This is something of a controversial topic. Ask just about anyone in the personal finance arena, and most will tell you that you need to pay off your mortgage as soon as possible. The basic concept is enabling yourself to live “rent free”, so you’ll have more money for everything else. It’s hard to argue with that concept, however paying off your mortgage isn’t always the best strategy.
Let’s consider the reasons…
There is a cosmic rule when it comes to all things money related: anything you spend money for or invest money in will cause some other area of your life to go unfunded. And so it is when you put more money into paying off your mortgage.
The fact is, paying off your mortgage is not a completely risk-free proposition. Committing money to such a large undertaking can cost you money other areas.
Three prominent examples:
- If you are using extra cash to pay off your 4% mortgage, you may be losing out on an 8% return in mutual funds (not guaranteed of course, but well-supported long-term)
- If you have non-housing related debt, it will make little sense to emphasize paying off a 4% mortgage, while leaving credit card debt with double-digit interest rates unpaid
- No matter how much equity you have in your home, if your bank account is empty (or close to it) you are virtually house poor – sitting on top of a lot of equity, but struggling to pay the bills every month
Now if you already have a substantial amount of money invested in mutual funds, and are able to continue increasing it while paying off your mortgage early, then it’s certainly worth doing. But if you have to make a choice between paying off your mortgage and either having money invested in mutual funds or used to pay off high interest credit card debt, paying off your mortgage will have little positive impact on your life, particularly in the short run.
It’s important to understand that there is little benefit to paying off a mortgage early until the loan is fully paid. This is because your monthly house payment will remain the same whether you owe $100,000 or $10,000 on it.
This is precisely why it is so important to have your non-housing financial situation under solid control before even considering paying off your mortgage.
Too Many Eggs in One Basket
If your home is your largest asset, you will only be increasing the amount of money sitting in it by paying off your mortgage early. If for example, you have $100,000 equity in your home, but only $2,000 in the bank – and no investments – your financial situation is completely unbalanced. It means that substantially all of your money is in your house, and that’s way too much in the economy and job market we are now in, and seem destined to stay in for the foreseeable future.
That creates another problem with paying off your mortgage…
Loss of Liquidity
It’s been said that “you can’t eat a house”, and never is that more true when you are facing a career crisis or a time of financial struggle. The problem with a large home equity position is that it is not readily convertible into cash. That limits its usefulness to something close to zero.
There are basically only two ways that you can get cash out of a house. The first is to sell it, which few people are willing to do even and especially during a time of financial distress (many even stay in the home until the sheriff comes repossesses it).
The second is to borrow out the equity. While that is far less traumatic than selling the property, it puts debt back on the house, reversing the effort to pay it off. As well, if you are facing financial difficulties, such as the loss of a job or impending bankruptcy, it’s very unlikely that you will be able to qualify for a second mortgage, a home equity line of credit (HELOC), or even a new first mortgage.
Unfortunately, most methods to cash out equity from a house during a time of financial distress are nonexistent. This is also why so many people lost their homes to foreclosure in the last economic crisis.
Loss of a Major Tax Deduction
The reality of today’s federal income tax code is that there are far fewer tax deductions available to the average household than there were a generation ago. But the one that has remained nearly untouched – for political reasons – is the home mortgage interest deduction. You can no longer deduct consumer credit interest, and even deductions for medical costs and employee business expenses are largely nullified by the fact that they must exceed a certain percentage of your adjusted gross income. For most taxpayers, that leaves only state and local taxes and mortgage interest as substantial deductions.
The ability to deduct home mortgage interest matters because it effectively reduces the interest rate you are paying on your mortgage. For example, let’s say that you are in the 25% tax bracket for federal taxes, and 5% in your state. If you have a 4% mortgage, the tax deduction means that you will be reducing your mortgage rate by 30% (25% + 5%). That reduces a 4% mortgage rate to an effective rate of just 2.8%.
Why would you want to lose that deduction, and why would you want to pay off a long-term loan with an effective rate of 2.8%?
One More Thing: There Really is No Such Thing as Living “Rent Free”
Finally we come to the ultimate reason that people want to pay off their mortgages – the promise of living rent free.
In reality, that’s really a fantasy. Even if you pay off your mortgage, you will still have to pay real estate taxes, homeowners insurance, property repairs and maintenance, and, if you live in a neighborhood association, homeowners association dues.
If your annual property tax bill is let’s say, $6,000 (or $500 per month), adding this to all the other expenses required for homeownership will get you to about $1,000 per month in a hurry. And that’s even without having a mortgage payment.
Now it’s true that paying off your mortgage will get your payment down to that level, which is not unimportant. But the fact is you will still not be rent free in any sense of the term. Yes, your monthly housing expense will be lower, but you will hardly be rent free.
Considering all of those limitations, do you really want to pay off your mortgage as soon as possible? I’m not making a case against paying off your mortgage in time for your retirement, but rather against doing it anytime much sooner.