It is the debtor that is ruined by hard times
- Rutherford B. Hayes
4 Reasons to NOT Pay Down Your Mortgage
I've probably been asked hundreds of times what clients should do with extra money which is not in retirement accounts. I'd like to share my conclusion and the reasoning behind it - precisely because my thoughts are contrary to how most people behave....
Let me start by making an important distinction. Namely, the difference between PAYING OFF a mortgage (all of it) versus just PAYING DOWN (applying extra money to the principal amount). Here's why I think its not a good idea to pay down a mortgage as well as some thoughts on how to best pay it off:
1) Paid-Down Mortgage has Same Obligation
Let's say you have a great year at work and your employer pays you a $25k bonus. You decide that rather than spend on something frivolous you will be responsible and apply it to your existing mortgage. If you had a $2,000 monthly mortgage payment prior, unfortunately paying down principal WILL NOT reduce this monthly obligation.
2) Need the Money? Too Bad!...
So you decided to pay down your existing mortgage by $25k anyways. You feel prudent and responsible - after all you didn't waste the money on an expensive trip to Paris.
Then something unexpected happens - you lose your job. You are short on cash and need the money you just paid down on your mortgage. Unfortunately, you are totally out of luck. No mortgage company is going to let you refinance or take principal out of the loan without a job. Same if you still have your job but are upside down on your mortgage. The bottom line: when you need it most - the money is not available.
3) Returns on Paid-Down Mortgage is LOW
Let's assume you have a 4% interest rate on your mortgage. If you are married and make even a modest $75,000 a year your "savings" for paying down your mortgage is a measly 3 percent after-tax (assumes a 25% federal tax rate). Also, you still have the monthly obligation AND you cannot touch the money when you really need it...
4) You Have Better Alternatives
Being debt-free is a meaningful goal which will generate peace of mind and financial security for your family. However, to reach this goal there is a better solution than paying down a mortgage. What I recommend:
1) Refinance if rates are low enough to do a "no-cost" loan at an interest rate which is less than your current mortgage and apply your cash to the principal - thus reducing not only your balance but your monthly obligation.
2) Establish an account earmarked only for paying off the loan on your home. Put money regularly into this account which you might otherwise have used for paying down your loan. When you have enough saved/invested you can pay off the entire balance. This strategy requires discipline - but will provide your family great flexibility against future unknown financial shocks.
Summary:
Most financial advisors recommend never paying off a mortgage. Why? Their explanation is that you can always do better over time than a 3 percent after-tax return. While that may be true - it's hard to quantify the value of being debt-free on family happiness. You will sleep better knowing worst-case scenario with your home is no longer on the table.
In my experience, clients with no debt tend to be far more mature investors and make better decisions when the bad times inevitably come. That more than makes up for the differences in financial returns.
