Help a Reader: Paying Off a Mortgage

Here's an email I recently received from a reader:

I know that you are a big proponent of being debt free even including mortgage, but I have some doubts about this method:
 
I've always been a little confused by the notion of paying off your mortgage early.  Because of inflation being typically at 3% per year, people will theoretically have more money (even though it will have less purchasing power) each year.  Does it make sense to pay off everything within the next 15 years instead of paying the minimum for 30 years since you would theoretically have more cash overall and your mortgage payments do not go up with inflation?

And you could hopefully be investing all the money you're saving and earning more than your mortgage interest rate of 4.875?  I wouldn't know how to go about calculating these scenarios, but I feel like if you invested the money, and earned a greater rate of return than 4.875 you would be better off than paying off your mortgage really early...

Does anyone have any advice for her?

Comments

[Crystal@BFS]

The way I see it, I can't guarantee myself a higher rate of return than my mortgage APR (5.375%), so paying it off early seems fiscally beneficial.

That doesn't even take into account how happy I know I'll be when my husband and I are 33 and 100% debt free - just 6 more years baby! Emotional benefits are worth something too. ;-)

[David]

Being debt free increases your flexibility. It does come at a cost, when you prioritize it over your total networth. It's up to you to decide how much it's worth to you.

[matt]

Those are a few big 'IFs'. IF you actually invest all of that money and dont spend it, and IF you get a better return than your interest rate. Up to each individual to determine if they want to live with those question marks or pay extra and get that guaranteed return.

[Nazim]

Just to get the right numbers in perspective, you pay taxes in the earned interest. So you better make at least a consistent 6.6% return to beat the equivalent on your mortgage at 4.875%.

If you look at it that way, that's a pretty good rate of return by just paying off the mortgage early.

Plus, if the property value is stable, paying off your mortgage increases your equity, which you can always leverage if you need it.

[Mike B.]

Paying down your mortgage is essentially the same as buying a bond. You are buying your bond back from the bank. As home interest rates keep shrinking, yes, paying it off becomes less enticing. I, like Crystal, am at 5.375. If you shrink to the low-to-mid fours I think it becomes an increasing difficult strategy to defend. At yours, high fours, I don't know, I'd really have to think about it.

For the record, I've been paying mine off (extra) for about six years. My return in my 401K over those six years (presumably about the same stocks I would've invested in outside of 401K): 0.8%. At the current time, I'm way ahead and I'll soon be rid of that nasty monthly payment FOREVER. Woo-hoo!!

[Ken]

It's been put to me this way before and I think Dave Ramsey has said similar...

"If you now own your home free and clear, would you take out a $200,000 mortgage on your house and invest that $200,000 in the stock market? Same question in reverse.

[JLP]

I think her reasoning makes perfect sense. Yes, there's an element of risk involved but it's also risky to pay down a house early (the money used to pay down the house quickly could have been used elsewhere).

[Money Reasons]

If you have perfect discipline, then paying off a house is a bad idea.

But if you are typical, then it's more of a forced savings!

I say this because I paid off my house and I'm having a hard time saving the additional money from our previous debt.

There is also a great feeling of your house really being your house!

Personally, I feel a bit more free and less stressed! But that's just me...

[Mr. ToughMoneyLove]

"Because of inflation being typically at 3% per year, people will theoretically have more money (even though it will have less purchasing power) each year." Except for the "less purchasing power" part, this assumption is almost laughable. For inflation to benefit a long term debtor with a fixed, low interest payment, their income has to at least keep pace with inflation. That is not happening folks. According to Census data released September 10, median household income was 50,303 in 2009. In 1998 it was $51,295. That's ten years with no increase, and yes with lower purchasing power. (These are adjusted for inflation.)

@JLP - "risky" to pay down your mortgage? Really? What risk is that? With knowledge of stagnant household incomes and go nowhere markets over the past decade, do you seriously want to borrow money against your home to invest elsewhere?

[Troy]

Couple points.

There is a difference between paying down a mortgage early and paying off a mortgage early.

Paying off is a good move. Paying down is kind or a dumb move.

The poster asks about payong off a mortgage over time due to inflation. Inflation cause appreciation. That is the entire reason real estate increases in value. And a fairly good predictor over time of the appreciation rate.

So the theory of a fixed payment as an inflation hedge is a great argument for buying vs renting. but as for paying OFF a mortgage, it makes no difference assuming the same level of risk.

I would accumulate the amount needed to pay off the mortgage in full with one check in a separate guaranteed account over time and pay it off when the account balance equals the remaining loan balance.

That is the only smart way to pay off a home loan.

[Apex]

Dave Ramsey has a great way of making things simple for those who are not financially savvy (almost everyone). Unfortunately it results in overly simplified advice on the whole.

His point about the 200K sounds right but it's a little misleading. I would argue if I had a 200K house and no mortgage with little to no liquid assets I would sooner take out a partial mortgage and have some in cash and stocks that I could draw on if needed. Who says I have to take out the entire 200K and put it in stocks.

The answer to the overall question it seems to me is a big "it depends"

You might get a better return in stocks, you might not, there is certainly no guarantee of that. But also who says it has to be stocks. There might be investments you have access to that do better.

I am investing in real estate and getting far better than 10% net profit returns without assuming any appreciation on my investments currently.

Others might have a small business they are starting or expanding that can return much better returns.

Others might feel the safety of having money in something more liquid (even stocks) than a house is worth leaving some as a mortgage.

Maybe you pay some down and invest / save others.

But if you want to start a fight about the ideology of which is better, you picked a perfect question to start that fight.

[FFer]

Don't pay off your home if you live in a hurricane zone or an area prone to massive natural disasters. If your whole area is hit with the big one, the insurance companies balk and you are stuck with a $300,000 flooded out and wind damaged house - believe me I know. At least if you don't actually own the house, you can walk away if the insurance company doesn't back you up (which is what you payed them to do).

[Mark]

Actually, your house is NEVER entirely paid off. Don't pay the property taxes, you'll lose title. A house is a lifetime commitment (until you find some other sucker to buy it). And in this environment where taxes keep going up, don't be too smug about the prospect of a "paid-off" house!

[Todd]

IF you invest all the money you would otherwise "invest" in paying extra principal, AND your interest rate is low enough, then you can conceivably earn up to 8% actively managing your stock and retirement portfolios. A fixed mortgage payment goes down every year as inflation goes up, and if you get raises every year, the spread is even better by not paying down your mortgage. Inflation, location, improvements, maintenance, and luck will make up the rest of your profit. But remember that the next house you buy will be more expensive per square foot in a similar size, location, and type of amenities that folks will want in the future. Inflation won't help you unless you move to Omaha from Myrtle Beach. McMansions and swimming pools are soooo 2007!

In 25 years of paying a mortgage, your monthly property tax and insurance could easily exceed principal+interest. Rent only goes up by comparison. As long as you maintain your career and salary, a long-term fixed mortgage payment will start looking like your typical TV/Phone/Internet bill. That fact alone should reduce your stress every year going forward, as to make the issue of having a paid off home a moot point. Don't forget maintenance and improvements in your final cost basis. They could also dwarf a 30-year fixed mortgage payment as a percent of monthly income.

I would just maintain a healthy equity percentage in your home just in case you had to switch jobs and leave quickly. You could price your home below comps and get a quick sale, even though you might have to give back some of that annual return on investment in your home. Also, you can use that equity line as an emergency fund if you didn't want to move.

[Todd]

When I retire at 62, my house in suburban Durham County not quite paid off, I will withdraw the amount needed to pay off the house from my 401k, assuming I still want to live in this house. I expect about $50K will take care of it. Even after the taxes I pay on the withdrawal, I'll still have made more money investing in other assets outside my house, minus the adjusted cost basis of necessary improvements like a new roof, etc. Most likely I will want to move to a more expensive retirement area in the Blue Ridge mountains, where services and activities for us older folks will be aplenty, and why my next house is going to cost a lot more than I imagine. Inflation driven profit is canceled out by inflation in labor, materials, and finite land in areas of high future demand, like Asheville. I'm 45 years old.

I will have made NO real profit off my current home either paying it off or paying it down. If I want to move after leaving my job, I will want to move right away. Chances are that others will be wanting to do the same, and my competition will affect what price I finally settle on, just to get to retirement utopia before dementia sets in. In that case, I will lose equity gained in any prior year inflation at the time in relation to my sales price. As a first year Gen-Xer (1965), I'm counting on many of those aging boomers to have to leave their vacation homes for nursing homes, so maybe that home in the mountains will be priced to sell with all the competition! (Yes, I know that's mean-spirited of me)

Let's be mindful of a mega-trend. Baby boomers who own homes now and working will retire in far greater numbers than their children. Will their children as a percentage of our population be in a position to buy all the homes that will hit the market at the price boomers expect to part with it, or will they have to settle for less when they can no longer take care of themselves and move into an assisted living facility or nursing home? They can't wait a few more years as more homes hit the market clashing with the reality of future buyers born in the low birthrate decade of 1965-1975. Heck, half those children may have to move back in to take care of their boomer parents! Who's going to buy your house, and when, should be a factor in determining if and when to pay off your present home. So should determining if you want to stay in an area until you retire or die, or you want to get out as soon as possible and start a whole new life.

[Mark]

To whoever said interest income is taxable: If you can deduct your mortgage interest, then the tax effects cancel. If you get dividends instead of interest, and your tax bracket is high enough, you get a net tax benefit. Dividend income of $100 taxed at 15% nets $85. Interest cost of $100 deducted at 35% nets a cost of $75.

Even if your income does not go up, the effect of inflation is to reduce the impact of fixed-rate debt. Assume inflation makes your house-payment the same as the cost of a loaf of bread. And assume today it costs as much as 1000 loaves of bread. Are you better off giving the bank one loaf or 1000 loaves?

There are many people who will experience very nice increases in income over their lives. The notional cost of their mortgage interest will decrease - Is a payment of 5% of your income easier or more difficult than one that is 20%? A young person starting out in a profession or trade should be thinking about this.

JLP's blog had a recent post where this was all discussed in great detail (linked from his signature above). I strongly encourage everyone to read this.

As a disclosure, I have a 30-year fixed at 4.62%. I had the resources to pay cash for my house or take pretty much any mortgage I wanted (15 year, ARM, fixed, etc.). I ran the numbers and took the biggest mortgage I could without PMI (i.e., 20% down).

[MJP]

@Mark You wrote: "Even if your income does not go up, the effect of inflation is to reduce the impact of fixed-rate debt." Sir, you are very confused. Let's assume that in 2010 when you buy your home, your mortgage payment is $1000/month (25% of your 4000 monthly income) and a loaf of bread costs $2. 10 years later, inflation increases the price of bread to $10. Per your assumption, your income is still $4000 and your mortgage payment is still $1000. How have you benefited from this scenario? You haven't. In fact, the impact on your spending power is negative because in 2010 you can afford to buy 1500 loaves of bread per month. In 2020, you can buy only 300. Back to personal finance 101for you.

[Troy]

Mr. TML.

JLP is precisely right. It is very risky to pay DOWN your mortgage. It's a bad move.

The interest rate charged on a home loan is actually a risk premium. Interest charged on a home loan is a risk premium for the risk of default.

As the loan's balance is paid down over time with payments, the interest rate (risk premium) stays the same on a fixed rate mortgage. But the risk is transferred. From the bank to you. Godd deal for the bank.

Example - You start with an 80% loan. $160K on a $200K purchase. The bank carries most of the risk. It is their $160K on the line. As time goes by, you the borrower pay the balance down, and by doing so you transfer the risk of default from the bank to yourself.

15 years later after paying extra payments diligently the loan balance is only $30K. But you are still paying a risk premium based on 160K. you have all the risk, because the bank has very little money tied up in your home. and upon default most assuredly would capture all monies owed including fes. Transferred the risk, but no reduction in the risk premium beign charged for that risk.

THIS is the key to profitable banking. This is how banks became the most profitable industry in the history of the world. I would much rather foreclose on a house with 50% equity than one with 5%. The 5% I will work with because I don't want the house...I will end up losing money. The 50% I will not.

By placing the "extra pay down the mortgage" money in a separate account instead of making extra principal payments you accomplish two things. You keep the risk of default on the lenders shoulders longer, and you maintain flexibility with the additional funds for future opportunities. Maybe that menas paying OFF the loan early, maybe it means a myriad of other opportunities.

The fact is you do not lose the opportunity cost of those funds.

[Mark]

@MJP: Sorry to hear you think I am confused.

Wouldn't it be nice if I had bought something which doesn't go stale (i.e., not bread), with the money I saved by NOT paying off my mortgage. Then I would still have 1500 of them, and could sell them at the new inflation-adjusted price to pay off my mortgage AND buy bread.

How am I better off if I used the money to pay off my mortgage instead of buying the items which DID go up in price? I guess I would rather defer buying that last brick of my house as late as I can if I know it is going to be proportionally cheaper later.

[StLPastor]

Mark-
my property taxes are about 1/10 my mortgage. If your property taxes are going to prevent you from living in your home after the mortgage is paid off, you aren't going to be able to pay rent either.

MJP-if your income does not at least keep up with inflation, obviously that's a problem. Hopefully income surpasses inflation over time, as you grow your career and working to add additional income streams. However, even if your income doesn't quite keep up with inflation-like the median family income over the last 15 years, if your income grows in real terms, the mortgage still becomes a smaller fraction of your total income. (with our bread analogy-say income 4000, bread 1, mortgage 1000. Then, inflation runs high enough that bread goes up to 2$, and your income didn't keep up-its only 6000$. Since mortgage is still the largest expense in most people's lives, they're still ahead even with inflation). In general, though, as always, if you buy more house than you can afford and you don't grow your career, finances are hard. If you spend wisely and have a good job, then either way you'll do fine.

[Jesse]

My wife and I paid off our house in full this past April before we both turned 30. Words cannot express the joy and freedom that comes with knowing that our house is not a liability but 100% asset. Dave Ramsey says that simple math might show that investing surplus money can earn more than a mortgage rate. But when you consider things like risk and psychological freedom/momentum as part of the equation, then all of a sudden, it becomes advantageous to pay off the house.

In our case, we bought the house for $88,000 due to its condition at purchase. We bought it in June 2009. We paid it off in 10 months because of money we had been saving while renting on the cheap (and the $8,000 government credit). We have spent $10,000 in improvements and the work is mostly done (the kitchen will have to be remodeled someday, but it is working fine right now). The most recent assessment was for $160,000.

And our first baby is coming this week :)

[Todd]

If your income doesn't go up with inflation, the effect of fixed debt payments are canceled out with regards to disposable income.

If your house value goes up with inflation every year equal to the amount of your income in deflation, the only way to offset your income loss is to tap the equity. However, it is the classic zero-sum game, because equity itself only rises with inflation. Your labor income losing value is replaced by equity increasing in value at an equal rate = zero.

It is risky to pay off a mortgage, but not to pay it down, unless you are already "underwater" and see no reasonable chance to recover your home's earlier value, which may have been driven up by irrational exuberance. No sense in throwing money into the black hole. Maintaining a healthy level of home equity however, let's say 50% of present market value, gives you many options if you need to sell, including balancing the risk premium with a bank. Beyond that, there are better places to invest that extra cash that would have been used to pay the house off, including wheat futures if you want to use the bread analogy.

[Mr. ToughMoneyLove]

All this theoretical about incomes keeping pace with inflation is nice but it's not happening. Six months or a year of unemployment takes the thrill of a low interest mortgage away in a hurry, as will a forced early retirement. And I am not talking about nickel and diming your mortgage - get rid of it.

When market returns are consistently good, a low interest mortgage can make sense for a younger homeowner. Unfortunately, that ship has sailed for the foreseeable future. IF (a big if) market returns trend up again for the current generation, increasing taxes on income, dividends, and capital gains will probably eat up most of that. This is what is coming.

@Troy - your risk premium analysis of the bank's position is interesting but of no practical importance to a retiree, an unemployed homeowner, or a worker with a flattened income curve, with a mortgage. As for opportunity cost, find me an investment currently returning a risk-free, after-tax return = to a mortgage payoff. I want to buy some.

@Mark - You brought bread into the equation, not me. The simple truth is that if your income does not keep pace with inflation, a fixed rate debt payment will take up an increasing percentage of your real spending power. This is also true even if you invest the difference but cannot earn an after-tax return that is greater than your mortgage interest rate + inflation. Like now and for the foreseeable future.

[JLP]

ToughMoney,

Wages may not have increased but prices have, which has the effect of making a fixed mortgage payment decrease over time since the money used to make the payment does not buy as many other goods and services as it once did.

[Amanda]

Thanks everyone for the advice.

To clarify, we bought our house in April of 2009, and got a decent deal on the price as it was a foreclosure and an investor bought it and flipped it to us in turn key condition. It is definitely worth a bit more than we paid and we also got the tax credit, which is another $8K that we really got back immediately.

I guess our situation is a bit unique in that we bought really what would be a perfect house for a middle age family after their first starter house. We sort of skipped past the starter house since there were so many good deals and we could afford it. However, we are realizing that the house is a bit large for what we need and we don’t plan on having kids, so we could really get away with something half the size and price. Unfortunately, we don’t have much equity yet in it, and we’d also have to pay back the tax credit if we move within 3 years. I would be curious to know what your thoughts are on the percent equity needed before selling. I tried to run some numbers and sadly it almost seems like if we did sell and downsize, it would be almost a wash due to the fact that we would have realtor fees, closing costs, etc all over again… Rookie mistake I guess :-\

I definitely want to be debt free, and we are working the debt snowball with the student loans and car loans that we have left to pay. We can get those all paid within 2 years at the rate we are going and then we can focus on the mortgage.

@ Troy: I didn’t understand your first post, but the second one clarified it a little more. You are saying to save the extra payments in a separate account until you can pay off the loan fully to avoid placing the risk on yourself instead of the bank. I guess it makes sense from a peace of mind standpoint, but you’d pay a little more interest in the long run…

@Ken: Great point about the Dave Ramsey quote. That definitely does put it in perspective.

[Kevin]

If you have <5% interest rate, perhaps paying your mortgage off early isn't the smartest move. But, for me to think this is wise, I think the following has to occur:

You have to have a risk-free rate of return greater than your interest rate + tax benefits. Its important to emphasize risk free, or to be practical, near risk free securities like treasuries, or I cringe when I say this, AAA rated securities (caveat emptor) to properly compare apples to apples. If you invested in equities from 2000-2010 instead of paying off your mortgage, you wouldn't be in good shape. I don't think this rate of return has been possible since ~2005 or so.

Can you really beat the peace of mind knowing that your mortgage is paid off? I can't wait for the day that happens. That is the day I will really be free. I will still need some money, but just enough to pay my property tax bill, which I can swing with any modest job (or even unemployment). Since I won't need credit anymore, I am no longer a slave to the system, and if a company pisses me off to the point where I don't feel like paying them, I don't have to worry about them dinging my credit and that costing me thousands of dollars down the line. The sense of achievement, the massively freed up cash flow... paying off that mortgage has a much greater value to me than the pure economics of it.

And with the massive volatility out there today, a guaranteed rate of return of about 5% is pretty attractive.

[Mark]

@MrToughMoneyLove: I will agree with you that if you cannot invest in anything that returns more than the rate of inflation, and your income will not rise over the remainder of your career, then you may not benefit from having a mortgage.

However, I think you are more pessimistic than you should be. I speak daily with people in their early thirties who have been handed 10% pay increases, have changed jobs for 10 or 15% increases, etc., etc.

I think these people are better off carrying a mortgage. Those whose skills will not provide the opportunity for higher incomes in the future are facing a scary future indeed. They should probably rent not buy.

[Mark]

I intended to roll this into my comment above, but my mouse-finger got twitchy.

Several people have mentioned the peace of mind of being debt-free. If your goal is peace of mind, and you understand that your decision is for that reason, then by all means go ahead. But don't try to rationalize it with a spreadsheet. Just pay off and be happy!

I would feel more peaceful knowing that I had cash in the bank (even earning NO interest), rather than an illiquid object. When you're unemployed, its difficult to get a home equity loan or to refinance.

I also know I have a one-sided deal in my favor. If interest rates drop I can pay off or refinance. If interest rates rise, the bank is stuck with me for as long as I want them to be.

[Troy]

Amanda:

That is exactly what I am saying. I do this for a living. Do not accellerate your mortgage payments directly to the lender. It is a foolish move driven by good intentions.

Take the additional amount and place it in a separate account that you own and control...like a bank CD. Pay the minimum on your home loan each month.

When the separate account balance equals the remaining home loan balance re-evaluate. At that time you have options. You can actually pay off your loan entirely. Or continue the separate account as is, or do something else with it. It leaves you with flexibility.

The additiional interest you pay is minimal. You would also earn interest on your separate account so the gap closes even further, and likely over the next 10 years the fixed interest rate will equal your current low mortgage rate. But this isn't about arbitrage or rates. This is about flexibility of cash management. The flexibility and availability of those funds is likely worth the extra interest cost.

Remember. You can pay extra for years. Then, one month you fall behind because of life and you get a letter. Three months behing you get a knock. It doesn't matter that you paid early and extra. Every month the bank wants their money, and they will get it somehow. If you had a separate account with 50K sitiing in it you would have a few more options if life happened...and life will happen.

[billyjobob]

I bought my home in 1980...our interest rate was 12%. We busted our butts to pay it off early and I haven't had a house payment for about 25 years. This allowed me to save more. I suppose if the numbers had been different it could be better at times to just pay the mortgage over time.

[Bill in Detroit]

The way I see things is that, once the house is paid off, the mortgage payment becomes 'money I don't have to cough up when the economy sucks'.

Our deed came in the mail today.

Now we only have to find the money to pay taxes, fix things and keep the lights on. The mortgage payment is off our shoulders. This means that, on my SS disability pension, we can keep our heads above water for the rest of our lives.

While everybody is running numbers that assume certain constants, no one is running the numbers that consider being sidelined years early. Run those numbers, if you can. Imagine if I was still trying to carry an $800 (or larger) mortgage payment.

That's the value of paying off that mortgage.