Homeownership is a goal for many people. The benefits of owning your own home are wide ranging. Having the ability to build equity in your home is usually at the top of that list. However, in order to make homeownership a reality, it usually comes at a cost. Most will experience this through the addition of a mortgage. A large piece of debt, that for some, will hang over their head for the next 30 years. This makes it normal for individuals to want to pay it off as quickly as possible. Not only for the debt relief itself, but also for the opportunity to avoid paying more in interest throughout the life of the loan. But is it really the right decision? Even with those benefits, is the opportunity cost of allocating more of your financial resources toward a mortgage pay down worth it? In this blog, we will explore the advantages and disadvantages of paying off a mortgage early.
Applying home equity and a mortgage into your financial framework
It is my belief that your home should not be looked at as an investment like you would your 401k, stocks, bonds, etc. A home is a sanctuary. A place of protection, peace (unless you have young kids), and privacy. One of the biggest reasons so many people were financially hurt during the housing bubble in 2008-2009 was the increased focus on their "return on investment" from their properties. This led a lot of people to make poor financial decisions, usually in the form of increased mortgage debt. However, since we do allocate a large portion of our financial resources to our homes each year, we can't disregard them as part of our overall financial picture.
First, let's look at a home in the same way we do our other investments. It (usually) increases in value every year, somewhere between 3% - 7% (http://www.freddiemac.com/research/indices/house-price-index.page). It's been even higher than that over the last few years. I would consider this to be similar to a bond. A home's value has been a relatively safe investment over a long period of time and the value of that investment grows at a similar rate you would expect to receive from a bond. Again, recently this has not been the case, but historically this is true. Also like a bond, the value of your home remains stable. There isn't a lot of volatility like you might experience with stocks or other more aggressive investments. So, as you continue to put your financial resources into your home, like paying extra on your mortgage, we can consider this action to be similar to purchasing bonds in an investment portfolio. Depending on how aggressive you are as an investor, and the amount of equity you have in your home compared to your other assets, you may be increasing the conservativeness of your overall financial picture too much. Or, it could be just right.
Interest Rates and the Cash Flow Quandary.
I think most people know that a big advantage of paying your mortgage off early is the savings you get in the amount of reduced interest payments.
Ex: Jim and Sara have a 30 year mortgage for $225,000. They put $15,000 as a down payment and financed the rest at 4.25%. Their amortized payment over the life of the loan would be $1,033.07. Meaning that if they paid their entire loan evenly over that 30 year period, they will have paid $161,906 in interest! However, if they increased their payment each month to $2,500, their mortgage would be paid off in about 8 1/2 years. Over that time, they would have paid about $39,600 in interest. Meaning they would save about $122,306 in interest payments alone!
At first glance, saving that amount in interest would be phenomenal. But there is always an opportunity cost to any decision, including this one. Let's assume that instead of paying an additional $1,466.93/month toward their mortgage, Jim and Sara invested that cash instead.
Ex: Let's assume that Jim and Sara invest their excess cash flow into a brokerage account, where they invest in a moderately aggressive way. For simplicity purposes, in this scenario we will not take into consideration the tax drag of this account. Let's also assume that in this investment account, Jim and Sara expect to receive an annual rate of return of 7%. In 8 1/2 years of paying $1,033.07 toward their mortgage, Jim and Sara will have a remaining balance of $174,529.54. They will also have an investment account balance of $203,668. Let's assume they are comfortably in the 15% capital gains tax bracket and they withdraw all the money. They will end out netting $173,117.80.
Which means, they will have almost exactly the amount needed to pay the remaining balance of their mortgage. So they end up in the same spot after 8 1/2 years approximately. However, paying off their mortgage faster would get them to that same spot without having to take on the investment risk like they would by making the minimum mortgage payment and investing the rest. So we can see that paying more on your mortgage vs. paying the minimum and investing the rest relies heavily on what interest rate, investment return, and longevity assumptions we use. A lower interest rate, a higher rate of return, and a longer timeframe means that paying the minimum mortgage payment and investing the rest becomes more financially beneficial.
In todays environment, a qualified applicant can get a 30 year mortgage at 2.65%. Also, using history as our guide (**Past Performance Does NOT Guarantee Future Results**) let's assume that instead of getting a 7% rate of return, we use 10% which is approximately what the S&P 500 produces on a 10 year annual average. With todays lower interest rates and higher expected investment returns, it's more financially savvy to pay the minimum on your mortgage and invest the rest. But you have to be willing to stomach the investment risk that comes along with this decision as well. And you have to have the discipline to actually invest the excess cash flow and not spend it on something else.
In 2017, the Trump administration rolled out the Tax Cuts and Jobs Act legislation. It reshaped the way our tax code works. One of the biggest changes was the increased standard deduction individuals can take on their tax return. This, along with limits on mortgage interest rate deductions, made itemizing your deductions less likely. So the benefit of having mortgage interest from a tax standpoint goes down. This would be an advantage of paying off your mortgage earlier than normal.
The tax opportunity cost of this would be missing out on (possibly) more favorable ordinary income and capital gain tax brackets today. For most pharmacists, they will find themselves paying capital gains tax in the 15% tax bracket. But what if this goes up in the future? By allocating more money toward your mortgage now could mean that the tax liability of future investment growth, after your mortgage is paid off, could be higher than it would be today. Higher tax liability in the future could completely negate the benefit of paying off your mortgage sooner.
It's also important to consider the opportunity cost of under funding tax advantaged accounts like Roth IRAs or Roth 401Ks. If you are putting more of your resources into paying off your mortgage sooner, you are giving yourself less cash to deploy toward those other tax advantaged accounts. Forgoing Roth contributions, Backdoor Roth conversions, and Mega backdoor Roth conversions to pay extra on a mortgage could have a long term negative net impact. Especially if we believe tax rates will be higher in the future.
As many baby boomers approach retirement, having less liabilities on their personal balance sheet becomes very important. The less you are forced to spend your money on something today means you have more autonomy to control your cash flow tomorrow. This is a big benefit when you are planning to set-up a retirement income strategy. But what about pharmacists who are not approaching retirement? If you find yourself in your 20s, 30s, or 40s you are probably less concerned about retirement income planning. So then what are the advantages of paying off your mortgage early?
For most, it comes down to two specific areas. One is excess cash flow. Not having a mortgage payment means more control over where that money goes in the future. This is important for people or families who see a major shift in their income coming in the near future. If you believe your income will be cut down dramatically in the near future, having less in debt payments could bring more spending flexibility. Two is peace of mind. To some, not having a mortgage, regardless of the opportunity costs left on the table, is worth it. To some, debt is bad and getting rid of it as fast as possible is a personal choice. If that is the case, go for it!
So, if you can afford it, should you pay your mortgage off early? Like most decisions when it comes to personal finance, the answer is "it depends." I hate answering questions with "it depends," so I will answer it the way I would advise someone in this situation. If you are younger (20s, 30s, early 40s), have a decent tolerance for investment risk, and you believe your income will remain stable for the foreseeable future, I would not recommend paying off a mortgage early. Mortgage interest rates are near record lows, so the interest savings on aggressively paying off a mortgage are reduced. I believe the long-term benefits of investment returns PLUS the unique tax planning opportunities that are available now out-weigh the benefits of that reduced interest savings. I also don't like the long-term illiquidity that you get with equity in your home. Most people don't use their equity until they get older, if at all. Which means you are keeping a large conservative bond-like asset on your balance sheet for a longer period of time, which isn't ideal for younger individuals. You can always borrow from your equity, but the cost to do so, diminishes the value you gained by paying the debt off faster to begin with.
In the end, there is not right or wrong decision. Do what is best for you and your family. Just be sure to make the decision with complete information. Understand the future costs of the decisions you make today to help balance the process of deciding whether you should pay off your mortgage early or not.