Why You SHOULDN’T Pay Off Your Mortgage

It was refreshing to see a recent article from our friend Larry at Krantcents making the case you shouldn’t payoff your mortgage.  Since contrarianism is sine qua non for interesting personal finance, let me throw my weight behind Larry’s viewpoint today.

Obviously, I’m going to couch that title with a few caveats – but hear me out:  The vast majority of personal finance web sites are, first and foremost, debt focused.  Pay off your credit cards?  Pay off your car loans?  Pay off your student loans?  When you’re in that frame of mind, it’s easy to become laser focused on one thing once you’re had a few successes: paying down debt at all costs.

So, for the majority of personal finance readers, a crowd which my site analytics tells me is mostly under 40, here’s a blast of fresh air… you shouldn’t pay off your mortgage next, at least not faster than you normally would.  Here’s why.

Your House Is Not an Investment

You might think your house is an investment.  Newsflash: it’s not.

Temporarily, in a period of time roughly from 1990 until 2006, it seemed like houses were an incredible investment.  That’s a period we now know as the “Real Estate Bubble”, the after effects of which we are still experiencing.

Don’t trust me?  Trust Robert Shiller, 1/2 (1/3?) of the eponymous S&P Case-Shiller index, who stated as much in an interview the other day.  Here’s the just-referenced index’s view of real estate prices over the no-so-distant past:

S&P Case Shiller Index 1987 to 2012

As for an inflation hedge?  Sure – you can probably match inflation, assuming we don’t have any other bubbles popping.  The idea of “Real Estate As An Investment” is a new idea – in the last generation.

Also remember, the Case-Shiller doesn’t include renovations.  That’s right – the structure depreciates, while your land might appreciate.  Good luck.  Here are some trailing average returns for the S&P 500 so you can compare the asset classes.

Transaction Fees Eat Your Return

As Larry pointed out in his original article, time is one cost to getting money out of real estate.  Add to that lack of liquidity onerous transaction fees – if you sell a house?  6% comes out of the sale price.  If you refinance to cash out?  Expect fees for appraisals, surveys, and insurance.

Let’s talk about stocks again for a second.  As long as the market is open, you can trade stocks basically instantly – or at least so fast (in most stocks!) you can’t tell the difference.  As for the price of stock trades?  Look at someone like , where you can make $4.95 trades.  Wake me up when there are $10 round trips for buying homes.

You Won’t Be Diversified

Feel free to roll your eyes if you actually are diversified.  This point doesn’t apply to you.

The rest of you?  You’re probably part of the under-40 cohort, a group which found its way here after reading advice to pay off debt in a certain order – Credit Cards?  Student Loans?  Car Loans?  Personal Loans?  If you’ve done a bunch of paying off debt, it’s only natural to look at the largest debt you find yourself owing: your mortgage.

Well, dear reader – odds are if you’ve been racking up the debts before discovering personal finance, you probably don’t have much in the way of assets.  So, let me preview your paid off mortgage for you: your largest asset will be a concentrated bet on real estate.  Residential real estate.  Residential real estate in your town.  Residential real estate in one specific neighborhood in your town.  Residential real estate in one specific neighborhood in one specific location with some specific neighbors and some specific traffic patterns and noise and foliage in your town.

Get my point?  If you don’t, read the “Your House is Not An Investment” paragraph.  House rich and investment poor isn’t the best situation to find yourself in.  Liquidity is worth something, you know.

Mortgages Are Cheap

I just looked – as of today you can get a 30-year fixed mortgage with an interest rate of 3.25% for your good credit.  The market currently expects inflation in the next 30 years to come in at around 2% annually.  Let me crunch the numbers for you: the real cost is expected to be 1.25% annually.

Wait, there’s more.  If you are part of the Schedule A Itemizing Club like yours truly (many homeowners in high tax states will find themselves in this situation), you also can write off that mortgage interest.  Depending on your state and tax bracket, this could mean up to 50% of the rate – turning that 3.25% into an effective 1.625% (less than expected inflation).  Obviously this isn’t everyone – in 2009, that applied to 36,541,819 households.

Sure, you can’t predict that the Mortgage Interest Deduction will stick around, but hey – this is the cheapest money you’ll probably see.

Your IRA and 401(k) Have More Legal Protection

Have less than $1.2 million in assets?  Let me paint a scary picture for you:

Two neighbors each have a net worth of $1 million.  They are both married and 40 years old.  One owns his house outright, valued at $1,000,000.  The other has $250,000 in equity in his house, and $750,000 between his 401(k) and IRAs.

They both are sued, and both have judgements of $2,000,000 against them.  Both declare bankruptcy.  What happens next?

Both neighbors are residents of California (look up your state).  California lets most married couples exempt $100,000 from home equity in a bankruptcy.  Neighbor A has $900,000 of assets at risk.  Federally, you can exempt $1,171,650 per person.  Neighbor 2 only has $150,000 in equity at risk.

I’m not a lawyer (not even by proxy).  The law is complicated and never common sense – consult your own lawyer and financial adviser when discussing legal protection.  These rules also don’t apply if the Government is the one asking for money.  Oh, and if you have that many assets, get umbrella insurance.

Still, I’d rather be neighbor B in this situation – note he and his wife can shield a very solid amount of assets in the case of a bankruptcy.  Did you know that retirement accounts and homes had such disparity in bankruptcy?

Don’t Pay Off Your Mortgage

Well… unless you’re fully diversified, aren’t treating it as an investment, it’s costing you too much, and you’ve already got $1.17 million in your name in retirement accounts.  Maybe that applies to you – we also write about non-PF topics here, stick around!  For the rest of you, paying off the mortgage at a normal rate protects you from all the scenarios I mentioned above.

To you that disagree?  If the calculus changes, someone who doesn’t pay off their mortgage could just use the money that they saved in lieu of locking up the mortgage to, well, pay off the mortgage.  And if you still disagree, find me a time when you wouldn’t have superior returns in treasuries or returns in stocks over a 30 year period – especially with a negative real cost with the MID.

Keep an eye out this week for a technical piece on the inflation/cost spread for mortgages, and read Larry’s take over at Krantcents, and Investor Junkie’s take.

Comments

  1. Bichon says

    Don’t forget risk sharing. Your mortgage company is taking on the risks of home ownership (home falling into a sink hole), market risks etc. Although, many hope insurance covers some of these events. But, as we have seen the last couple of years, people have the option to walk away when things go south. And they probably would do so less if they had more on the table.

    When I was a cowdawg living in Texas, there were homestead laws which protected one from “taking your home.” Of course, that didn’t stop them from getting a judgement against you and filing a lien, but it certainly discouraged it. At the end of the day, getting sued is low likely event for people like me (not to say it won’t happen). But, the chance is so low “protections” don’t dictate my investment plan.

    With low interest rates, I love my mortgage.

    • JT says

      Risk sharing is a great reason to keep equity as low as you can. Totally agree. And hey – there’s no shame in turning in the keys if the market falls out. Let the bank eat the loss.

      • says

        I seem to recall a discussion about the ethics of mailing in your keys. I don’t see the complaint…

    • says

      Florida too, IIRC. I think OJ had a house there.

      Yeah, it’s definitely state by state. I find it interesting that here in CA I don’t get nearly as much protection as the median home price. I bet they haven’t touched the limits in a while.

    • says

      Do you think Ben Bernanke read our articles and was like, “Excellent. My plan is finally working…”?

    • says

      Mr. Ramsey might be mad and assume I’m targeting his advice, haha.

      Riddle me this – how can he suggest paying off a mortgage if he also talks about 12% stock market returns?

  2. says

    I chose to buy a house cash because I could afford it and wanted to have complete freedom. I know it makes no financial sense but am happily paying for that luxury. Otherwise I still have a rental mortgage that I don’t plan on overpaying any time soon.

    • says

      What’s the APR on that mortgage? Just brainstorming, but if you can get a better rate on your primary you could try pulling equity out of your home and retiring the rental to arbitrage the rates?

      • says

        2.29%. Mortgage on the primary which is a Guatemalan property would be 7% at best. You are right rentals are usually more expensive.

        • says

          Haha, never mind then – unless you think there’s going to be some crazy inflation disparity. I wouldn’t risk trying it – you’ve got it correct.

  3. John S @ Frugal Rules says

    THANK YOU for writing this. While I can understand the desire to be completely debt free, there are so many reasons why (in general) you should not be rushing to pay off your mortgage. We have everything paid off, other than the house, and it makes much more sense to throw that money into our IRA’s or some other vehicle.

    • says

      Haha, you’re welcome!

      ‘Consumer’ debt is a good rule of thumb, up to a point. There’s a difference between CC debt at 20% and a .79% student loan.

  4. Joe says

    Diversification is the reason I took on a mortgage in the first place. My partner and I could have cashed out a bunch of stuff and bought the place in cash. But than we’d be entirely illiquid/100% concentrated in a single asset, and have no margin of safety to absorb unforeseen events! Not cool. Hence the mortgage. Even after some expensive work on the house, we have under a 3rd of our net worth in the house. Yes, leverage makes it a bit riskier but we’re not concerned about capital gains so the downside risk has no chance of being realized it’s just a potential paper loss. We are, however, going to actively pay down the mortgage and eliminate it in year 4 (before age 30) or, less likely but possibly in year 5. But we shouldn’t have more than 60% of our wealth in the house at any time (accounting for the upside risk and the fact that we’re bound to dump more money into improvements).

    • says

      I don’t want to represent myself as a Canadian real estate expert (haha – ask me about Silicon Valley, though!), but how concerned are you about the near future? At your age you can weather a lot of a downturn, but if it falls you’ll want to buy (“Buy when there’s blood in the streets.” – Baron Rothschild).

      Also, please tell me you’ve seen Crack Shack or Mansion (or the sequel)!

  5. freeby50 says

    I totally agree. The big key here is the extremely low interest rates. I remember about 5 years ago I was making 4% interest on simple savings. Thats not so unusual. Our mortgage is 3.75%. Long term 10 year treasury notes averaged 7%. I’m sure we’ll see those kind of numbers again within a decade.

    I think all the other arguments against paying off a mortgage make sense but it would make more sense to pay one down if interest was 6-8% range.

    • says

      I know you’ve seen the calculators, haha. 75.61% f trailing 20 year S&P returns beat 7% geometric average so I think you’re targeting in approximately the right range.

  6. Jose says

    Good point, I’m not big on paying off a mortgage. Even if I pay off all of my other debt, I’d rather focus additional funds investing in returns that can pay bigger returns than wht I am paying on my mortgage, which after I finish refinancing will be 2.75%

    • says

      15 year? I’ve got to say, there’s a real chance we see inflation higher than 2.75% over the next 15, heh. If so, you totally win.

      • says

        That’s the my plan my friend. But I’ll probably be out of this home in 5 so I’ll be at the mercy of whatever the rates are then.

        • says

          5 is definitely tougher to call than 20, but you’ve gotta do what you’ve gotta do, right? I think we can deal with my current house for a while – there’s a huge attic just begging me to expand into it if I need it.

  7. Brick By Brick Investing says

    Okay! I’m going to be the first to go against the grain. While I see your points (very good ones) I believe you are forgetting one important aspect. When you own your house outright you no longer owe anyone a dime. For the financially savvy with proven track records in the stock market I would say, it’s ok to put that extra money in the market. However, when you take on a mortgage you are paying significantly more money for that home and are responsible for all the upgrades. I didn’t do a cost analysis but I’d be willing to say over 30 years you are going to pay double that price in interest and expenses. Additionally if you lose your job or income you are instantly on the hook for payments no matter what, yes I saw some comments stating you can just walk away but to where? I have a family and I couldn’t just walk away from our home if I lost my job and could no longer make payments.

    I will chalk it up to saying it depends on the individual’s situation. For the Dave Ramsey types who like to eliminate debt and invest in mutual funds I would say paying off debt is in their best interest.

    • says

      WHAT? NO!

      Just kidding, haha. Somebody has to pick up the baton… I didn’t realize there was such an untapped current of contrarian mortgage knowledge.

      Anyway, let me take a shot at the 30 year number. I don’t have the 30 year numbers built (here’s all of them), but versus 3.25% we’ve seen 100% of 40 year returns, 99.11% of 20 year returns, and 89.58% of 10 year returns beat that. It doesn’t mean it’s guaranteed, obviously – but I like those odds. (This is for a dividend reinvested S&P 500).

      As for maintenance, do you think whether the mortgage is paid off or not affects psychology with home improvements? The way I see it is you’re going to spend most of the money anyway (necessary maintenance, perhaps). In my situation, at least, if I lost a job I’d prefer the cash – I could pay off the mortgage a month at a time and live off the cash that would otherwise be in the house.

      • Brick By Brick Investing says

        hahaha somebody had to do it! I agree and understand completely where you’re coming. Just had to point out that for some paying off a mortgage would help them sleep better at night.

        • says

          Haha, I sympathize, but I can’t say I empathize. I have nightmares about not maximizing my opportunity costs, since I’m weird like that… or something.

  8. says

    Good post on this topic. It really shows that general advice on financial matters can get you into trouble. For some situations your advice is excellent. It could even be argued that owning real estate is a bad deal these days. Your arguments really indicate it may be better to rent and the American dream of home ownership is a dead or a bad deal at best.

  9. Darwin's Money says

    Agree, lots of great points here. I’ve always sought to push my funds elsewhere; I’m vehemently opposed to pre-paying my mortgage as it’s a poor use of excess capital.

    • says

      The top California rate is around 52%, high 40s after the state tax deduction – why would people pay off 1.625% 30 year or 1.375% 15 year money short of a deflationary crisis? (Or, perhaps, if low rates are the new normal and 1.625% is a *good* return over that time. I hope not.)

  10. says

    I think it all comes down to what else you could be doing with the money. And since mortgage rates are so ridiculously cheap at the moment, you could be doing tons of other far more profitable things than paying off your mortgage.

    I suppose it if comes down to a choice between paying off your mortgage early and buying still more crap, paying off your mortgage probably wins.

    • says

      In a crap versus mortgage argument, I’ll take mortgage everytime! (Sort of similar to the “tax refunds are horrible!” argument – if that’s what it takes to avoid buying dumb things, fine by me).

  11. Financial independence says

    I still could not get a point with diversity. Perhaps an isolated examples – but quite a few colleagues of mine downsized prior retirement. It helped them a lot to close the gap when market was down, while they could stop working.

    Some who could not do it, start thinking about it now (following the 2009 market crash).

    I think the main driver for paying off mortgage was low stock market returns. This what driven people to pay off the mortgage.

    The way you painted picture – there is absolutely no point to pay off mortgage. Historically housing never been an investment – just barely covering inflation.

    I calculated two real example properties – owning them outright – without speculating on the property price growth and renting them out – return is just 1-2%. The advantage of the return is that inflation adjusted, i.e. the rent will raise with inflation :-) : http://www.niterainbow.com/2013/01/rate-of-return-roi-on-investment-real.html

    • says

      I don’t have the confidence or the life experience to say never, haha. You’ve got a few scenarios where it might collapse – large, long-term stock declines would make it better to own hard assets like RE, for example. Deflation would be a killer. Also, you can make the argument for paying it off in retirement.

  12. 101 Centavos says

    You said it right, the house structure is not only a depreciating asset, it is a *deteriorating* asset. Anyone with a lengthy list of home maintenance projects will attest to that.

    • says

      My house is deteriorating to spite me – “Oh, that can wait” and the house replies “Nope.”

      My fault for moving into this fixer, and a net gain, sure… but eventually all the new fixtures I add will be ‘old’ and I (or someone else) will have to do this all over again…

  13. says

    I agree with literally all your points. The ONLY thing that sways me is the fact that it would be off my monthly nut. My mortgage is about $2K a month (with another 1K ish and a few hundred for Home Owners Insu). To get rid of that QUICKLY I would have $24,000/yr more to live on. That is a seductive mistress.

    • says

      And if you took the money you would have used to pay it off and invested it in the S&P 500? In all things, a trade-off, haha.

      I like the ‘co-investment’ idea. Dump the money you would have used into an account where you are prepared to use to pay the mortgage if you need to. Even if you don’t have the full amount saved, you could float the mortgage for a while in case of a job loss or something.

  14. says

    Thought I would stop by and say Hi PK! I just bought a home and financed it with a 3.5% fixed conventional loan. I’m never gonna pay off that sucker! Why would I at 3.5%? I like the Boldin trade the 49ers made, l want to see how they do in the draft though.

    • says

      My enlightened friend! As long as inflation is positive, you’ll thank me. If we have an extended bout of deflation, well,we’ve got bigger problems.

      I’m definitely more concerned about this loss of Wes Welker. And we didn’t even counteroffer? For shame!

        • says

          I am, and plans are to stay here a while, heh. I know Boston is very disappointed about lacking one PK… but, hey, I can evangelize for the sports teams!

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