David R. Henderson  

Should You Pay Off Your Mortgage?

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That's a question asked by Louis J. Prues and answered by the Wall Street Journal's Kelly Greene in the weekend Journal. Ms. Greene summarizes the findings of an analysis by Tony Webb, a research economist with the Boston Center for Retirement Research. Mr. Webb points out that the rate of return you can expect to earn on a riskless asset is likely to be lower than your mortgage interest rate. That argues, all other things equal, for paying off your mortgage.

He also considers one other factor, which you can read about.

But he doesn't consider two factors that could be important, one that argues against paying off your mortgage, and one that argues for.

First, the one against. A fixed-rate mortgage is a great hedge against long-term inflation. In fact, for most people, it's the main inflation hedge they have.

Second, the one in favor. Think about whether you itemize your deductions using Schedule A. If you do, then your itemized deductions (mortgage interest plus most state and local taxes plus tax-deductible charitable contributions plus a few other items that apply to very few people) exceed your standard deduction. For a married couple filing jointly, the standard deduction for 2009 is $11,400. What if your sum of itemized deductions is just over that, say, $13,000 and your mortgage interest component is say, $6,000. That leaves $7,000 for the other tax-deductible items. Then, although we think of mortgage interest as being deductible, your incremental deduction due to the mortgage is really only $1,600 ($13,000 minus $11,400). So you're "wasting" the other $3,400 of the mortgage interest. And you're doing it to invest in assets that are taxable from dollar zero. I could go on, but I'm guessing that you get the point.


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COMMENTS (17 to date)
Yancey Ward writes:

One needn't take a absolutist approach one way or another. Right now, there are no real riskless investments that pay more than about 2% interest- max. If you have, for example, $500/month that you wish to add to your investments, it probably makes sense to use that to reduce the principle on your mortgage if you are paying 5% plus. If market rates/inflation rises, you can readjust this plan as appropriate.

Yancey Ward writes:

Also, I will point out that owning a house and land is also a hedge against inflation.

John Thacker writes:
One needn't take a absolutist approach one way or another. Right now, there are no real riskless investments that pay more than about 2% interest- max.

Assuming that we're ignoring inflation, the 10-year bond rate is 3.4740%. That is a riskless investment in one sense; yes, the price that someone will pay you for the bond will decrease if interest rates go up, but you can hold the bond to maturity and receive that guaranteed rate.

The problem, of course, is that if interest rates go up, then you're locked in to the earlier rate. But for the short term view, if you get a 30-year mortgage, then there are situations where investing in a 30-year bond would be better than paying off the mortgage faster. It's just possible that if interest rates go up dramatically in 10 years, then it may have been better in hindsight be to pay off the mortgage for the first ten years and then buy 10 year bonds after that.

However, it requires, as the paper notes, a combination of factors that are individually common but don't tend to occur together:
1) Itemized deductions
2) High marginal tax rate so that 1) is useful
3) At most not saving any more than maxing out 401(k) + IRA contributions, so that any extra towards the mortgage would come from tax-deferred/tax-exempt returns instead of from taxable accounts.

1) and 2) go together, but generally not with 3). If you do have all three, it can make sense, but that tends to be people with extraordinarily high preferences for consumption now over savings, who may not be as interested in optimal investing anyway.

The other example, which the paper acknowledges, are people far from retirement who have a preference for a 100% position in stocks. In this case, over their long time horizon, it may make sense, if their appetite for risk is appropriately large.

Joe Cushing writes:

Yancey Ward writes:
"Also, I will point out that owning a house and land is also a hedge against inflation."

Agreed

Anyone who has a mortgage should think twice about buying investment grade bonds. Why invest in others debt and take on default risk when you can invest in your own debt with 0 risk? Actually, I would consider debt reduction to be a negative risk investment. That is, it lowers the the risk of your portfolio beyond that of just investing in a 0 risk asset. It does not take great cash flow to live without debt.

One does have to consider liquidity risk when investing in ones own debt. While the principle isn't liquid the interest payments are.

diz writes:

I don't pay off my mortgage because I value liquidity.

Would like to have enough money in liquid accounts to live on for a couple years or so.

After that, may as well pay off the mortgage.

Or buy a bigger house.

John Thacker writes:
I don't pay off my mortgage because I value liquidity.

Would like to have enough money in liquid accounts to live on for a couple years or so.

How likely do you think you are to need that? Paying off your mortgage allows you to get a HELOC or home equity loan or refinance. Yes, the rate may be higher, but you may be effectively paying a really high rate on your "insurance policy" of needing liquidity for "a couple years or so." The rate for a HELOC right now isn't that much higher than the rate for a mortgage right now.

Bob Murphy writes:

Great post, David. Yes, the reason I'm not too worried as say, my parents are about massive price inflation, is that I'm sitting on an underwater house with a fixed-rate mortgage. (I am ashamed to say that we bought it in the fall of 2006. Yeah.) So let it rain, Ben!

ajb writes:

There is a more complicated economic reason for younger people to have a mortgage. It is still the safest and most tax preferred method of obtaining leverage.

Assuming something like the permanent income hypothesis and positive returns to stocks in the long run, a young person at the start of his career will be low on financial assets and high on human capital and expected lifetime earnings. This suggests overinvesting in stocks by maxing out one's 401k in stocks and effectively borrowing through a mortgage. As he gets older, his horizon will shift and the share of his wealth in financial assets -- esp. stocks -- relative to human capital and future income will grow. This argues for more bonds which can easily be accomplished by paying down the mortgage.

And of course, there's the psychological component. Can you continue to invest as vigorously once you've paid off your mortgage? Some are likely to slack off monthly savings.

Mike Rulle writes:

One more point for not paying back mortgage is liquidity preference. If one pays back mortgage, it is possible one may not be able to "re-borrow" if one needs access to liquidity.

diz writes:
How likely do you think you are to need that? Paying off your mortgage allows you to get a HELOC or home equity loan or refinance

Well, part of the issue is I have a non-standrard mortgage, job and house.

I don't feel comfortable assuming that equity will be available in exactly the situations where I would need it.

Sure, it's got a negative carry -- but then so does my insurance...

David F. Nolan writes:

When we bought our present home in 2005, the interest rate on our mortgage was 5.25% and money markets were paying 4.95% - so it made sense to keep most of our assets liquid. Today, money markets pay almost nothing, so it makes sense to pay off at least part of our mortgage -- which we just did, because it results in an immediate reduction in our monthly payments.

On many loans, however, if you pay off part of the principal, it does NOT result in lower payments. Instead, the lender reduces the number of future payments, which is usually worthless to the borrower. Why pay off the portion of the loan that you'll probably never use anyhow? Most people stay in a home for far less than 30 years, or even 20.

Vangel writes:

Of course, one could argue that given the inevitable collapse of the USD it makes much more sense to buy gold or silver and to pay as little of one's mortgage as possible now because it can be paid back later with dollars of much lower value.

Yancey Ward writes:

David Nolan,

You wrote:

On many loans, however, if you pay off part of the principal, it does NOT result in lower payments. Instead, the lender reduces the number of future payments, which is usually worthless to the borrower. Why pay off the portion of the loan that you'll probably never use anyhow?

While it is true that most mortgages are simply shortened rather than getting a reduced mortgage payment over the remaining course of the loan, it isn't like you threw the money away. When you do dispose of the house, you will have paid less interest and you have more equity. In other words, you keep more of the sales price at disposition.

David F. Nolan writes:

Yancy: You are of course correct, but somehow the idea of giving up money now to get it back much later, when the dollar is likely to be nearly worthless, is not appealing. With our present loan, principal reduction results in an immediate reduction in payments, as well as increasing our equity.

Kevin writes:

David N and Vangel are arguing that it makes sense to carry mortgage debt in order to either consume now or buy other inflation hedges. This is a high risk strategy that works if the dollar goes to zero, but you'd better be right about that "inevitably" thing and that "nearly worthless" thing.

Nobody with a non-recourse loan should pay down principal without pricing the put to the bank. If the house has appreciated a lot, there might still be enough juice to make it worthwhile to pay it off, but this is an important hurdle to clear. Even with a recourse loan, it might be worth it to just hide/shelter assets and file bankruptcy. That's obviously a high-friction strategy, but if making the payments busts you anyway, the bank/government/taxpayer might as well share some of the pain.

Melissa writes:

I am just finding this site, and have been researching whether or not I should pay down / off my mortgage. This by far has been the best information I have found.
My situation is, I have stock that has increased to almost it's peak, and want to sell it. I could easily use 1/2 of the money to pay off my mortgage, and still have more than 1/2 left over.
I am 40 years old, and the prospect off owning my home is very appealling. I have no other debt. My home is my only payment other than living expenses. Thoughts?

tecumseh writes:

There is also consideration that your home is largely judgement proof. If you would lose a large lawsuit, slip and fall, medical malpractice greater than your insurance, it is extremely unlikely they will take your house away from you. The liquid assets are not so protected.

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