Is Conventional Wisdom about Paying Off Your Mortgage Always the Smartest Move?

Is Conventional Wisdom about Paying Off Your Mortgage Always the Smartest Move?

One thing many of us have been programmed to believe will always be in our best financial interest is eliminating our mortgage debt. The idea seems to be something that is not even up for any consideration; it’s settled! But is it always as simple as that?

James inherited approximately $150,000 from his late wife’s estate and was convinced that it was in his best interest to use it to eliminate the remaining balance on his mortgage – which, incidentally, is about that much. After all, every media financial guru he’s ever seen believes that is what any smart homeowner in his situation should do, without any reservations whatsoever. From what James understands, why not pay off the mortgage and save himself the 5 percent interest he’s paying to the bank? Besides, when he sells his house later on – as he is planning to do when he retires in a different state – he will get to keep all the proceeds to augment his retirement income.

First of all, it is important to remember that I am all about doing the things that are in the very best interest of my clients. Yet, it seems to me that those who think it is always in your best interest to pay off your mortgage quickly are seeing only one side of the picture: the cost of the mortgage. But they are forgetting – or ignoring – a very critical piece of the puzzle: the cost of actually paying off the mortgage. Yes, there is also a cost for paying off your mortgage to consider.

In James’ case, the $150,000 mortgage is costing him 5 percent, or $7,500 a year, but that is  before taking into account the fact that he claims the same $7,500 on his schedule A tax form, on which he receives $1,875 at his 25 percent marginal tax bracket. So in reality, his mortgage ends up costing him $5,625 a year. In other words, James’ 5 percent mortgage really costs him 3.75 percent.

Now let’s look at the other side of the picture – the facet that seems to elude many. What would James do with the $150,000 if he doesn’t use it to pay off his house? In this case, he could invest it toward his retirement. Let’s say he was able to invest this money at an interest rate greater than 3.75 percent a year. Would it still be in his best financial interest to use it to pay off his mortgage? We found James an income-tax free investment vehicle that would earn him a guaranteed interest of 4.5 percent a year, after deducting the associated costs.

So here’s the final math: Keeping his mortgage would cost him $5,625 a year. However, he’d earn $6,750 on that $150,000 in the first year. Therefore, James would actually improve his financial situation – get richer – by NOT paying off his mortgage. Looking at it from another angle: he could pay his mortgage and still earn $1,125 with the interest he’d make by investing the money rather than eliminating his mortgage. Another thing is that – just like most investments do – his investment pays interest on a compound basis, so in year two he’d earn more than $6,750 a year, and his profit situation would only improve from there as time progresses.

Something that James didn’t really think about is whether he will be able to guarantee that he’ll have a specific amount of equity when he retires and sells his house. Now how can he guarantee such a thing? He can’t – because the value of his home is determined by outside forces, and as such is totally up in the air. On the other hand, he can make sure he invests his $150,000 cash with some guarantees.

Of course, every situation is different and must be reviewed carefully. There are several factors to be considered, which is exactly what I’m driving at here – don’t simply buy into the litmus test financial planning mold.
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