Not too many sane people like paying interest. Especially on debts that can equal several years’ worth of gross income for you and your spouse. For this reason, many people have historically aggressively pre-paid their mortgages as fast as possible. The goal: to get to the great, happy “mortgage burning party” as fast as possible.
If sane people actually want to pay off their mortgages as fast as possible, you may want to get measured for that custom-fitted straitjacket soon. Because for many families, paying off mortgage debt just doesn’t make much sense, say experts.
“For a lot of people, the home mortgage interest deduction is really the only tax break they have,” says Thomas Jensen, a fee-only financial planner in Portland, Oregon, and principal of Vaerdi Financial, LLC. “I don’t see the mortgage interest deduction going away any time soon.”
Jensen’s advice: “There’s no simple, one-size-fits-all answer. But in most cases, I wouldn’t advise paying off the home early.”
His reasoning: Interest rates on home mortgages have gotten ridiculously low. As of this writing, in late November 2011, the average interest rate on a 30-year home loan had just fallen below 4 percent, according to the Freddie Mac Primary Mortgage Market Survey – and rates on 15-year mortgages had fallen even below that – to as low as 3.3 percent. With the current inflation rate – the rate of increase in the Consumer Price Index over the trailing 12 months – heating up to well over 3.5 percent according to Inflationdata.com, the real cost of a mortgage, net of inflation, has fallen to almost nothing. And get this: When you take inflation into account on a 3.3 percent 15-year mortgage – the average new mortgage of that length in America today – it’s like the bank’s actually paying you money!
Jensen’s advice: Consider the opportunity cost – what are the other things you can do with the money instead? Can you put the money to work to provide more than a few tenths of a percentage point in value to you? After all, that’s the only hurdle you need to beat to stay ahead of inflation. You could consider any of the following alternatives:
- Pay off higher interest debt, or debt for which you cannot deduct the interest.
- Make home improvements (you can deduct interest on up to $100,000 in debt secured by the equity in your home).
- Create an emergency fund.
- Braces for the kids.
- Education – especially education that will help you increase your income in the future. (Keep in mind that student loan interest is frequently deductible.)
- Start a business.
- Buy rental property.
- Enjoy it!
Any one of these alternatives is a perfectly acceptable use for the money, advises Jensen. And remember – paying off debt doesn’t change your net worth. Any increase in home equity from paying down debt is offset by a decline in cash on hand.
Remember, too, that, cash is liquid. It’s easy to convert into goods and services. If you spend down cash to create home equity, you may not be able to get that equity in your home back out quickly when you need it.
When to Pay Off Your Mortgage
There are some circumstances where you may want to go ahead and pay down your mortgage – not that there’s anything wrong with that!
For example, in some jurisdictions, state law grants significant creditor protection to home equity. Florida and Texas, for example, provide unlimited bankruptcy protection to home equity. If you keep cash in the bank, or in other securities outside of a retirement account, it could potentially be subject to creditors, says Roccy DeFrancesco, an attorney and founder of the Wealth Protection Institute. By deploying your assets into home equity in states that exempt home equity from creditors, you may be able to protect some of your net worth against marauding bands of lawsuit-happy trial lawyers.
State laws vary, though. Be sure to consult with a qualified attorney licensed in your state for personalized advice.
Should I Pay Off My Mortgage With Life Insurance?
Life insurance brings up a couple of unique issues. First, a life insurance could be the single biggest cash infusion a widow or widower gets during his or her lifetime. But that cash is normally simply the replacement of the future earnings of a breadwinner. If you have received a large, tax-free death benefit, you may be extraordinarily liquid. But that cash may need to last a lifetime, Jensen advises. Deploy it carefully.
Alternatively, you may have amassed significant cash value in a permanent life insurance policy. In most cases, you can tap this money tax free for anything you want – provided you don’t surrender the policy. Technically, you can withdraw dividends and then take a loan against the eventual death benefit to pay off the house (or do anything else you like!).
Again, though, Jensen advises to use caution before using the money to pay down a mortgage. Interest and dividends in life insurance is federally tax free – and frequently enjoys at least some protections under state law, just like home equity. All things being equal, don’t move money from a protected source to an unprotected vehicle.
Whole Life vs. Universal Life Cash Value Considerations
If you have a whole life policy, your cash value is guaranteed never to go down unless you withdraw it or borrow against it, or use your cash value to pay your premiums. But if your policy is a universal life insurance policy, or a variable universal life policy, your decision is a little more complicated. Your cost of insurance – internal to the policy – increases as you get older, just like a term insurance premium does. Eventually, your cost of insurance may overwhelm the interest or returns in the policy and your ability to pay premiums to keep the policy in force. In this case, you may be better off paying off your home, rather than letting your policy eat itself and eventually lapse. Underfunded universal life policies can be perishable assets. Remember that you purchased the policy for a reason, presumably. Someone needed money if you or your spouse died. If the original reason for purchasing the policy is still in effect, be very careful about surrendering life insurance policies.
If you have a universal or variable universal life policy, ask your agent for an in-force illustration. This is a projection of the likelihood of lapse, and what it will take to keep your policy in force. Remember that if you do surrender a policy, any gains in the policy may be taxable.
The Bottom Line
While the mathematics of paying off a mortgage versus an alternative investment at a known rate of return can be readily calculated, we all know that sometimes things don’t work out as predicted. For that reason, be very careful about investing in risky assets as an alternative to paying down a mortgage. A risky asset is any asset where the minimum rate of return is not guaranteed. For example, rental real estate, mutual funds, stocks, bonds, small businesses, education – all of these things may not pan out as expected. Always try to account for the unknown element of risk, says Jensen. If, having considered the alternative uses for the money, you decide you just aren’t comfortable with market risks, and nothing else you can invest in looks good to you, and you have three to six months’ worth of expenses in the bank, you can be comfortable paying off your mortgage. And there’s nothing wrong with that.