Like most things in personal finance, there is no clear cut answer as to whether you should pay off your mortgage or continue to hold one. Everyone’s individual situation is different, and today we will discuss some considerations investors should take into account that are often overlooked.
Keeping Your Mortgage To Invest In Stocks
It is true that the expected return on stocks is probably higher than the interest rate you are paying on your mortgage. This leads some people to keep their mortgage and invest in stocks instead. People often don’t think about it this way, but you are effectively investing on margin by borrowing money to invest in stocks. This may lead to some unintended consequences.
The reason the expected returns of stocks are so high is because of the associated risks that come with investing in stocks. This is known as the equity risk premium (ERP) or the return of stocks minus the risk free rate. Currently the risk free rate is near zero. The market sets prices based on the ERP that the market requires. If we assume the market requires an ERP of 7% (meaning 7% of expected return is required for people to invest in risky stocks), that is a total return of 7% minus the risk free rate of 0%. (If the risk free rate was 2% the total return would be 9%). But your debt is not at the risk free rate; it’s somewhat higher. Therefore, if you are holding a mortgage at 4% and taking the risk the market requires to gain 7%, then you are only capturing 3% expected return on a risky investment. That doesn’t seem like a solid plan to me.
Of course it is a little more complex because of taxes, but generally speaking if you are borrowing money at a higher rate than the risk free rate of return you are earning less than the ERP while taking the same risk.
Another thing to consider is that paying off your home and investing in stocks is an apples-to-oranges comparison. Paying off a mortgage gets you a guaranteed rate of return equal to the after-tax interest rate of the mortgage. Stocks only have an expected rate of return. Therefore you should be comparing paying off the mortgage to what you can earn on CD’s and other low risk instruments.
If your plan requires you to have high returns to meet your goals and you are comfortable with taking on a high degree of risk, it still might make sense to own a mortgage while investing in stocks.
Keeping Your Mortgage To Invest In Bonds
This may seem like something nobody would ever do, but it happens all the time. If you are nearing retirement age you are most likely starting to take some risk off the table by moving some of your stock allocation into safer bonds. If you are also carrying a mortgage you are actually borrowing money from the bank to lend it back out to the market. Normally this doesn’t work out in your favor. Let’s say you have a 4% fixed rate mortgage and own a bond fund paying out 2%. This is a losing proposition because you have a negative arbitrage – borrowing at a higher rate than you are lending.
Interest rates are currently at historical lows. If you were able to lock in a low fixed interest rate, then the math may turn in your favor in the future. This possibility should factor into your decision.
Taxes
Deducting mortgage interest is one of the best deals for individuals in the tax code. The stated interest rate of your mortgage is actually lower once you account for the tax savings. This tax adjusted interest rate should be used when calculating the benefits of keeping a mortgage. The mortgage interest deduction even survives the AMT, but interest on home equity loans do not.
This leads people to want to keep the mortgage to keep the tax benefit; most people hate paying taxes. However, this may be costing you money. Recently I looked at a tax return of a client who was saving about $9,000 a year by deducting his mortgage interest. This sounds great, but he was paying the bank over $12,000 per year in interest payments. Essentially they are paying the bank $12,000 for the government to give them $9,000.
If you would like to pay off your mortgage, but your assets are in tax deferred accounts, such as a 401K, it creates other issues. Since you have never paid taxes on your 401K dollars, any withdrawal will be included in your gross income. This may push you into a higher tax bracket or phase you out of certain deductions. The math should be done to calculate the balance between paying higher taxes and saving on mortgage interest.
Inflation Protection
Owning a long term fixed rate mortgage is great inflation protection. Regardless of the amount of inflation, your monthly payment will never change. This only helps you, however, if your income and investments are keeping up with inflation.
To get a feel for what the market thinks the risk of unexpected inflation is we can look at the spread between TIPS (Treasury Inflation-Protected Securities) and nominal bonds. Currently (on 9/20/2013) 10-year TIPS are yielding about 0.5% while nominal 10-year treasuries are yielding about 2.75%. This implies an inflation rate of 2.25%.
If the math tells you there is only slight advantage to paying off your mortgage, then it might make sense to keep it because of the inflation protection benefit.
Behavioral Reasons
Even if the numbers tell you keeping the mortgage is beneficial, paying it off may still be the preferred choice. Being able to sleep at night is a real benefit. This way if the markets have another period like 2008-2009 you won’t be forced to sell investments at market lows to pay your mortgage. Also, knowing you own your home might help you make the hard (but correct) choice of rebalancing your portfolio – buying more stocks when everything around you is telling you to sell them.
Conclusion
It is always hard to say with certainty that a particular strategy is preferable when it comes to personal finance. Normally paying off your mortgage is the right strategy, but the only way to be sure is to run the numbers. If interest rates rise in the future and you have a low fixed rate mortgage, then conventional wisdom may go out the window and keeping your mortgage may be the right strategy. Whatever your ultimate decision, make sure you are considering all the pros and cons before paying off your mortgage.
