I get challenged all the time on my decision to pay off my house early, and more often then not the person challenging me thinks I simply haven’t done the math which PROVES that it is a bad idea to pay off a mortgage early. I firmly believe that having a paid off house is a major milestone in reaching financial independence and that it isn’t the major mistake that my detractors suggest.
1. When It Doesn’t Make Sense To Pay Off The House Early:
I absolutely abhor the Home Mortgage Tax Deduction. It functions as a gimmick to entice high earners to spend more money on houses, which in turns drives up prices for everyone. The vast majority of this $70 BILLION tax credit goes to people with incomes over $100,000. Since it is a tax deduction people in a higher bracket benefit more. If you are in the 35% tax bracket, you get a 35% break on the mortgage interest you pay. Because the home mortgage deduction reduces AGI, it reduces state and local income taxes as well. In high tax states this could reduce mortgage interest by 45%. If your cost to borrow is almost half priced, then it really doesn’t make sense to pay extra on the house.
2. Does It Make Sense To Pay Off My Mortgage?:
Let’s look at two homeowners who both just purchased homes with a $100,000 4% 30 year mortgage. We aren’t going to play games with down payments or PMI here in order to keep an apples to apples comparison.
For Homeowner A, paying off a mortgage early is crazy and he will hold his mortgage for 30 years without paying an extra dime. He will put the same amount of money in a Total Stock Market Index Fund every month that Homeowner B puts extra on his mortgage.
For Homeowner B, paying off the mortgage early is a big goal and he has decided to pay his off in 10 years, by paying an extra $535 per month on his mortgage. Once his mortgage is paid off he will put his former mortgage payment and the extra he was paying per month into a Total Stock Market Index Fund.
So What Happens?
On Day 10,957…
IF the Total Stock Market Index Fund returns 8% over the 30 year period, Homeowner A will pay off his house on the last day of the 30 year period and will have an investment account with $785,460. Homeowner B has had his house paid off for the last 20 years and his investment account is at $600,411. Homeowner B has $185,049 less because he paid off his home early. He has only 76% of the investment account that Homeowner B does. In effect he paid an extra $9,252 per year to live “debt free” for 20 years.
Clearly the math shows that paying off the mortgage was a bad move….however consider that these investments are only a small part of these homeowners investment portfolios.
If both of these guys earned $50,000 per year and saved an additional 20% of their pay, then each year they would put $10,000 into their investment accounts. At the end of the 30 year period they would both have $1,223,459. Now this paints an entirely different picture.
Homeowner A just paid off his house and has total investments of $2,008,919. Homeowner B has lived debt free with no mortgage for 2 decades and has $1,823,900. Homeowner B has 91% of the investment account that A has. A is still ahead, but in the grand scheme of things that $185,049 doesn’t make that big of a difference.
What About Market Risk?
I use 8% as a historic average for the stock market, but it is entirely possible that over the next 30 years stocks could under perform. With paying off the mortgage the return is guaranteed. You are getting the return that your interest rate is. If you pay off $5,000 extra in the first year of your mortgage, that is a locked in 4% return for 3 decades.
If the market returns 7% during this time, the ending value delta shrinks to $115,969. If it is 6% then it drops to $64,283. If it drops to 5% it’s only $26,058.
So with a 7% market return we lose $5,798 per year for having our house paid off early, with 6% returns we lose $3,214 per year, and with 5% returns we lose $1,302 per year.
There are intangibles involved as well. The house feels different when you own it outright. The total amount of money you need to come up with in a worst case scenario is vastly different. With a paid off house the single largest expense that most people have is now gone. For 2 decades Homeowner B had this protection. If he lost his job or ran into other hardships, his monthly cash outflow would be substantially reduced. Homeowner A would still have to make that mortgage payment, and probably would not have access to his investments tied up in retirement accounts without taking a major tax and penalty hit from the IRS.
Peace Of Mind:
I’ve personally never lost a house before, but Mrs C. has. When her childhood home was taken from them it literally tore their family apart. They lost all the equity they had in the home and lost many possessions as well. I know that in the back of her mind no matter how much money a piece of paper from the bank or our investment accounts says we have that she still worries about losing our home. Is it relatively irrational, sure, but its part of her life story. Having a paid off home would give her more security and peace of mind.
There’s also the concern of what if something happened to me? Her income could cover all our bills excluding the house payment, but she would certainly struggle to get by with the house payment. If I died she would get $500,000, but there is no large lump sum if I became disabled. I don’t have disability insurance and Social Security claims can take YEARS to get approved. Having a paid off house would ease her mind on this issue as well.
Having $2 million instead of $1.8 million in 25 years will not carry anywhere near the weight that having a paid off house 3 1/2 years from now will have.
Will I most likely end up ahead financially if I don’t pay off the house early? Yes. But maximizing total net worth at retirement age isn’t the only factor in life. How we live now matters too. By the same token, if I cut cable, cut our grocery bill in half by making only meals from bulk ingredients, and drove only 1 vehicle we could save an extra $7,000 per year and in 25 years we would have $407,000 at 8% gains, FAR more than we would gain through investing the difference on what we pay extra on our mortgage; but that lifestyle would be difficult. It’s OK to do some things that aren’t the best for your nest egg when they are the right things to do for your comfort and stability now. I track my mortgage payoff by using my Mortgage Spreadsheet, which keeps me motivated because it shows me a running total of how much interest I have saved to date and when my constantly shrinking payoff date is.
Are you paying off your house early, even if the math says you might end up ahead if you invested that extra money in stocks?