Here is the best financial lesson I can offer: there are two sides to the interest rate – the getting side and the paying side. You want to be on the getting side.
How do you do this? Pay off your mortgage as soon as you can, and definitely pay it off before you retire. And don’t buy a home if you can’t afford to pay it off between five to 10 years.
Unfortunately, that’s not the norm. Thanks to the commonplace position of the 30-year mortgage, it is more popular despite the lower costs of shorter-term loans. The 30-year mortgage was originated during the Great Depression to help borrowers lower their monthly payments and avoid foreclosure. But now, Americans are more indebted to banks for mortgages than homeowners in other advanced market economies. In exchange, those paying longer obligate themselves to pay more than double over the lifetime of the debt.
On the other hand, the 30-year mortgage is very friendly to real estate brokers, home developers, and banks. Simply put, it allows them to sell more expensive houses. Bankers are gleeful to hand out mortgages that more than double their interest revenue.
Here’s an example of how the math works. In April 2018, a 30-year mortgage charges about 4.18% in interest, whereas a 15-year mortgage charges about 3.75%. If you borrow $100,000 for half the time, your total interest paid doesn’t just decrease by half. It falls from $75,626 to $30,900, or by 60%.
But why pay the bank $30,900 at all? Put it in your retirement account. This way, you earn the interest.
Here are answers to the objections I usually hear when I advise people to pay off their mortgage.
- “The government lets me deduct the interest.”
Answer: If you are a high earner and pay an income tax rate of 39%, you pay the bank $1 and the government reduces your taxes by 39 cents. But the bank still gets your 61 cents! Do you like banks better than your favorite charity or yourself? And, as you get closer to paying off your loan, a larger share of each monthly mortgage payment goes to principal rather than interest. This decreases the amount deducted from taxes, making the deduction worth less.
- “I want to use cheap mortgage money to make more money.”
Answer: Sure, businesses pay interest and leverage hoping to invest in ventures that pay a higher rate than the interest rate. That’s the plan – and the hope. Most businesses fail because hope doesn’t come through -the debt overwhelms them. Individual households have even less means or scope to handle leveraged risk.
- “My house will appreciate more than the interest rate, especially after the tax deduction.”
Answer: Maybe, but you could also be paying tens of thousands to the bank and be underwater. Average house appreciation rates vary wildly, and a financial crisis can happen at any time, perhaps when you reach your 60s.
- “If I use all my money to pay off my mortgage, I won’t have any money for emergencies and I will be cash-poor and house-rich.”
Answer: Don’t be cash poor. Have six months of salary in cash for emergencies. Max out on your retirement savings and pay off your mortgage. Paying off a 4% mortgage (even with a tax deduction of the average 28%) is like earning a risk-free rate of 2.88% (4% – 0.28% of 4% = 2. 88%). There aren’t many places on the planet where you can earn 2.88% risk free. No longer paying interest on your loan, paying it off can be like earning the equivalent risk-free return.
- “I don’t want to store all my wealth in my house.”
Answer: Diversifying assets is always best practice. However, most families’ greatest asset is Social Security and Medicare (worth about $400,000 for an average couple), followed by home equity of about $110,000, and their retirement account with about $30,000 in stocks and bonds. Having a large chunk of your money tied up in your home might seem unwise, but not when you consider that you are also using the house for a necessary consumption. You need to live somewhere, and you can’t live in a stock or bond. Also, if your house appreciates in value, you can sell it or refinance. But if you don’t pay off your mortgage, you won’t have the equity.
- “I haven’t contributed the maximum amount to my 401(k), IRA or other retirement accounts.”
Answer: I often hear this as a reason why people slow down their efforts to pay off their mortgage. While paying into your retirement account is a better use of your cash than paying off your mortgage, ideally you want to max out your retirement savings and accelerate your mortgage payments.
But retirement security is a big topic and anyone trying to secure their retirement needs more tactics than paying off their mortgage. Some tactics include changing spending plans and saving in retirement accounts and others include a more comprehensive national policy solution. For instance, everyone needs a retirement savings plan and to contribute to it from the beginning of their career. I have two small and easy-to-read books on how to have enough in retirement and how to change federal policy so we can rescue retirement with a Guaranteed Retirement Account.
[Pro-Tip: A good way to reduce interest payments is to make extra payments to pay off the principal. Decreasing your balance decreases your interest paid.]
- “I have high interest credit card debt.”
Answer: Using cash to pay off high-fee credit card balances is another good reason to temporarily keep some mortgage balance. You want to use your cash to pay off high-interest loans. Paying the monthly minimum of $110 on a credit card balance of $5,000 with 15.99% interest rate will take 25 years to pay off. And the $5,000 will balloon to $12,000. Its even worse if you continue to use the card, adding more debt.
[Pro-Tip: Tear up your credit card, then pay off the balance as soon as possible. Do keep one – you can’t rent a car without one – but use it like cash and record every card expenditure in your checking account log.
Let’s be positive. Here are the reasons to pay off your mortgage:
- Good retirement planning is about accumulating assets AND reducing spending. You will have less income in retirement, so eliminating your monthly mortgage can greatly increase the amount of money you can spend on fun activities and medical expenses that will surely increase. Ideally, you followed the advice in the first paragraph and didn’t buy a home with a mortgage longer than ten years.
- Paying off your mortgage early transfers the money you would have paid the bank to your pocket.
It almost always makes sense to pay off your mortgage before you retire, but use a mortgage payoff calculator to convince yourself that it’s better to pay off your debts before retirement because new costs – like medical costs will soar.