For many people, a home is the largest purchase they will ever make, and nearly all homes are purchased with mortgages. But is paying off the home mortgage the smartest thing to do with our money? I know this is a subject of some debate within personal finance circles, and there are strong opinions on all sides. It basically boils down to two major viewpoints, so in this post I’d like to take a closer look at the debate and offer my two cents.
But first I need to clarify that I am specifically discussing our personal residences, and NOT investment properties. Rental properties may require a different approach altogether. I’m also NOT talking about the benefits of buying a house vs. renting. That’s also a discussion for another time. I am specifically addressing the question of whether or not it’s wise to pay off the mortgage for our primary home.
Approach 1: Maximize Returns
This approach asks the question, “What will earn me the most money?”
If there are investments that offer a higher rate of return than the interest rate on the mortgage, mathematically it makes more sense to make minimum payments on the mortgage and invest the rest. This especially makes sense when the interest on the mortgage is tax-deductible. For example, if I have an interest rate of 3% on my mortgage and my investments return 8%, then I have a net gain of 5% if I put the money into those investments instead of the mortgage. This is not an insignificant amount of money. I know people who buy their homes with interest-only loans and then they invest everything else.
I call this the mathematical approach because the numbers all add up. It should result in the highest net worth over time. It says, “Pay as little as possible into a low-interest mortgage, and invest the rest!”
Approach 2: Minimize Risk
This approach asks the question, “What will minimize my chances of loss?”
You see, even though it comes with the lowest interest rates among all the different flavors of debt and it’s even sometimes labeled as “good debt”, a mortgage is still debt. Debt ALWAYS increases risk. So we might assume that we’ll always have a job or be in good health to make house payments for the next 30 years, but if we are honest with ourselves, we all know that no such thing is ever guaranteed. So this approach says that if I pay off my house as quickly as possible (preferably pay for it outright in cash), then at least I won’t get my home foreclosed on if I lose my job. (This is assuming that we can at least afford the tax, insurance, and other costs of operating the home.)
The risk management approach says, “Pay off the house as fast as you can!” While it may not result in the greatest net worth in the future, it would help preserve our home in case of some unforeseen calamity.
What We Do
If you’ve read our one-year reflection on being homeowners, you will know that we are trying to pay off our house as quickly as possible. (In fact, we plan to be done within 2015, so stick around and we’ll let you know when we do. Update: We did it!) So indeed, we subscribe to the second school of thought seeking to minimize risk. Here are a few additional arguments that swing us over to this camp.
- History Repeats. Firstly, the mathematics of approach 1 work only in an environment of secure incomes, steady home prices, and healthy financial markets. Not long ago, word on the street was that our homes were investments that would NEVER go down in value—hopefully the financial crisis of 2008 shook us out of that delusion! If 2008 has anything to teach us, it’s that in times of financial turmoil, 3 things go together: 1) Financial markets crash, 2) Housing goes down in value, and 3) People lose their jobs. In such a scenario, if I had overleveraged myself by borrowing from my house to invest in the market (which is essentially what approach 1 proposes), I’m in no-insignificant financial risk! Not only may my investment portfolio crash through the floor, but also my house may be underwater right when I need to sell to move to find a new job. (Or worse, be at risk of foreclosure!) While a paid-for home will still go down in value at such times, at least the bank’s not going to evict me onto the street.
- Cash Flow, Cash Flow, Cash Flow. Secondly, for us personally, we already knew that when we start having kids, Deb is going to become a stay-at-home mom. What that means is that we anticipated our income being essentially cut in half. Having a paid for home means we have slashed a significant portion of our monthly expenses to enable us to live on a whole lot less when Baby Crumb Saver arrives. Just imagine how many more diapers we can afford not having to pay a mortgage OR rent!
- Don’t Overpay. Lastly, the most aggravating thing about long drawn-out payment plans is all the extra interest that we have to pay. It’s bad enough to pay full price for anything, but by paying interest over DECADES, we are paying obscenely more than the actual list price of the house. If we took out a $200,000 mortgage at a 4% fixed-rate over a standard 30-year term, we would pay $143,739.01 JUST in interest! So for the privilege of spreading out the payments, I pay enough interest to nearly buy a second house! It hurts just typing that!
Having said all of this, I recognize that some people might find themselves in the rare and enviable position of having significant enough investments (that’s liquid) that could pay off their mortgage at any time. If such individuals choose to make minimum payments on their homes while investing the rest, they’ve essentially got the best of both options: Higher returns with reduced risk. Unfortunately for the rest of us, that’s not likely an option we have.
Well…there’s actually a third approach…
While we intellectually discuss the merits of these two approaches of risk vs. returns, we need to recognize that this is largely a theoretical dilemma because there’s actually a third approach–which happens to be what MOST people do. That is, make minimum payments (perhaps dropping in a few extra payments once in a while with a fleeting sense of superiority), SPENDING everything else, and patting ourselves on the back that we’re “cutting down our taxes”. In other words, the third approach is simply the “normal” approach toward mortgages…just paying the minimum payments for the length of the mortgage with little to no additional effort.
For those practicing this third way, I say that either of the other two options would serve you better. At least invest the difference even if you’re not going to make extra mortgage payments!
No More Business As Usual
If you’ve got a home mortgage or are thinking of getting one, the one thing I hope you take away from this article is to not settle for the standard practice. You can do better. Your home may very well be the largest purchase you ever make, that’s why you want to make sure that you get the absolute best deal!
We shared some additional thoughts on home ownership in our post written on the one-year anniversary of buying our first house. Read it here if you haven’t already: 7 Lessons as One-Year Homeowners: And paying it off in less than 3 years