Your mortgage is (hopefully) the largest debt you will ever carry. And one of the most frequently asked questions for financial planners is whether to pay off a mortgage. But opinions vary about the wisdom of accelerating a mortgage payoff.
Reasons not to pay down your mortgage
“Having a mortgage saves on taxes!” Many people are under the impression that carrying a mortgage is a good idea. Mortgages are often characterized as “good debts.” In my view, no debts are good debts. Some debts are better than others, but ultimately it depends on terms of the loans in question. The lower the interest rate, the better the debt, all other things being equal. And typically, mortgage debt ranks among the lowest of interest rates.
Since mortgages tend to cost less in terms of interest rate, they’re considered better debts to carry than others. But another reason people think mortgages are something beneficial to be maintained is the tax benefit.
I’ve lost count of how many clients have professed their belief in this proposition. People say they don’t want to accelerate paying down their mortgage because they would lose the tax advantage. But let’s take a closer look. The mortgage interest tax deduction doesn’t make your mortgage FREE. It only makes it slightly cheaper. I usually offer a generic example: If your current mortgage interest rate is 4%, the impact of the deduction might make it actually cost 3.5% instead of 4%.
If you are paying $10,000 per year in mortgage interest, at a 25% marginal tax bracket, you are saving $2500 in taxes. Paying $10,000 to save $2500 doesn’t sound like a deal to me. Since I want to live in my current house, I therefore must pay that mortgage interest each year. So, getting a tax break helps soften the blow, but it doesn’t make the interest go away!
Right here, right now, let’s discount the idea that one should maintain a mortgage for the tax benefits.
“You should invest your money instead of paying down your mortgage.” This logic is often propagated by investment professionals. Occasionally, I have had clients who believed this premise. The idea is instead of paying, for example, an additional $1000 on my mortgage to accelerate the payoff, I should invest that $1000. The rationale is I could earn more on my investments than the mortgage is costing me.
This argument has some legs. Hypothetically, I COULD earn more on investments than the mortgage is costing me. The key word here is “could.” Investments can be fickle creatures, and investors can be even more fickle. With so many variables, the outcome could result in a situation that is not, in fact, more favorable than a mortgage paydown strategy.
Where this argument really falls apart is when it is used to encourage people to TAKE a mortgage or home equity line of credit against their house in order to invest it. That is gambling, pure and simple.
Reasons to pay down your mortgage
You’ll save interest over the long haul. If you simply pay the equivalent of one extra payment per year on your 30-year mortgage, you eliminate eight years of mortgage payments. Even small amounts of extra principal paid in the earlier years of a mortgage will have a significant impact on the total interest you pay over the life of the mortgage.
Peace of mind. Especially when heading toward retirement, it is a huge relief if your house is paid for in full. The added bonus is that without a mortgage payment, your expenses are lower, so your need for income in retirement is lower.
The right way to pay down your mortgage
If you are now eager to accelerate your mortgage paydown, just hold that thought. Don’t just start tacking on extra principal payments. The most financially advantageous way to pay down your mortgage is to first do the following:
Pay off all other debts first. Continue paying minimum payments on your mortgage until you have fully paid off all other debts. I recommend the Debt Snowball technique, which is outlined here.
Be sure you are fully funding your savings goals. Are you funding your company’s retirement plan to the maximum allowed? If you are eligible to fund a Traditional or Roth IRA, are you fully funding that? What about college savings or other savings goals? If all your savings goals are on track, then you are ready to accelerate the payoff of your mortgage.
“But wait, Dawn! Didn’t you just say that you shouldn’t put investing or saving ahead of mortgage paydown?” I did! For me, it comes down to priorities. You have many financial goals, most likely. Some goals are oriented towards saving, some are earmarked for paying down debts.
My recommended order is:
- Save a small amount for an emergency cushion.
- Fully fund company retirement plans to the extent contributions are matched.
- Pay off consumer debt (credit cards, car loans, etc.)
- Build your emergency cushion further.
- Fully fund all available retirement accounts and other saving goals.
- Accelerate mortgage principal paydown.
- Once debt-free, invest excess cash like a person possessed.
The argument for investing in lieu of paying down the mortgage is where I differ. My prioritization will help you meet all your likely financial goals. If you can’t stand the thought of accelerating the mortgage instead of investing all your excess cash, then do both. Split the difference. Invest half and use the other half to accelerate the principal paydown.
Clearly, this is a more conservative strategy. Some folks are comfortable with a more aggressive strategy and are totally comfortable with investing all excess cash and choosing to live with a mortgage. To each, his own. For me, I will take the “guaranteed” rate of return of the mortgage paydown over the “possible” rate of return of investments. It’s all about moderation.
What are your thoughts on paying off your mortgage? Share your strategies below.