Hi Friendos,
A couple weeks ago I wrote about the potentially huge payoff of shopping a mortgage. Today is about the potentially huge payoff of prepaying a mortgage. I’ll discuss some of the “math” aspects of this but my view is that the non-math considerations are far more important.
I hear a lot of people say things like, “My mortgage is only 3%, I can do a lot better in the stock market.” Or, “If you pay off a mortgage early you lose the valuable tax deduction.” If you read financial press and personal finance writers, here are the factors you typically see discussed regarding paying off a mortgage early:
- Pro: save money on interest.
I agree with this. If you reduce your debt, you pay less interest to other people.
- Con: loss of the mortgage interest deduction.
Most people overestimate the benefit of the mortgage interest tax deduction. Around 90% of taxpayers claim the standard deduction, which means the mortgage interest deduction is worth $0 to them. For those who do itemize, it is only the amount of their itemized deductions exceeding the standard deduction that can be counted as a benefit. Think of the mortgage interest tax deduction as perhaps reducing the interest cost of a mortgage.
- Pro: free up future cash flow.
Yes, once you have a mortgage completely paid off, you no longer have to make those monthly payments.
- Con: loss of liquidity as money is tied up in your home.
That’s right, you can’t spend the money tied up in your house unless you sell your house. But is that really a helpful way to think about the possibility of early mortgage paydown? I know with certainly that I’m going to need housing for the rest of my life. So what opportunities do I foreclose by paying down my mortgage early? Some kind of…business investment? The chance to time the stock market? Those aren’t things on my horizon and I have a fully funded emergency fund.
- Con: lose the opportunity to put the money elsewhere like in the stock market.
This is similar to the last one, but more concrete in its alternative scenario. The stock market is risky and you don’t know what return you will earn over a given period of time. Paying off your mortgage earns you a guaranteed after-tax return of your mortgage interest rate. For anyone who says they’ll do better in the stock market, first I ask you to tax-adjust your stock market returns. Then, I ask you to think about risk and look at the after-tax returns of the bond portion of your investment portfolio. When you take out a mortgage, it’s like you sold a bond to your mortgage lender – your liability is their asset. Does it make sense for one part of your financial life (your investment portfolio) to own bonds as an asset and another part of your financial life (your home mortgage) to have sold a bond as a liability?
Today, you might earn something like 5.5% on highly-rated corporate bonds (pre-tax), which reflects the credit risk of companies not repaying their debt. 30-year mortgage rates are over 6% (after-tax), which is something like 7.5% – 10% pre-tax, depending on a person’s federal tax bracket and state and local income taxes. To a mortgage lender, you are riskier than corporate borrowers, so they charge you a higher rate. But after you’ve borrowed the money, if you pre-pay the mortgage, you are guaranteed to avoid that interest cost going forward. It’s risk-free from your perspective, so compare it to buying a long-dated Treasury bond. Today, 30-year Treasuries yield 4.63% (pre-tax). That’s a lot less than the 7.5%-10% pre-tax rate of today’s mortgages. The asymmetry favors prepayment.
- Pro: peace of mind, a “feeling” of security.
The reason people without a mortgage feel more secure is because they are more secure. With fewer dollars required to maintain your life each month, you are less dependent on cash from your employer or your investment portfolio. Back in 2010, I was part of a team at work that focused on bond and derivatives-related litigation (think: mortgage-backed securities), so we had more business after the financial crisis while other parts of the company had major dry spells. That year my company laid off 10% of U.S. staff, including a much older colleague who sat in a cubicle outside my office. I didn’t know about the layoffs until I saw him and others packing their things. Later that year, I got my highest ever year-end bonus and my boss “joked” that now they just needed to get me into a big mortgage. He meant that I would not be able to earn as much elsewhere, so I would really need that job to repay the debt. Yikes!!! Safety first, thank you very much.
-Stephanie
Frequently Taxed Questions 