Looping the Hen

Mortgaging the Castle

I remember more than once having the discussion with folks on paying off a mortgage early (or a student loan or other relatively low interest loan) vs. the benefits of tax deductability or investing that money in a (hopefully) higher earning investment account.

In the past few months I have read several articles in the money portions of various online magazines that advocate similar financial tactics. The latest one is here, and I, as usual, disagree with the theory that paying off your mortgage (or any other low-interest rate, possibly tax-deductible loan) early is a waste of money better used elsewhere.

Much of the article presents good advice in the Dave Ramsey fashion I advocate (maxing out 401k, paying off higher interest credit card debt, building an emergency fund of 3-6 months expenses, etc), but the majority of the article obscures the main premise: there is an opportunity cost for every extra dollar spent on a mortgage that doesn't go toward something else.

While this is true, it also goes for every dollar spent anywhere, from the extra $2 for a meal spent at McDonald's (as compared to eating at home), to the huge money spent on a new car vs. a used one. I contend that once all of ones' other bills and priorities are taken care of (including all the things she advocates, including insurance), paying off a mortgage ranks higher than keeping it around for the tax benefits, or to invest the money elsewhere. It is simple really, and one can turn around the question and ask it this way: if I have a paid off house, should I take out a home equity line (assuming it is at a equivalent to a mortgage rate) and invest that money in the stock market?

I hope the answer to that question for most people is 'heck no'! But why? According to these types of articles, if a home-interest rate is below my hopeful returns, I should invest. Annual stock market returns are almost always higher than home-interest rates, so why shouldn't I always have a maxed out mortgage, second mortgage, and home-equity line all contributing to my mutual funds?

Well, there are several reasons. First, paying off my mortgage provides a guarenteed return of at least the interest rate of the mortgage minus the tax benefits (which can sometimes be 0, as is my case). Currently my mortgage is at 6.75%. However, because the annual interest is not higher than my standard tax deduction of $3750 or so, it does me no good to itemize the interest on my mortgage. So paying down my mortgage will guarantee me at least a 6.75% annual return, far better than the returns in my 401k for the past 6 years (except 1). It's not great, but it's better than today's average bank CD by almost 2%.

Next, the tax deduction advantage is a little misleading. For example, say I have a $1500 mortgage and the average interest over the course of the loan is $1000 monthly. At the end of the year I can claim $12,000 in deductions. However, on income of $75,000 that really only amounts to around $3,000 in additional refund money. Personally, I'd rather have the $12,000 cash in my pocket to invest as I please that I would have with no mortgage. Not having the mortgage gives me a pretty significant boost in cash flow that I can put into the same investments the high-mortgage advocates suggest. If I can pay off my mortgage with additional payments in 15 years instead of 30 (a fairly easy thing to do), I now not only have saved the $50,000 or $100,000 in interest on a $150,000 loan, but I can also invest all of that money (assuming I transfer the mortgage payment to an investment account) to get the 'average market returns' for the next 15 years. Heck, I can now rent my mortgageless house and use that to pay the mortgage for a new home. That's a pretty big dividend.

And I can do so without risk, which is the reason people don't generally take out loans to put the money into the stock market. (Although some do, and those are called margin traders, if I remember my Great Depression lingo.) What good are my hypothetical returns if I lose my job? Get sick? Have to take care of a loved one? My plan is to have my little condo paid off in 4 years. After that, I could support myself pretty comfortably trading little people on Ebay and playing small-stakes poker (or working at the local Best Buy). For every 2 years of working after it's paid off, I can retire about a year early. Or I can rent it and upsize if I feel like it. (which is what I am looking to do)

Having a paid off mortgage gives me financial options I don't have with a $1,500 payment. However, most important in the paid-off mortgage scenario is the qualitative benefit of having no worries. My honey has done a great job keeping afloat in a higher-mortgage home, but I know it has caused her a lot of stress. Personally, I'd rather have someplace to go when times get tough than have to worry about having to drastically alter my circumstances if a catastrophe happens.

Anyhoo, that's just my Financial Peace moment for the day! Anytime someone advocates remaining in debt for some perceived financial benefit, I take it with a grain of salt.