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Should I pay off my mortgage? Thumbnail

Should I pay off my mortgage?

If you’ve owned your home for more than a few years, the question will inevitably come up as to whether or not you should just pay off your mortgage. As in many things in the financial planning world, there is no right or wrong answer to this question. There is only what’s right for you.

One way to think about this is from a left-brained vs. right-brained analysis. The idea here is that left-brained thinkers are analytical, and right-brained thinkers are more creative, or in this case, it might be more appropriate to think of them as "feelers."

I won’t address home ownership vs. renting, debt ratios, income ratios, or similar topics. This analysis is geared primarily toward someone who already owns a home, either has the means to pay off the mortgage in full today, or has surplus income and is wondering if putting some of their surplus dollars towards the mortgage is a good idea. If you don’t have the means to pay down your mortgage today, come back to this article in a couple of years.

For the analytical left-brain folks out there, it makes sense to have a mortgage for three reasons: opportunity cost, leverage, and taxes. Let’s explore each in turn.

The "opportunity cost" can be thought of as the cost of not doing something else. In the case of the mortgage, the opportunity cost is expressed as the interest rate. Another way to put this is to talk about the "spread" - the difference between the interest rate you are borrowing and the return you are receiving on your investments. By way of example, if you borrow money at 3.5%, and if your investments are earning 6% on average over long periods of time, then you come out ahead by having a mortgage. (Note: as of this writing in 2022, interest rates on new conforming loans are in the 5%-6% range. However, 3.5% is not unusual if you placed your mortgage in the last few years. In years to come, I think we will look back at this period of time as the lifetime low in mortgage rates.) One caveat, which can happen if your natural instinct is to hold too much cash: if you borrow at 3.5% and then keep too much money in an FDIC bank account, earning next to nothing, you are effectively paying 3.5% for the security of a well-stuffed mattress.

The second advantage to holding a mortgage is that it is a form of leverage. If we assume the housing market generally goes up over time, then leverage will enhance the returns on your investment in a home. By way of example, assume that you buy a home for $1M and put down $200,000. If, after a few years, the house goes up in value by 20% to $1.2M, your original $200,000 investment has doubled to represent $400,000 of equity. That is a 100% return on your initial investment. Alternatively, if you had put down the full $1M purchase price, a 20% increase in the home's value would represent a 20% increase in your initial investment. This example is somewhat simplified but is instructive in understanding leverage's power. It is worth noting that leverage is a double-edged sword and can be disastrous in periods of housing price declines. When you only have a small amount of equity in a home, then small declines in housing values can entirely wipe out your equity. Housing prices in the US have historically gone up over time, but there are some geographical exceptions (such as Detroit, MI) and over periods of time (such as the Great Recession of 2008-2009).

The third argument for holding a mortgage, and this one is very popular with tax professionals, is that it is an income tax deduction. Remember that recent tax law changes have limited this deductibility, and you should consult with your tax professional to figure out if and how you are impacted. The key here is that the more money you make, and therefore the higher the tax bracket you’re in, the bigger the impact of this deductibility. This is because the impact of the deductibility is a function of your marginal tax bracket. If you are in the 10% tax bracket and have $10,000 of deductible mortgage interest, you are sheltering $1,000 of income. If you are in the 37% bracket, you are sheltering $3,700 of income. I have never felt that the tax benefits should be the leading reason to own a home and carry a mortgage. It’s a nice to have and a freebie from the IRS that I will gladly accept, but spending money on a mortgage to save on taxes is a bit like the tail wagging the dog.

For our right-side brain folks out there, the flip side of this evaluation is that there are advantages to living in a paid-off house. These advantages can be hard to quantify, and they fall broadly into two categories: things that make clients happy and things that make financial advisors happy.

Starting with the second item first, as a financial advisor, I want clients to focus on what they can control and accept that things are out of their control. For example, the returns in your portfolio are largely out of your control. However, spending is one category where an individual can exert control. You can choose which car to buy, you can control what vacations you go on, and you can control how much you eat out at restaurants. One way you can take control of your expenses is to reduce your expected spending needs as you approach and enter retirement. In other words, I can make better predictions about the "success" of your retirement, as measured by not running out of money when your expenses are lower. I often see people enter retirement with a fairly large monthly mortgage payment, with that monthly payment relatively large relative to their new retirement income and/or retirement assets.

When trying to make a point, I sometimes find it helpful to take a look at things from the complete opposite standpoint. In arguing against a mortgage, the opposite base case would be to start with the assumption that you are living in a completely paid-off home. Ask yourself this question: would you take out a mortgage on your paid-off home, upwards of 80% of the value of your home, to invest in the stock market? If the answer is NO: you should probably think about working to pay off your mortgage ahead of schedule. If your answer is YES: you are much more comfortable having a mortgage. This question is instructive because, in an extreme interpretation of having a mortgage, you are borrowing from your home in order to invest in your retirement account. The instructiveness is somewhat limited because, depending on your situation, it may be counterproductive to focus on paying off the house at the expense of saving for retirement.

The second advantage to paying off a house is psychological. When I work with a client, and they decide to pay off their house, I often get the impression that there is some kind of switch that flips inside their brain. There are two phases. The first is generally a short-term euphoria immediately before and after making that final payment. The second is long-lasting happiness in the knowledge that you are not beholden to a mortgage and that you can not be foreclosed on for missing a monthly mortgage payment. This is probably an oversimplification, but I sometimes say that people simply sleep better at night in a paid-off house. While difficult to measure, the psychological impact of living in a paid-off house should not be overlooked, regardless of how difficult general happiness is to measure.

To recap, the math for having a mortgage is fairly hard to argue against. If your cost of borrowing is lower than the expected investment returns, and the leverage of having a mortgage increases the rate of return in your home, and when you get a tax break for having a mortgage, it can be very advantageous to own a home and not pay off your mortgage.

That said, if you are the type of person who would sleep better at night knowing there is a mortgage on your house to worry about, then there is no amount of math that will override that feeling. If you choose this path, just know that you’re going to need to fend off your engineer friend with the spreadsheet, and you are going to have to be adamant with your tax professional, but you can do it.

The path that I have personally chosen is to target a specific age for having the house paid off. I’m taking into account my financial planner brain (to minimize my expenses as I approach retirement), my math brain (enjoying the advantages of opportunity cost optimization, leverage, and tax breaks), as well as my emotional brain (I very much look forward to sleeping in a paid off house). I recently refinanced my house to take advantage of those lifetime low-interest rates. To stay on track for my goal, I did some calculations and now pay a little extra every month in order to hit my target payoff date.