Does It Pay to Pay Off Your Mortgage?

Within the structure of longterm mortgages, interest rates, tax deductions, inflationary pressures, it is sometimes better to not pay off your loans.

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There are scenarios when paying off loans is not smart

Reducing debt is generally a good thing, or so we are told. However, paying off your mortgage as you grow older may not always be in your best interest.  I know this may come across like financial blasphemy, but read on.

The freedom from monthly mortgage payments and full ownership of your home is certainly an appealing prospect.  It becomes even more attractive for those who depend primarily on Social Security or a fixed pension for their income. Although my financial advice-giving colleagues Suze Orman and Dave Ramsey preach debt freedom from the mountaintops, does it always make financial sense?  Let’s play devil’s advocate for just a moment.

Factors to Consider

To properly answer this question, we need to consider two factors: opportunity cost and flexibility. The opportunity cost is what else you could be doing with the money you use to pay off your mortgage. If, for example, you’re looking to pay off a $100,000 mortgage, you should first consider where you could invest that money instead — and what rate of return you could get. In general, if the rate you could earn is higher than your mortgage rate, you may be better off keeping the mortgage.

For example, if you have a conventional 30-year fixed-rate mortgage with a 4.5% annual percentage rate (APR), but you could earn 5% on a fixed-rate bond or tax-deferred fixed annuity, you might be better off investing the money in the bond or the annuity.  Then again, you might not be better off. It depends on several other factors.

This general rule applies even after we consider the potential tax bite.  If you itemize tax deductions, the interest portion of your mortgage payment is tax deductible, which reduces the effective interest rate on the mortgage and adds incentive to investing your money elsewhere. However, income derived from any alternative investment (outside a Roth IRA) is ultimately taxable, thus reducing its effective yield.  Therefore, your alternative investment strategy may turn out to be a wash in the long run. If you are paying significant commissions on the investment, the strategy becomes even less attractive.

However, it does retain some merit from a legacy-building perspective.
The other factor to consider is flexibility. Money tied up in real estate is not liquid, and much less so these days. If you want to tap into that money, you will either need to take out a mortgage or sell the property. Money held in a traded investment, however, is much more liquid. In the case of stocks or mutual funds, you can convert it to cash within days. Even most annuities have a surrender-free withdrawal option. And, should you need to draw down this money to pay for living expenses, it’s fairly easy to do so if it’s held in liquid investments.

Is Refinancing a Better Option?

Given today’s historically low mortgage rates, you might want to consider refinancing rather than paying down the principal, especially if you currently have a mortgage with an APR of 6% or higher. If you are thinking of refinancing, be sure to compare rates and estimated closing costs. Also, keep in mind that although current bond yields may be low, long-term returns on more stable investments such as long-term U.S. government bonds have averaged 10.1% for the 30 years ended December 31, 2010.1
So if you’re thinking of paying off your mortgage early, make sure you first check out the alternatives and consider what kind of cash cushion you may need in the years ahead.

1Source: Barclays Long-Term Government Bond Index. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

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