.

[Mike]

This will be controversial. I am in a single earner family with spouse and a 5 year old. I saved in conservative instruments for 5-6 years to collect enough to pay cash for a house - bought just enough house that I could afford to pay for. I am 35, but debt free. Yes, a mortgage (and leverage) makes sense - but, now I just put in what would go into mortgage payment in high return investments - they could sink, but, I will have no one evicting me from my house. And, now I am maxing my 401k as well. Yes, I had 6 months of free cash, before buying the house. And, I saved nearly 3k in loan expenses.
Interest arbitrage etc. are fine - however, do them after separating your personal needs from financial needs. Remember, irrespective of finacial returns, you still need a house to live in - do not risk it with lofty growth projections.

[J at Home Finance Freedom]

Mike, I do not consider that controversial.

I should have written that MoneyMonk's plan has worked "so far" but a 10% market/portfolio drop and/or a house unsold after the mortgage reset (reported DOMs are often cooked and the housing crash is still new) can flip the leveraged investment into a loss (but I hope she does OK).

[Robocop]

Mike,

Your plan may be controversial but, in my book, it is dowright brilliant. Congratulations!

[Toby]

First of all, let me point out that the statements in the article and post suffer from framing. By framing the prepayment positively and the investment of savings negatively, the choice is obvious, we'd all be fools not to pay off our mortgages and get 5% *GUARANTEED* return!

Recently, I left an lengthy comment on TheSimpleDollar which discussed the scenario of paying extra on the mortgage versus saving and investing the difference. An extra $500/mo invested over 30 years compounding at a rate just 1% higher than your mortgage rate, yields over 100k more than paying down your mortgage in 15 years and then investing the whole mortgage payment+$500 for the next 15 years. (roughly $680k versus $570k). How low is your mortgage rate? After you adjust for tax savings? You think you could maybe beat that by 1%? 2%?

And investing your money elsewhere is somehow more risky? In fact, I think the exact quote was "other investments will bring other risk, a ton more in fact." How is diversifying your portfolio riskier than putting all your eggs in one basket (your home). I guess the Mole is not better than a chimp at asset management. Guess I won't be hiring him to manage my assets.

What happens when you are sitting on a ton of equity and lose your job? Still have that same mortgage payment. The bank won't re-amortize you loan unless you refinance, so that is a fixed cost that doesn't go down no matter how many extra payments you make. Oh, you have an emergency fund? 3 months expenses? So now imagine your in the midst of a recession and you are out of work for 6 months. How about 9? 12? How's that E-fund doing now? Getting nervous yet? What's that? The bank wouldn't let you tap your home equity because you have no job to pay back with? Tut tut....wouldn't you rather be sitting on a pile of cash?

You see, the risk that you may lose your job and be out of work for an extended period of time is also there. Just like the risk that your investments will take a turn for the worse and under-perform you mortgage rate. You need to weigh those and figure out what you want to do.

Let's face it: Simple advice like the Mole gives or Dave Ramsey is just that, simple advice for simple people. The problem is that most people's situations are not simple and their advice does not always fit.

[Jeremy]

This is one of the most foolish statements I've ever heard: "Don't let the house own you, let you own the house and be able to protect yourself" (SB above)

Why? SB suggests that NOT paying off your house somehow protects you. As long as you owe even $1 on your house, YOU DON'T OWN IT. Someone else has the title, and you are at risk of losing it. Sure, the risk seems small because of the stability of our economy over several decades, but that can change overnight -- either for you personally or for our nation as a whole.

I am currently focused on building a 6-month cash reserve, but after that I'll be pumping everything into my mortgage (5% 15-year fixed). I want to own my house, not be a slave to the bank that holds the title.

[Swim Upstream to Wealth]

Just want to correct Jeremy. Even with a mortgage, you own your house. There is a lien on the title until the mortgage is paid, but you are the owner.

The bottom line is paying off a house isn't just a numbers decision. It is also an emotional one. When you look at the numbers, you are better having a mortgage. I have never seen an example that shows otherwise.

However, if having the mortgage unnerves you, then by all means pay off the house. Either way, if you are paying your home off faster or saving in the markets, you are doing something positive.

I prefer a mortgage. My Dad just paid off a mortgage a couple years back. He bought the house in the 70s for $26,500. The mortgage was big for him back then as he only made $7,000 when he bought the home. Of course, by the time he paid off the loan, the payment was laughable. Inflation reduced the cost of his mortgage as a percentage of his income. By saving rather than paying off the mortgage, he got to experience the bull market of the 80s and 90s. Of course, I don't think he put too much away unfortunately.

[Rev]

"Just want to correct Jeremy. Even with a mortgage, you own your house. There is a lien on the title until the mortgage is paid, but you are the owner."

When people say this it always drives me nuts. Its just semantics. Yes the house in technically yours with a lien on it. BUT until that lien is paid the bank is the one who calls the shots. If you really did "own" it you wouldn't owe anyone for it. As long as you are paying someone else for the privilege of living in something "you own" you don't really own it.

[David]

"As long as you are paying someone else for the privilege of living in something "you own" you don't really own it."

By this logic no one ever owns their house. The govt always has a lien and will evict you if you do not pay your taxes. You are always a slave to them.

Personally, the risk that my house will be destroyed by an uninsured event is greater than the risk of me missing a mortgage payment. I would rather have the bank take that loss than myself. IRA assets are not attachable in a bankruptcy. Recent events in San Diego and New Orleans should make people more aware of this risk.

[kitty]

"How low is your mortgage rate? After you adjust for tax savings?"

Why are you adjusting for tax savings? Your returns are taxable as well. So if you adjust mortgage payments for tax savings you have to do the same with your gains. Long term capital gains are taxable only at 15%, but as it was pointed out, there is risk involved. I agree that if your rate is only 5% on a 30- or 15- year fixed, then you can easily get higher returns. You can get a Countrywide CD for 5.65% and be ahead. If rates come down, you still have the option of taking money after your CD matures and sending one large check to the mortgage company if you so desire.

I wouldn't compare the ARM rate, though. ARMs are risky because you have to sell or refinance before the rate goes up, and the real estate prices are still going down. Nobody knows for how long. For all we know it could be a repeat of what we've seen in the 90s.

Everything really depends on the rate and individual circumstances. I am not a follower of Dave Ramsey as I've never had a consumer debt, so I've never needed his help, and this is the first time I read about Mole. I think in some circumstances it makes sense to pay it early and in some it doesn't. But because I was burned by the stock market, I don't take the returns for granted. Sure I invest, just not everything.

When I had a mortgage I wasn't sending extra payments. But at one point at the top of internet bubble a friend suggested that I sell a some large percentage of my stocks and paid off my mortgage. I told him I was earning more in the stock market. Then my gains evaporated, but I still had my mortgage. So, a couple of years later when I sold a condo I was renting out (I moved to a larger place during the 90s) with a nice gain, I used the money to pay off my mortgage. Maybe I should've invested it instead and refinanced to get a smaller interest rate (mine was 7%). I am still not sure I did the right thing. But had I paid it off when my friend suggested, I'd have both a paid home and all these real estate gains to invest. At any rate, I can testify that living in a paid off home is nice.

David has a point about an uninsured loss. It is something I do worry about.

[kitty]

"He bought the house in the 70s for $26,500. ... Inflation reduced the cost of his mortgage as a percentage of his income."
What was his rate? In late 70s - early 80s the rates were in double digits. If he had bought before the rates went to double digits he certainly had no reason to pre-pay. I heard that around 1980 you could get 18% guaranteed for 30 years on non-callable government bonds. When I started working my very first CD yielded 13% (an idiot that I was then, I only locked it for 6 months instead of 3 years). Certainly there was no reason to pre-pay for someone who had a single digit mortgage during the time of double digit inflation.

[Toby]

@ kitty: Absolutely, I never said you didn't have to adjust for capital gains. However, depending on how you structure your investments, your extra money could go into a Roth IRA where you would not have to pay taxes on gains. Or perhaps you can structure things so you pay long-term capital gains tax (15%) while your tax deduction for the mortgage interest will be at your marginal tax-rate (25%+). This makes beating your mortgage rate that much easier.

I don't know what to tell you about your losses in the stock market. I think most of us suffered quite a bit of loss at that time. I would hope that, rather than become distrustful of the markets, it has led you to review what happened, how you behaved, and the mistakes that a lot of us made during the tech bubble. I know I've spent a lot of time thinking about it and also learning more about the markets. Now, I'm more confident than ever that the stock market is the place to stash my money for the long haul (that or starting my own business), I'm just more "picky" about what I invest in.

[Lord]

It is important to realize there is no one answer to this question but it will vary with circumstances. It is probably better to keep the mortgage if the rate is low and better to retire it if it is high. It is likely better to keep it if you rely on a fixed pension and thus are greatly exposed to inflation risk and better to retire it if you are wholly dependent on stock returns to pay for it. It is likely both possible and desirable to pay cash for an inexpensive home, but neither for an expensive one.

[Eric]

It's funny, this is one of the more touchy issues out there. There is the "all debt is bad" camp (aka Dave Ramsey), and the "you're dumb if you have a house paid off" camp (aka the NAR or Kiyosaki). In the end, if the math were black and white, don't you think one would have come out and given hard evidence? The reality is that this is one of those issues where the math could go either way.

If you maintain a mortgage and invest beyond that, are you truly investing rather than blowing it? Are you investing in a well diversified, low cost, low turnover portfolio? If the answer to both of these is yes, you are probably okay whichever route you choose. Maintaining a mortgage and investing the difference entails market risk, but provides diversification from having all of your wealth and liquidity tied up in the house, and provides an opportunity for higher returns. Paying off the mortgage in lieu of investments eliminates stock market risk.

Ultimately, the question is not which decision is "better". Rather, which decision do you feel better about? When the math does not provide a definitive answer, you have to ask how you feel about the decision. I find that many people feel better having their house paid off as they approach retirement.

[Matt1999]

Thanks for all of the great information. I've been trying to do the math since that is what seems to be missing. This is how I look at it, let me know what I am missing.

This is assuming paying off a $150,000 up front or investing $150,000 in the S&P 500.

Buying $150,000 home with a 6% mortgage:
Interest savings: $173,757.28 (Referrence: Amortization Table)
1st years interest: 8,208.31 (no tax savings. My standard deduction for married 2007 is $12,000)
Value of home in 30 years considering average national average of 6.5% increase in value: $442500
Total value in 30 years: $442,500 + $173,757.28 = $616,257.28

S&P 500 investment of $150,000 assuming 10% gain in 30 years.
2% broker fees $3000
$147,000 @ 10% interest in 30 years: $441,000
15% capital gain tax - $66,150
Interest total gain: $374,850
Plus initial investment: $147,000
Total: $521,850

I may have missed something or miscalculated so please let me know what you think.

Matt