Should you pay off your mortgage early? It's a difficult question to answer. There are many factors to consider. However, there is one easy way to make the decision. I've created a simple test to answer the question "should I pay off my mortgage early?".
Why Is It Such A Hard Question?
Vested Interest in the Mortgage Industry
In the old days, this was an easy question. Everyone tried to pay their mortgage early. However, the realty and mortgage industry has grown substantially over the years. We now have many so called "financial planners." Realtors, mortgage brokers and financial advisers all have a vested interest in making sure you have and keep a mortgage.
- Mortgage brokers and banks obviously want you to have a mortgage. Mortgage payments are extraordinarily safe income (defaults on mortgages are historically very low) for them each month.
- Realtors get a bigger commission check with a larger mortgage. They want to push you into a large house and therefore a large mortgage to get a higher commission.
- Financial planners and advisers want you to put your money in mutual funds and stocks. Most Financial advisers (unless they're fee only) make money pushing certain investments. They can't earn fees and commissions if you pay off your mortgage instead. This is a definite conflict of interest.
Most of the people we trust to offer financial advice have a vested interest in mortgages.
Too Many "If's" in the Tax Code
Talk to someone about paying off your mortgage and the first thing you'll hear is "what about the tax advantages?" Yes, what about the tax breaks?
Here's the trick. There is something called a standard deduction. This is the fixed amount of money you can deduct from your taxes if you don't itemize. You have to itemize in order to deduct your mortgage interest. Most taxpayers don't itemize.
According to the CPA Journal:
Approximately two-thirds of all tax returns use the standard deduction. Accordingly, many so-called “deductible” items (charitable contributions, for example) do not actually affect the tax liability of most taxpayers.
So when someone tells you that you have to keep your mortgage for the tax break, tell them they're full of crap. In order to itemize you have to have enough qualifying expenses (like medical bills) that exceed the standard deduction. In 2007 the standard deduction for married filing jointly is $10,700. That's a lot of expenses for the average US household considering an average household income of $48,201.
I'm sure there are situations where the mortgage deduction makes sense. Your best bet is to talk to a CPA and find out if you benefit from the mortgage interest deduction.
The "Should I Pay Off My Mortgage" Test
This is the easiest test you've ever taken. There's one question and no wrong answer. Simply answer yes or no to the following question:
If you woke up on day and your mortgage was completely paid off, would you go get another one?
If the answer is yes, then you should keep your mortgage. If your answer is no then you should pay it off. It really is that simple.
But I'm Smart, I'm Putting My Money in the Stock Market Instead
That's fine; you should do what makes sense for you. You might want to read this Wall Street Journal article about the lost decade of the S&P 500.
The stock market is trading right where it was nine years ago. Stocks, long touted as the best investment for the long term, have been one of the worst investments over the nine-year period, trounced even by lowly Treasury bonds.
The fact is paying off your mortgage is a 100% safe investment. You can't lose money paying off your mortgage. Stocks are not guaranteed. I'm invested in the stock market for the long run. However, I paid off my mortgage for the short run.
But I'm Really Smart, I Qualify for the Deduction
Congratulations, you've figured out how to spend a dollar to save 25 to 35 cents depending on your tax bracket. I'm in awe of your genius.
I'm sarcastic to illustrate a point. How are you saving money by spending money? It doesn't make sense to me.
Do What You Want
The point of this article and the over simple question is that you should do what makes sense to you. Personal finance is 90% psychological and 10% economical. You need to feel safe about what you're doing.
If paying off your mortgage gives you an enhanced feeling of security, then you should do it. However, if you've convinced yourself that you can make more money in the stock market, then you should do that.
What do you think? Have you paid off your mortgage? Do you want to? Leave a comment and let me know what you think.
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Comments
4 Comments so far
How can you choose one option (paying off your mortgage) without first ascertaining the risk and reward for all of your options? Your dismissal of investing the stock martket based on one arbitrarily selected period of time is laughable…why 9 years? Because it supports your pre-determined conclusion?
A better estimation for the long term (30 year) expected return of the SP500 should be based on its long history. This website(http://politicalcalculations.blogspot.com/2006/05/sp-500-best-average-and-worst-returns.html) has a nice calculator that will tell you the highest, lowest, and average return for any time period. Thus for every 30 year period since 1871 the SP500 averaged 9.4% return, with a high of 16.4%, and a low of 4.1%. Thus, over every 30 year period of the SP500 since 1871 the lowest return ever received was 4.1%. Since my mortgage interest rate is low (<6%), I'll take my chances that the SP500 outperforms my mortgage interest rate over the next 30 years. Plus I'll diversify (in small stocks, EAFE, REITs, and bonds) and annually rebalance, which should let me be able to beat SP500 over the long haul.
I think paying off a mortgage is a good idea but for a different reason than you mention here. Having a mortgage means that you need to have a larger income to make that payment each month.
If you were disciplined enough to pay off a mortgage you would no longer be required to set aside that extra income for the payment each month. Without a mortgage you could quit your full-time job or set aside that money to invest in the stock market or whatever else you wanted to do. No mortgage means freedom.
Jeff,
Thanks for the information. I do enjoy your counter arguments.
I chose 9 years because that's how long I've been investing in the stock market so it dovetails quite nicely with my argument. It also illustrates the fact that the market repeatedly enters dead zones where it performs rather poorly and true gains are infrequent and irregular.
I have a question for you. First I'm assuming you have a conventional mortgage and you are making monthly payments thereby creating a small amount of equity in your home each month.
If that's true, do you also have a line of credit based on the equity in your home (second mortgage, etc)?
It would seem to me that if you believed the stock market was a better investment you should either obtain an interest only loan or an equity line of credit.
If your argument was correct, you would not pay off your home; instead you would invest that money in the stock market.
I’m curious if you or someone you know does that. It would be a fascinating experiment.
Thanks for reading!
Chris,
That is an interesting idea, but not one that I think would be feasible for me to try.
I would expect that interest rates on 2nd mortgages and interest only loans (not used for the purchase of your home) would be fairly high right now–I would guess around 8%-9% or so if you had good credit. Plus, it would probably include loan fees.
Assuming I could get a low rate (5-6%) with little or no loan fees, there are a couple more risks with this strategy that would make me think twice. The first is that interest only loans (HELOCs) have a fixed period where they are interest only (5-10 years), after which time you need to either repay them or refinance. Since in the short term stock prices can behave much differently than their long term return (as illustrated by in the last 9 years), I could lose money in the stock market and not be able to fully pay off the 2nd mortgage when the payments increase. Secondly, I would also run the risk that my home value would drop (puting me upside down), thus severely limiting my refinance options. It just seems like an awful lot of risk to take on…especially when your return is speculative.
However, when you have a 30 year fixed mortgage (and don't have to worry about refinancing) you have a time horizon that allows you to reduce the speculation of your return or risk. This reduction in speculation allows you to make a reasonably prudent investment decision, i.e., taking on a little extra risk to receive a little extra reward.