They call it “The American Dream”—and the idea of owning a home is so ingrained in our collective psyches that we often act against our own best interests in pursuit of that “dream.” For example, we often buy a home when renting is far less expensive.
Most of us who “own” houses don’t have full ownership of them. Those who lent us the money through a mortgage have a claim on our homes. For many, the ultimate “American Dream” won’t be realized until the day when their mortgage is finally paid off.
You’ve scrimped, saved, and invested for much of your life and are sitting on a decent retirement nest egg. Should you use some of that to pay off your mortgage? Maybe. Maybe not.
Paying off your mortgage reduces your need for income from your investments. Do the payments saved exceed the income potential for those same dollars invested? That depends on how you invest.
Let’s assume you bought a house 15 years ago for $200,000 on a 30-year mortgage with an interest rate of 5 percent, or lower. (If it’s higher, why haven’t you refinanced?) You still owe $136,000 on your mortgage for 15 more years, and you are considering paying it off. If you leave the mortgage in place, your cost for the principle and interest payments will be about $193,000 over the next 15 years. Your mortgage interest tax deduction (assuming a 25 percent tax bracket) would save a portion of that for a total net cost of about $180,000.
The $136,000 you would use to pay off your home is in a tax-deferred portfolio with 50 percent in stocks and 50 percent in high-quality bonds. You conservatively expect—based merely on past performance—an average annual return over the next 15 years of 5 percent. If you left the $136,000 in your tax-deferred investment account that earned an average of 5 percent per year, you should end up with more than $280,000.
Based on these assumptions, leaving the money invested in a moderate risk portfolio would mean about $100,000 more in your pocket by the end of the 15-year mortgage term. Of course, if the $136,000 is in 100 percent safe assets—making no more than 2 or 3 percent—paying off the mortgage makes better financial sense, but there is something else to consider: liquidity.
What if one day you needed $100,000 or so to pay for healthcare or some other crisis?
While the investment markets rise and fall, you know that if you need any part of the money in your no-load fund portfolio you can liquidate your securities on any business day and have the cash in hand a couple of days later. Plus, the transaction will cost you nothing.
Home values also fluctuate (remember 2008), but a home locks up your capital far more tightly than stocks and bonds. To get $100,000, you can either borrow against the house—at (likely) higher interest rates than your current mortgage—or sell it. Selling a home takes time and has high transaction costs. And you’ll still need a place to live.
From a purely financial perspective, it’s hard to justify paying off a mortgage early, but it’s hard to put a price on emotions. If you plan to remain in your current home for the rest of your life and place a high value on perceived stability and security, the relatively modest profit prospects pale in comparison.
The host of the nationally syndicated Don McDonald Show for over 20 years, Don now co-hosts Talking Real Money with Tom Cock on Seattle’s KOMO radio Saturdays at noon (talkingrealmoney.com). Don also publishes the investing magazine, real investing journal (realinvestingjournal.com).