Ryan M. Vogel, CFP®
When Does It Make Sense to Pay Off Your Mortgage?
Being too conservative can lead to poor financial decisions.
Before rushing to pay down that mortgage, think about where else that money could be deployed.
Also consider the tax consequences of paying off your mortgage early.
One of our most important jobs as advisors is to help our clients maximize their resources and to make the best use of their cash flow. Lately, with mortgage rates on the rise, several clients and prospective clients have asked us whether it makes sense to pay off their mortgages, especially if they’re getting closer to retirement age.
Because people have strong emotional ties to their homes, the mortgage pay-off decision isn’t just a math exercise. For instance, many people have been raised to believe they should NEVER carry a mortgage into retirement. I understand the psychological satisfaction of “owning your home” outright, but if you’re tying up a lot of cash to pay off a relatively low-interest rate loan like your mortgage, you are sacrificing hundreds of thousands of dollars in cash that could be invested in stocks, bonds, commercial real estate or other assets with a higher potential return. Paying off your mortgage early is like having tons of extra money in your checking account. A large bank balance may make you feel good. However, that cash is earning little or no interest, so you’re losing money after taking inflation into account.
Real World Example
Before rushing out to pay off your mortgage before retiring, think about how that decision impacts the rest of your financial plan. One of our clients lives in a luxury home in a very nice neighborhood. They still have $600,000 remaining on their mortgage, which is not unusual in that upscale zip code. Further, they’re paying a very attractive fixed rate of just 2.75%, so their monthly principal and interest payment is less than $2,500. In theory, there’s no rush to pay the mortgage off, but since they’re approaching retirement, they’re concerned about the size of their mortgage.
They have large retirement accounts (IRAs) and some joint account money that they could theoretically use to pay off the mortgage. One option is to take some money from the joint account and prepay the mortgage. It sounds great to have that mortgage off your back, but why would you tie up lots of cash to pay off a 2.75% loan when you can get a much higher rate of return by investing in a diversified stock/bond portfolio—or even 4.5% on a short-term Treasury bill? Further, since that $600,000 chunk of money is no longer in their joint account, (it was used to pay off your mortgage), they will have to use IRA distributions sooner to help meet their living expenses in retirement. With this approach, their income would be higher, but their deductions would be lower, which means they’d be paying more in taxes.
When It Makes Sense To Pay Off The Mortgage
There are some cases in which it can make sense to pay off your mortgage early. Suppose you are still working, but you have a job in which bonuses and/or commissions are a large part of your compensation. Since your income can vary greatly from year to year, you may want to pay down your mortgage aggressively when you have high-earning years. In this example, employment risk is high, so you may want to reduce your financial risk in other areas of your life to improve future cash flow and have lower fixed expenses.
Good Debt Versus Bad Debt
Not all debt is bad, by the way. A mortgage is an example of “good debt.” A mortgage allows you to buy a home, which is an asset that generally appreciates over time. It also allows you to spread out the payments for up to 30 years – and the interest portion of those payments is tax deductible. Compare that to “bad debt” such as credit card debt in which you’re buying a consumable that goes away instantaneously. You’re not financing an asset; you’re servicing debt at a much higher interest rate than you’d pay on a mortgage. That’s why carrying a balance on credit cards is considered bad debt.
When Inflation Is Good
When it comes to long-term loans like mortgages, inflation can work to your advantage since it erodes the value of your debt. For instance, a $5,000 monthly mortgage payment may seem like a fair amount today. But if it’s a fixed rate 30-year mortgage, that $5,000 fixed monthly payment will feel more like $3,474 ten years from now (at 3% annual inflation) and more like $2,700 twenty years from now. While recent high rates of inflation have made other costs go up (think eggs), your mortgage has become much less expensive.
Another reason many people ask me if they should pay off their mortgage early is because they believe it will improve their net worth (i.e., what you own vs. what you owe). On the surface, that’s a correct assumption because you’re moving a big number off the debt side of your personal ledger and moving it to the asset side while avoiding future interest payments. But doing so subjects you to “liquidity risk.” That’s when you have lots of assets, but not enough working cash to meet your living expenses or emergency cash needs. You can’t take your net worth statement to the grocery store, doctor’s office, or auto body shop. You need cash. When you pay off your mortgage aggressively, you’re tying up a lot of money that could often be put to more productive use in other areas of your life.
Mortgage financing decisions are not easy and involve difficult tradeoffs. That’s why an independent advisor can be very helpful; we can help you understand these tradeoffs so you can make the best-informed decisions possible. If you or someone close to you has questions about tax planning, cash flow, asset allocation, or retirement readiness, please don’t hesitate to reach out. We are happy to help.
Next week we will discuss the FHFA's updated mortgage fee structure changes, who will be affected, and what it means for your financial plan.
RYAN M. VOGEL, CFP® is the CHIEF PLANNING OFFICER, PARTNER at Novi Wealth