Saturday, March 19, 2011

Is Paying Off Your Mortgage a Good Idea?

I have written a few blog posts lately on buying a house.  I had written that for someone buying a house, you should take out a 30-year fixed rate mortgage and pay back the loan in depreciating dollars.  I received a comment from someone asking, "If I had no debt (other than my mortgage) and an extra $1000/month to spend, would it be better to put that $1000 towards the principal of my 5% fixed-rate mortgage, or to invest/use it in some other way?"

I used to be an advocate of paying down the principal on your mortgage with the goal of paying it off early.  I agreed with Dave Ramsey on this.  The reason for this is because it is a guaranteed return on your investment.  If you have a 5% interest rate on your loan, then you are getting a guaranteed 5% return on your money by paying down the principal on your loan.

It is amazing how many people disagreed with me on this strategy.  The most common comeback was, "well, what about the tax deduction on the interest paid?"  First, the tax deduction is overrated.  There are some married people with a small enough loan who don't even benefit because they can't itemize their deductions.  The mortgage interest deduction is not in addition to the standard deduction, it is instead of it.  So in many cases, people are not benefiting nearly as much as they think.

In addition, the tax situation works both ways.  The guaranteed 5% return (or whatever rate) is a return that you don't owe taxes on.  To get a 5% after-tax return on other investments, you would actually have to earn around 6% to 8%, depending on the type of investment, how long you owned it, where you live, and what tax bracket you are in.

So why have I changed my mind (somewhat) on this strategy?  My only answer is because of the political environment.  With quantitative easing (money creation) by the Fed and huge deficits by the politicians in DC, inflation (monetary or price) is a huge threat.  If we are going to experience massive inflation, why not pay off your debts in depreciated dollars?  If your mortgage payment is currently the equivalent of 10 weekly grocery bills and in 20 years it will be the equivalent of one weekly grocery bill, why would you want to hand over 10 weeks worth of groceries now instead of one week worth of groceries 20 years from now?

If you are retired or near retirement, I would suggest using your Social Security checks or some other fixed income to make your fixed monthly mortgage payments.  If you get an increase due to inflation, then I'm sure you can find something to do with your extra money.

If you are younger, and assuming you aren't wealthy, then you should take out a 30-year fixed rate mortgage if you buy or refinance a house.  I would not recommend anything shorter (like a 15-year) because it is like paying it off early, without the flexibility.

I understand the appeal of paying off your mortgage and owning your house free and clear (even though you will continue to have property taxes).  It can be a powerful feeling.

So for someone with an extra $1,000 per month who wants to pay down their mortgage, why not split the difference?  Investing and managing money isn't an all-or-nothing game.  Take $500 per month and make an extra payment toward the principal on your home loan (assuming you have an emergency fund and other debts are paid off).  This will give you a guaranteed return and a good hedge against deflation.

Take the other $500 per month and put into an inflation hedge to offset your deflation hedge of paying down your mortgage.  Use this $500 to by gold, gold investments, silver investments, oil stocks, etc.  Then you will be covered either way.

If you have money and you are heavily invested in things that do well in an inflationary environment, then take extra money and pay off your mortgage.  But for the vast majority of people who are very vulnerable to inflation, paying off their mortgage is probably not the best thing to do with any extra savings.  Of course, there are a lot of worse things they could do with it too.

UPDATE:  I have written a special report on this subject.  You can buy it for your Amazon kindle for just $0.99.  It will take the average reader about half an hour to read.  It goes further into depth on whether you should pay down your mortgage.  There is no definitive answer on whether paying down your mortgage is a good idea.  It depends on your personal situation and your goals.  In this special report, I discuss both the advantages and disadvantages of paying down (or paying off) your mortgage.


Gmac Mortgage said...

Behind the argument for not paying off your mortgage is the reasoning that you could invest the extra money and earn a higher return, while keeping your money more liquid. That may have been a good reason in the past but the rate of return on investing now is more questionable, compared to the fact that every dollar paid to reduce a mortgage balance provides a guaranteed return equal to the interest rate on the mortgage.

Lora Holmes said...

I think this argument is a case-to-case basis and depends largely on your financial status and your terms. If you’re on a 30-year mortgage and you have good financial standing, prepaying your mortgage is obviously a good idea. If your budget is slim, it’s better to allocate your resources on more urgent needs, especially if you have debt to pay.

Genny Stutesman said...

Paying down the principal on your mortgage definitely works if you want to pay it off early. The next month’s principal amount you paid can knock off years on your loan, which leads to a shorter payment term of the mortgage. It does work, and if you consistently do it, you will surely be closer to paying off your home before you retire.

BrentKLee said...

Stopping your mortgage payments indicates that you are in trouble financially and that you may be aware that your home could go into foreclosure.

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