Why You Should and Shouldn’t Pay Off Your Mortgage

MoneyWatch details the reasons why you shouldn't pay off your mortgage -- then the author tells why he paid it off anyway.

Here are the reasons he gives for why you shouldn't pay off your mortgage:

• You need the liquidity.
• You could probably do better investing the money elsewhere.
• You expect inflation.
• You expect housing to rebound.

Then he tells why he paid off his mortgage anyway:

The logical explanation is that I had enough risk in my portfolio, and as for the low-risk portion of my money, it made no sense  to borrow at 3.0% after taxes and invest it at 2.2% in, say, Treasuries.  That would be acting like a very dumb hedge fund.

But there’s a less rational reason too. Like a lot of post-crisis Americans, I’ve had it with debt. I don’t want to be beholden to a bank and in an uncertain world I’d rather not have the certain obligation of a mortgage payment every month.

I asked Meir Statman, a behavioral finance professor at Santa Clara University about this caution, expecting a lecture about “availability bias,” or the exaggerated  fear of a bad event simply because it is fresh in memory. Instead, I was relieved to hear Statman admit that he’d paid off his mortgage too. “Maybe you could earn a higher return by arbitraging the difference between your mortgage and the stock market,” he said. “But you have to ask yourself what your money is really for,” he said. “Personally, it gives me satisfaction to know that I own the four walls around me.  Satisfaction and peace of mind are a kind of return, too.”

As you might imagine, I have a few things to say about the thoughts above. Here goes:

• As far as needing the liquidity, if your gap is large enough, you can have plenty of cash and pay off your mortgage as well. I was able to manage both.
• As for investing the money elsewhere and getting a better return, maybe you will do better, maybe you won't. This last year you would have done much better by having the money in the market. The couple years before that -- not so much. And, of course, paying off debt is a guaranteed return. Investing is not.
• Do you expect inflation? Or deflation? I don't know what to expect these days when it comes to our economy.
• As for a housing rebound, this sounds like the best bet to me -- if you have five to seven years to wait.
• And for the "had it with debt" argument, this is why I paid off my mortgage almost 14 years ago. I list "being deep in debt" as #3 on my list of the 10 worst money moves you can make, but for me having ANY debt was a bad money move. I wanted to get rid of it all asap -- and my house was the last to go (I didn't have much before that, though). So for the last 14 years, I've had satisfaction, peace of mind, and no mortgage payment. Yes, it's been sweet!

If you're in debt and think you can't get out -- you're wrong. Here are seven steps to get out of debt. Apply them over a long period of time and you WILL get out of debt -- including mortgage debt (if you work at it long and hard enough.)

Comments

[Everyday Tips]

I personally don't care about the opportunity cost of not investing the extra money I put toward my mortgage because I can't put a price on peace of mind. I still have a few years to go, but if I had a lump sum of money, it would go right on my mortgage without a second thought. Then I would take out a loan to go out to have a huge dinner to celebrate. :)

[Todd]

"The logical explanation is that I had enough risk in my portfolio, and as for the low-risk portion of my money, it made no sense to borrow at 3.0% after taxes and invest it at 2.2% in, say, Treasuries. That would be acting like a very dumb hedge fund."

To me, this is the only rational reason to pay off a mortgage early. Depending on your age, if say, 25% of your entire portfolio is conservative, which includes a house and its historical long term appreciation rate of 3%, it makes no sense to divert the principal to low-interest earning treasury bills or fixed income investments that for the near future are going to return less than 3%. If interest rates start going up rapidly, so will inflation. Your house may go up accordingly during that period, but if you need to move somewhere else, homes in other areas will be more expensive because of inflation, as will any labor and materials to maintain the home as they age. You really don't gain anything unless you can move from Manhattan to Nebraska or some other low-cost housing market, while avoiding a considerable loss of income relative to that housing cost.

You have to look at the long term, whether it's real estate or equities, instead of what things are going to be like in 5-10 years time. You also have to assess risk with regards to your age and the time for any investment to perform along historical long-term averages, as you re-allocate your portfolio.

People keep saying the reason they pay off their mortgage is because of risk, but owning a home is risky as we all have clearly seen. If you are one of the lucky ones who bought a distressed property or one in a trendy growing area, you may have seen extraordinary returns, but that just means your house had become an aggressive part of your portfolio. As any investment rises precipitously, one has to decide when to get out before the herd, and put your free cash flow in more attractive investments.

[Old Limey]

In my case it was the most common reason of wanting to retire debt free.
Retirement generally means taking a severe cut in pay, and I was no exception, so it is logical to make a good cut in one's expenses. This is particularly true if you have a variable rate mortgage. We were also four years away from being able to take SS at age 62.
I also agree with the first poster that "Peace of Mind" cannot be overstated. When your mortgage is no more it is a great relief to know that no matter what happens, your home is safe no matter what. When I received the paperwork from the lender marked "PAID IN FULL" it was certainly cause for celebration for us.

[Jaime @ Like a Bubbling Brook]

We bought this home cash 3 1/2 years ago and are so glad we did. Lord willing, we'll never have a mortgage again.

We are debt-free, and truly believe that the borrower is servant to the lender. What freedom and peace there is without debt!

We live below our means, and purchased a fairly modest home in a nice part of town. It's nothing excessive, and our property taxes are low as well.

We hope to help our children do the same one day.

[AFP]

Currently my only debt is the house, but we are working on disposing of that debt as well.

To me it seems the liquidity argument is an argument against owning a home, not against paying it off.

If you need the liquidity, then don't buy in the first place. If you don't need the liquidity, buy a house with cash, or pay off the mortgage as soon as possible.

[meir statman]

This is from Meir Statman who is quoted in this article and who paid off his mortgage years ago for peace of mind. You might find more about what investors want, beyond high returns, in my just published book, "What investors really Want."

The book centers on behavioral finance, drawing from the literatures of finance, marketing, and psychology. It is easy to read yet rigorous, combining systematic studies with anecdotes and recent events.

The book presents the cognitive errors that bedevil investors, such as framing and hindsight errors, and the emotions which mislead them, such as fear, exuberance, and unrealistic optimism. Yet the book goes much further in describing investors as "normal," neither rational nor irrational. We are "normal smart" at times and "normal stupid" at other times. We commit cognitive errors and are misled by emotions on our way to what we want.

We want three kinds of benefits in all products and services, whether watches, restaurant meals, or investments. High returns and low risks are the utilitarian benefit of investments, as calories are the utilitarian benefits of restaurant meals and time-telling is the utilitarian benefit of watches. But we also want expressive and emotional benefits, such as the ambiance of a restaurant, the prestige of an expensive watch, or the hope of winning with a well-chosen stock. Moreover, we want to feel pride when our investments bring gains and avoid the regret that comes with losses. We want the status of hedge funds and the warm glow of socially responsible funds. You will find these and many more in What Investors Really Want.

[Money Reasons]

I was pretty happy with paying off my house.

I don't think I would do so today with the rates so low, or if I did, I would milk the low borrowing rate until my standard deduction matches my itemized deduction.

Of course I would only go with a fixed interest rate, instead of an ARM.

That said, I do have to admit, the monthly extra $1,500 of non-mortgage cash is very nice!!!

[KH]

I think the main argument against, is liquidity. And the amount of risk you take when you lose the liquidity by paying off your mortgage depends heavily on the quantitative factors of 1) how expensive your house/mortgage is, and 2) your net worth.

If you have a high net worth and a low mortgage--it's a no brainer because you won't risk much liquidity by paying off your mortgage now.

If on the other hand your home represents the majority of your net worth, you could actually lower your overall risk by keeping your mortgage (and your cash) liquid--just in case you lose your job and have to sell so you can move to find a new job. Because you can't rely on selling your house quickly for the next couple of years.

[Mark]

The one reason I do not understand at all is "You expect housing to rebound". What does this have to do with making a mortgage a good or bad deal versus paying off?

If you are living in the house, you can either make a monthly mortgage payment or reduce that payment by making an upfront lump-sum payment. This has NOTHING to do with the value of the house.

If you plan to sell, and have an underwater mortgage. then you may want to pay off now so you don't have to bring money to closing, or you can pay off at the closing. Once again - I don't see where the value of the house comes into this decision.

On the high-net-worth argument: I have a high enough net worth that I could pay off my mortgage AND have plenty of liquidity left, but I am not doing it because I expect inflation and have invested at better rates.

A couple of people seemeed to imply that high net worth would support paying off the mortgage. I would argue that preceisely BECAUSE I have the high net worth, I can afford to be wrong - if I am paying 4.6% and it turns out to be a bad deal, so what? And I sleep well because I know I could write the pay-off check tomorrow if I had to.

From an investment side, I have dividends taxed at 15%, and deductions due to my mortgage interest which reduce my tax at a rate of 33%. (Property tax alone in Texas is almost as large as my standard deduction so almost all the interest gets this 33% benefit.)

If my earned income drops, the tax math will change, but for now the mortgage remains a good deal because taxes bias the decision in favor of the mortgage.

[Mike]

Everything I do personally is to someday live debt free. So I am definitely all for paying off that mortgage as quickly as possible. I have about 3 years remaining and I am counting down the days.