Picture this: Through your hard work and discipline, you have accumulated a relatively significant amount of savings outside of your retirement accounts. You have more than enough cash set aside in your emergency fund, which is your safety net, and you are thinking about whether you should use some of your excess savings to pay off the mortgage that is left on your home. So, should you?
Just like most financial questions, there is no easy answer. The right answer could be different for you than it is for your friends or family members. The best you can do is to try to understand the pros and cons of both sides of the issue so that you can make the best decision for you and your family. This article will attempt to help you understand the pros and cons of this tricky question.
In the financial planning community, there are two schools of thought on whether you should pay off your mortgage. Many advisors think that you should do everything you can to eliminate all debt, including your mortgage. Other advisors believe that there is a difference between good debt and bad debt and that a mortgage is considered good debt. (A couple of examples of bad debt would be credit cards and auto and boat loans.)
So, what are the benefits of paying off your mortgage? Obviously, there’s the fact that you will no longer have a monthly mortgage payment. Not having that monthly obligation will free up cash flow that you can use to pay for other things that are important to you. There’s also the peace of mind factor. There’s no way to put a value on the warm and fuzzy feeling that comes from laying your head on your pillow each night knowing that, no matter what happens in the financial world, you own your home and nobody can take it away. There are studies that say that the happiest and most successful retirees are the ones who own their homes free and clear.
Are there any cons of paying off your mortgage? The most obvious is the opportunity cost on the money you used to pay off your mortgage. Opportunity cost is the benefit you would have received if you had made a different decision. If you still had those funds, you would most likely have them invested. The return you could have earned on those funds is the opportunity cost of paying off your mortgage. And therein lies the rub. Because of the fluctuations in the investment world, you don’t know what kind of gains, or losses, you might get on those invested dollars.
What are the benefits of not paying off the mortgage? One answer is the opposite of the opportunity cost discussed in the previous paragraph. Depending upon the interest rate you are paying on your mortgage, you may be able to invest the funds and get a better return. In today’s low interest rate environment, that’s not a very high bar. If you have a mortgage in the 4% range and can get more than 4% on your investment portfolio, you are ahead of the game. Of course, most investments are not guaranteed. The way that I typically explain this concept is like this: If you have a 4% mortgage and you pay it off, you are, in effect, getting a 4% guaranteed return on those dollars. If you do not pay off the mortgage and invest instead, you will do better if your portfolio earns more than 4%, worse if it earns less or loses money.
Remember that mortgage interest is also a tax-deductible expense. So, if you are still able to itemize your deductions, you will pay a lower “net” interest rate on your mortgage. To illustrate, let’s assume you are in the 25% tax bracket and have a 4% mortgage. By deducting your mortgage from your taxable income, you are effectively paying a net rate of 3%. That’s pretty cheap money.
I fall into the camp that believes that, in most cases, a mortgage is good debt, especially in today’s interest rate environment. When interest rates finally move higher, I will undoubtedly re-evaluate my position. But for now, I consider the historically low interest rates we have available as incredibly cheap money.
Many of you know that my wife and I are building a new home. As we were going through the mortgage process to secure the funding for our home, we reviewed the 15- and 30-year options. Fifteen-year mortgages are at extremely low rates, but we opted for the slightly higher 30-year option because it gives us the flexibility to lock in a very low rate for a very long time. We can certainly make additional principal payments if we want, which could pay off the mortgage in 15 years, but having the 30-year option in place gives us flexibility on paying the mortgage down in a way that is comfortable for us over the years. In the meantime, we can keep our investment portfolio intact, hopefully growing our portfolio by more than the cost of our borrowed funds.
But it’s important to remember what I mentioned earlier. Just because it might be the right decision for me not to pay off my mortgage doesn’t mean that it’s necessarily the best option for you.