Have you thought about paying off your home mortgage? Wonder if it’s the right thing to do?
There seems to be a movement these days that all debt is bad. Whether it’s credit card debt, auto loan debt, student debt or mortgage debt, the rally cries seem to be: “pay off all debt – period.”
Is that right or should you have some debt? Are certain types of debt good? Why is credit good, but if you use it, debt is bad? What has been the case historically with debt? How do millionaires use debt?
Let’s talk about what debt is and why it’s unpopular right now.
As you know, debt is when you borrow money from a lender – whether that’s a bank, credit card company, other institution or personal friend, it means you owe somebody.
If you’re a responsible person and have a steady income, that’s probably not going to cause you too much stress because you have the cash flow to pay the payments on the debt.
Stress occurs when you don’t have the income to pay it or the asset you borrowed to purchase decreases in value. That can cause all kinds of problems.
I think debt has become unpopular since the 2008 recession because asset values on homes declined and also people lost their jobs, so it was a double whammy.
People felt strangled and burdened by the payments and had a hard time keeping up.
Student loans became non-dismissible even in a bankruptcy, so students who couldn’t find jobs felt the pressure of their loans accumulating.
Consumers bought so much “stuff” in the early 2000’s that they had credit card debt up to their eyeballs.
So debt became a bad thing and the campaign to pay off ALL debt became popular.
But is it the right move for you financially? I’m going to suggest that it’s not and I’ll show you why.
1. Credit is a good thing, we all can agree on that. Having good credit and access to credit is very helpful. Typically we have about a month to pay it off. If we don’t, the credit card company charges interest. The interest rates today are exorbitant and can be well over 20%, so we definitely want to avoid running up credit card bills.
But what if you used your credit cards to start a business? It might take you a while to get it up and running, but if you know what you’re doing, it could provide an income with which you could pay off all your debt! So if you use the credit card for something that will generate an income, it can be a good thing. Many successful businesses were started with credit cards and bootstrapped.
Debt for a college degree may also be a good thing as long as you eventually find a good job and can pay it off. Studies show that people with college degrees earn a higher lifetime income than high school graduates, so it can be a worthwhile investment in yourself. Just pay it off as quickly as you can because there is no student loan relief, even from bankruptcy.
So we probably agree these are good uses of debt, but what about a mortgage?
2. Money has an opportunity cost – that is, if you invest it in one thing you can’t invest it in another. You can only use the money in one place at a time. It could be that you use money to pay off your mortgage or that you invest the money, but not both.
When you select where to put your money, you are making choices that will impact you for many years to come. Obviously a mortgage can be 15 or 30 years, so they are a very long-term decision. If you move and get a new mortgage, the clock starts again, so it can go on for a large part of your lifetime.
The disadvantage of paying off a mortgage is that you don’t have use of your money for investments. For example, if your home was worth $400,000 and you paid it off, that $400,000 is not available to invest. Let’s assume you put down 25% or $100,000 and are considering using $300,000 to pay off your mortgage or you could average an 8% return over time in the stock market (8% has been the historical average for the lifetime of the S & P 500). If you had invested it instead of paying off the mortgage, that $300,000 could grow to $951,650 in 15 years and $3,018,797 in 30 years!
(It’s only fair to take into account the interest you would have saved by paying off the 15 and 30 year mortgage. So in the example, for a 15 year mortgage you would forgo paying interest of $502,604 ($300k for 15 years @3.5%), so subtract the interest you don’t have to pay: $951,650 – $502,604 = a net advantage of $449,046. For a 30 year mortgage, the net savings is $3,018,797 – $842,038 ($300k for 30 years @3.5%) = a net advantage of $2,176,759. It still makes sense to me NOT to pay off your mortgage).
Well, at 3.5% interest you certainly are “earning” less than 8%. You might even do substantially better than an 8% return in the stock market, but you can never do better than 3.5% paying off your mortgage!
You can calculate your own numbers by downloading my free 7-page report.
3. When the cost of money is low, it makes sense to borrow. I always say, “if we ever get back to double digit interest rates”, which I believe we will some day because of cycles, “we will wonder why we didn’t load up on debt at only 3.5%?” Money is so inexpensive, it makes sense to pay 3.5% if we can invest it at a higher rate. That’s a no-brainer.
4. If you add a little bit extra to your mortgage payment, you can have the best of both worlds. You can pay off your mortgage sooner and have an investment fund on the side. By just paying 1/12th extra every month, that becomes one extra payment. One extra payment per year will shave about 8 years off of your mortgage. So for example, on a $1,200 a month mortgage, 1/12th is $100. If you added that extra $100 to your $1,200 payment and paid $1,300 a month, in 12 months you would have paid one extra payment. It’s fairly low cost to do, but it saves you thousands of dollars in interest and about 8 years off your mortgage. Your mortgage is paid off sooner and cheaper so it’s a win-win. If you can afford 2/12ths or 1/6 (meaning $200 extra per month paid on your mortgage), you will pay it off even sooner with very little effort or cost.
One listener thought I was giving conflicting advice to say “don’t pay off your mortgage early” but then I recommended paying an extra payment to pay it down. What they didn’t understand is it is the lump sum payment that makes the difference. What I’m trying to express is that the opportunity cost of investing a lump sum is huge – in fact it could be millions of dollars difference. So my point is don’t use a lump sum to pay off your mortgage, but do make an extra payment each year. That way you have the benefit of “good” leverage, but also have the benefit of paying off your mortgage ahead of time. I hope that makes sense to you.
You can also invest the rest of your discretionary income into an investment fund that will grow and compound over time. It will still work out to be a good idea to invest rather than pay off your mortgage.
I haven’t even mentioned the tax benefits of having a mortgage. Of course, you may have that benefit if you itemize, so that’s another plus to keeping a mortgage and letting the government assist you with tax deductions.
5. The one caveat is housing prices must continue to rise long-term. Since housing has increased a lot already, I’m expecting we could see another housing crisis, especially if interest rates rise dramatically. That will send the value of homes down. Hopefully, long-term your home will still be a good investment and it will straighten itself out. That’s the one stipulation is if housing goes down, you may have wished you paid off your house.
You may also want to pay off your house if you’re near retirement age. Most retirees do not want to continue to have a mortgage. The only problem is if you are age 65, you could live to 85 or older, which means you could have been compounding your investment fund an additional 20 years, even if you are taking income from it. Again, the compounding you would receive would likely be more than the interest saved by paying off the mortgage.
Which brings us to our last point: emotion.
Many people feel emotional about having debt. It makes them worry. They feel exposed to the risk of foreclosure if anything went wrong and they couldn’t make a payment. Not having debt helps them to sleep better at night.
You have to know yourself and whether you’d rather have less money (a lot less), but not have to worry about your house OR if you can manage your risk, pay extra money on your payments to reduce the length and amount of the mortgage and end up with more money. Which would you prefer?
My goal is always to maximize my wealth because the more money I have, the more options I’ll have, but you may not agree and that’s ok.
Do what’s right for you…just know that if you want to maximize your money, the best plan may be to keep your mortgage.
Your action items:
1. Look at your mortgage statement. What is the interest rate you are paying? Is it competitive or should you talk to a mortgage broker about refinancing?
2. Is it a fixed rate mortgage or a variable rate mortgage? I recommend getting a fixed rate since interest rates have started to increase.
3. Calculate 1/12th and 2/12ths extra on your mortgage payment. How much would that be? Could you afford to tack that onto your payment so you are making an extra one or two payments a year, thereby paying off your mortgage about 8 years sooner and saving thousands of dollars in interest?
4. If you have automatic payments deducted from your checking account, go and increase the amount you’re paying on your mortgage. It will give you the best of both worlds – paying it off faster with little additional cost.
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