Recent market volatility seems to have more and more people reevaluating the question, "Should I pay off my mortgage early?" Up until now, conventional wisdom said no. Invest that money in the market, and keep paying interest to the bank to get the tax deduction. Doug Keegan of Harris SBSB is here to dissect both sides of the issue and offer his advice.
Before we get started, I was just curious if you thought attitudes have changed over the years with regards to carrying a mortgage.
Attitudes have changed tremendously. To get some perspective, let’s start with the Great Depression and what our parents and grandparents learned from that era.
During the Depression, banks could cancel your mortgage at any time and ask for their money back. And when they ran out of cash that’s exactly what they did. Borrowers did not have the time or money to repay, so millions of Americans lost their homes to foreclosure. From that horrifying experience, Depression era Americans learned that to never lose your home, you have to own it outright. And they instilled that value in their kids.
Fortunately, Congress changed the rules. Banks no longer can do that. So carrying a traditional 30 year fixed mortgage today doesn’t carry the risk it once did. Yet, many people still prepay their mortgage because that is what their parents taught them. And by the way, I am not here to challenge that attitude. In fact, I think as a culture we have swung completely the other direction when it comes to handling our debt. I think somewhere in between is best.
When should you consider prepaying your mortgage?
Unfortunately, there is no "one size fits all" answer to your question. Personal finance is personal as the saying goes. But hopefully I can offer some basic rules of thumb.
Let’s ignore the math and economics of it for a moment. For many, the biggest advantage of prepaying their mortgage is peace of mind. Many people simply prefer to be free of debt. Once your mortgage is paid off, you’ll wake up every morning and fall asleep every night knowing that the roof over your head is 100% yours. You can’t put a price tag on that kind of security. It may not make complete analytic sense, but it’s never the case that numbers are completely right and attitudes are completely wrong.
But are there cases when it does make analytic sense?
Yes. I think paying off your mortgage early is a bit like locking in a guaranteed investment return. For every dollar that you pay early, you’re "earning" the interest that you would’ve otherwise paid on it over the balance of the loan.
It works particularly well when investment alternatives like government bonds and CDs are paying very low rates. In that environment, you’ll have to find investments that may provide higher returns, like stocks. But with higher returns comes risk. There’s no investment risk to prepaying your mortgage.
You’d also want to pay off your mortgage during periods of deflation. The fact is, though, we really haven’t experienced prolonged periods of deflation since the Great Depression. But if we ever do, you’ll want to prepay your mortgage as fast as you can.
And finally, there is a behavioral finance aspect to prepaying your mortgage. It protects you from yourself. In other words, while paying the minimum on your mortgage and investing the difference might sound like a great idea, there are no guarantees that you’ll actually do it.
So, when shouldn’t you consider prepaying your mortgage?
The biggest downside to prepaying your mortgage is inflation. For example, assuming a 4% inflation rate, a $1,000 mortgage payment today is only worth about $300 in "real" buying power 30 years from now. If you prepay, you lose that advantage.
Also, as time goes by, we hope that our income goes up. If your mortgage payment is fixed, your payments should become cheaper relative to your income. In fact, it could become insignificant when compared to your income after, say, 20 years.
There is also "opportunity cost". Every time you make an extra payment, you deny yourself the opportunity to invest that money elsewhere. Since prepaying your mortgage is risk free, I think a fair comparison would be a similar, risk-free investment like a government bond or CD, but certainly not the stock market as many financial advisors incorrectly recommend.
Let me give you a real-life example of what I mean. My parents took a 25-year mortgage in 1960 for about 5.5%. By the late 1970’s and early 1980’s interest rates had gone up so much that CDs, a virtually risk-free investment, were paying 8-12%. Had my dad paid off the mortgage early, all of his money would have been tied up in the house with none to invest in high-interest CDs.
Because he hadn’t paid off his mortgage, he had money available to put into CDs, earning up to 12%. In today’s climate, it’s hard to imagine rates that high, but if rates are expected to go up, one could take advantage of it by locking in a low-interest rate mortgage today. Right now we have very low mortgage rates. Lock it in.
So as a financial planner, what do you recommend people do?
The first thing anyone should do before prepaying their mortgage is to pay off their credit card debt. Unlike mortgage rates, credit card rates can soar as high as 29%. So pay off your credit card debt first. Then you will want to make sure you have enough saved for a rainy day so that if a personal financial crises hits, you have enough cash cushion between you and life to last you for a while. Otherwise, how will you pay your bills? So make sure you have at least 3 to 6 months of living expenses in cash for a rainy day.
Next, save for your retirement. Your retirement will cost you a lot of money. Look at it as a cost. We all know the sooner you start paying something off, the sooner it will be paid off. View your retirement like that. Start now and start aggressively. Research suggests we need to save at least 15% of our gross income each year in a 401k-type plan. With those plans, you pay no taxes on what you put in and earnings grow tax deferred. Plus, your company may match what you put in. That’s free money and will build your retirement nest egg.
So before prepaying your mortgage, do those steps first. After that, it’s a personal choice.
Are there any other strategies for paying down your mortgage right now?
Yes. If you can come up with enough cash to pay down your mortgage balance to 80% of your home’s appraised value, no mortgage insurance would be needed and that translates into money saved. Also, if a partial prepayment lowers your mortgage balance from jumbo loan status to conforming loan status, you can save a lot of money in interest. We’ve been helping our clients do this because most of them live in high cost areas and those areas can now get a conforming loan up to $729,750, thanks to the stimulus bill. Usually, conforming loan limits are much, much lower. The difference in the rates could be as much as 1% to 1.5%. That’s huge and translates into an excellent return on your investment.
Doug Keegan’s Making Cents reports are heard monthly on Lincoln Radio Journal. www.lincolnradiojournal.com