Should I Pay Off My Mortgage?

by on February 12, 2012Jason Van Steenwyk

should i pay off my mortgageNot 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.

{ 18 comments… read them below or add one }

Katie K. June 3, 2013 at 4:15 am

I disagree wholeheartedly that you should stay in your mortgage just to reap a yearly tax credit or deduction. The math does not add up. If you are capable of paying off your mortgage early, do it! Any step closer to owning your home out-right is a smart step. Not only is it a huge asset to you, but it is where you and your family rest your heads every night. That’s a big deal! Make your house your own as soon as possible. There is no downside to having no mortgage payment!

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Diane Zaidan June 9, 2013 at 10:22 am

I had always thought that paying off your mortgage and owning your own home was everyone’s dream. We have only 5 more years to go to pay off our mortgage!! Looking forward to having more money each month and owning our own home!! Mortgage payments are usually the largest debt each month for every homeowner!

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RobM1981 July 25, 2013 at 11:31 am

You are so correct. This article is basically spinning things for the bank.

Consider…

Let’s say that you pay $1,000/month in mortgage interest, and you are in the 40% tax bracket. Big house; big income; big mortgage.

At the end of the year you’ve paid the bank $12,000 in interest. BUT, you get to deduct 40% of that, or $4,800, from your tax return.

How do you view that? If you are sane, you say: I paid $7,200 in loan interest last year, because that’s the net. You still PAY $7,200 to the bank.

If you have no loan, then consider the same $12,000 with no tax shelter. Uncle Gimme takes 40% of it. You pay the IRS a large amount – $4,800… but you keep the rest. You keep the $7,200.

So which would you prefer to do with $12,000:
Pay the bank $7,200, and keep $4,800 or
Pay the IRS $4,800 and keep $7,200?

This is the easiest decision in the world…

Not to mention the principal that you don’t have to pay.

Pay off your mortgage if you can. Listen to Dave Ramsey – he knows what he’s talking about.

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Tim July 7, 2014 at 5:59 pm

It isn’t that simple. If you are paying $1,000 a month in interest on your mortgage, it means you owe the bank around $266,000, assuming a 4.5% interest rate. If you have that much money lying around, what else can you do with it? If you can invest it somewhere that gives you a 5% return, that’s $13,300 a year. Minus 15% in capitol gains tax, that is $11,305. You are still paying $7,200 a year in interest on your mortgage, but you have a net gain of $4,105.

Of course, piece of mind may be worth $4,000 a year to you. It depends on your comfort level with risk.

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Marylnn May 6, 2013 at 8:16 am

My husband the only bread winner is going into retirement. We have no debt besides our home mortgage (no credit cards or other outstanding bills). I feel it would be beneficial to take a lump sum from his retirement to pay off our mortage since his monthly stipend will not suffice to pay mortage and survive. Any other suggestions?

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susan June 12, 2013 at 12:35 pm

rental properties are hot. take lump sum get good agent, pay cash on a nice house, then rent it out for ur motgage payment.

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Oscar coellar March 21, 2013 at 5:46 pm

Do you recommend making biweekly payments in our mortgage in order to reduce the length of the mortgage?.

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Jesus March 11, 2013 at 5:38 pm

Jason, the way there is diffrent cash value life policies, there is diffrent term life policies, people should not need life insurance for their whooooole life.

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Annette January 24, 2013 at 10:14 pm

I’ve been paying a little of my principle mortgage every time I receive a check from someone whether the amount is 200.00 of less. I have a 15 year mortgage which started in May 2012 with interest of 3.375 and so far I have paid in principle in the amount of 1,200.00. I am hoping to pay it off within 10 years and not 15. Would you recommend any other ideas?

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Jesus March 11, 2013 at 5:43 pm

debt stacking concept. look it up on a google search.

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Steve December 6, 2012 at 5:54 pm

I am sorry but the writer doesn’t look at risk even with your home you live in. Believe me, I wish I had paid off my mortgage in 2007. Instead I purchased a home with the intentions of selling the home I was living in. Had I used the down payment (20%) for the new home to pay off my existing home, I ‘d be living in a paid for home today. Instead I am anchored down with two mortgages – one is my last home I am now leasing out. I could sell my old home at a huge loss, but still with equity. It provides positive cash flow and is now almost paid for. My financial statement over the past 5 years has taken a double hit as well with owning two homes. The only winner in home mortgage(s) –> the banks. By not paying off your mortgage,if you have the means, you are saying I would prefer to pay the bank $10,000 a year in interest so I don’t have to pay uncle sam $4,000-$6,000! Crazy thinking.

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Jason Van Steenwyk December 7, 2012 at 12:54 pm

Hello, and thanks for writing.

A few points:
1.) The risk that your home value will fall is there whether you pay it off or not. Paying off the mortgage in cash does nothing to change that. It also doesn’t change your net worth, it just makes you less liquid. Indeed, it increases your risk, because the fall in your home value is offset by interest you earn on your cash – or returns on whatever you invest it in, assuming you invest in something that is not closely correlated with your home price. Buying another home does not qualify.

(Yes, it increases future cash flow, because of mortgage payments you don’t have to make, so it could be worth the fall in liquidity, depending on your situation and what you do with the money.)

2.) Your argument ignores opportunity cost. The argument is not saying I would prefer to pay the bank 10 percent per year to avoid paying Uncle Sam 4k-6k (not sure where you got those numbers from). If I had a 10 percent mortgage, I would immediately refinance it to south of 4 percent. And then look around. If I can invest money at greater than 4 percent, why on earth would I want to give it to the bank? Yes, there’s a mortgage interest tax deduction. But interest on investment debt is also deductible as well, so it’s a wash. The variables cancel out. All you are left with is 3.6 percent or whatever you got a mortgage at today (they’re close to that as of this writing) vs. whatever you can get elsewhere.

You seem to be throwing out the whole concept of leverage. There is a long history of borrowing at a low interest to finance investment at higher rates of return. Indeed, the western economies have functioned on just that principle since the Borgias created the banking industry as we know it during the Rennaissance.

It is not a risk free strategy, sure. Anyone would tell you that leverage magnifies risk as well as returns. But if you use the debt proceeds secured by something risky (a home) to invest in something less risky (cash, cash equivalents) then you decrease your downside risk by the amount of interest you can earn (at the cost of a higher upside if real estate does well).

Now, if you can find an asset that tends to move the opposite of home prices, but still has a net positive expected return over time (this is very difficult) then you can increase returns AND decrease risk. Theoretically.

Meanwhile, had you bought a portfolio of treasuries, rather than another house in 2007, you would have been better off than had you bought another house. Had you bought stocks in late 2008 or early 2009, you would have been even better off – and much more liquid in both cases. The diversification benefit at work – though hindsight is almost always 20/20.

Lastly, if the home you are leasing is providing positive cash flow, then I’ve seen worse problems. ;-)

The problem was buying another home at what turned out to be the peak of the market. But it goes back to what I said earlier … if you double down on the same asset class (residential real estate), then you aren’t getting any diversification benefit (see Markowitz, Harry and Modern Portfolio Theory).

Thanks again for your comments!

Jason

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Kristina Krovane September 1, 2012 at 2:11 am

We paid off our house. Doing so brought us a great sense of peace of mind, in that, no matter what the future holds, we own our home.

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Jesus March 11, 2013 at 5:42 pm

awesome

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vixinwash July 5, 2012 at 1:27 pm

In my view, for those who have a 401(k) option, it is better to pay off the mortgage and contribute the amount you would have paid to the bank towards your retirement. This way, the amount is still tax deductible, AND you get to keep that money instead of feeding the banks. I realize that this is a tax deferral rather than deduction in the long run, but then at least you can reap the benefits from the contribution that you could not have made otherwise.

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Katie K. June 3, 2013 at 4:03 am

Not always sensible due to risk factors of stocks and bonds.

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John March 21, 2012 at 2:35 am

Pay off your mortgage ASAP: it is a sure way to get a piece of mind.

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maria rivera March 14, 2012 at 12:31 am

can I write off interest next year for taxes…….

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