Photo: Flickr / Mr. Wright
“Why don’t we just pay off the mortgage?”To many struggling homeowners, the notion of being able to pay off a home loan might seem hopelessly out of reach. But to those who have been paying on their mortgages for some time or have aggressively prepaid over the years, that question may pop up from time to time.
A surprise inheritance or commission check can make getting rid of the mortgage note–something that seemed so elusive when they first signed on the dotted line 10 or 20 years ago–a realistic possibility.
A recent thread on Morningstar.com made me realise that the temptation to deploy cash to pay down a mortgage rather than to buy investment assets might be particularly strong right now. Despite stocks’ surge during the past three years, equity market aggregate performance has been underwhelming for the past decade. Retiring debt, meanwhile, has seemed like a money-good option, even though home prices have generally sunk. And there’s always something to be said for a sure thing–paying off debt prematurely is a guaranteed return on your money, while that’s not necessarily the case for investing in the market.
Does that maths still add up, however? Mortgage interest rates seem to touch new lows every week, while equity valuations aren’t outlandish by many measures, even after their three-year runup. Although out-earning one’s mortgage interest rate might not have seemed realistic a decade ago, with 30-year mortgage rates higher than 7% and the market still working through post-dot-com-bubble valuations, doing so doesn’t look so unreasonable today. 30-year fixed-rate mortgages are available for less than 4% today, whereas even the usually bearish investment firm of Grantham, Mayo, Van Otterloo is forecasting real returns from equities of more than 5% for the next seven years.
But the decision about whether to pay off a mortgage or invest in the market is far from black and white. For those who are close to retirement and already have plenty of other liquid financial assets, paying off a mortgage is apt to be a very wise use of cash.
Such homeowners aren’t likely to be saving a lot because of their mortgage-interest deductions, which tend to be more valuable early in the life of the loan than in the later years, and their investment-asset mixes might be skewing toward low-returning cash and bonds, not stocks. Moreover, many retirees concur that reducing their in-retirement overhead by retiring debt reduced worries and freed up cash for travel and other enjoyable pursuits.
For others, however, a mortgage paydown might not be the right answer. Although it might seem comforting to own your home free and clear, there’s invariably a trade-off involved. You’re giving short shrift to your investments in more-liquid assets in favour of plowing money into an asset that’s not liquid at all. A happy medium for many households might be to balance modest prepayments of mortgage principal with ongoing contributions to retirement-plan accounts.
Here are some of the key questions to think through as you make this important capital-allocation decision for your household.
1. Is your retirement plan on track?
Before paying off a mortgage, spend some time evaluating the viability of your retirement plan, either by sitting down with a financial advisor, using online calculators, or both. Yes, paying off a mortgage rather than investing in the market will mean that you’ll have fewer liquid investment assets earmarked for retirement. However, with lower household expenses, you might be able to step up your future retirement-plan contributions; having a paid-off home will also mean that your in-retirement costs will be lower, allowing you to reduce your planned withdrawal rate.
Time horizon is an important aspect of the decision-making here. Those with more years until retirement can better harness the compounding benefits of investment assets they put to work today, whereas those who are nearing or in retirement and expect to begin drawing on their investment assets might not get such a big bang from steering additional assets toward their investment accounts.
2. What’s your investment mix, and where are you holding it?
In a related vein, the composition of your investment assets and where you hold them are also important considerations. One might realistically forecast a 4%-5% real (that is, inflation-adjusted) return on stocks in the decade ahead, giving an equity-heavy portfolio a reasonable shot at outearning today’s ultralow mortgage rates. The case for investing in the market rather than prepaying the mortgage gets even stronger if you hold your investments within the confines of a tax-sheltered vehicle and/or you’re earning matching dollars on your contributions. On the flip side, portfolios that are heavy on cash and fixed-income securities, especially those that are fully taxable from year to year, are less likely to outearn mortgage interest rates.
3. How diversified are you?
Although it’s a less common mind-set today than it once was, some homeowners think of their houses as a retirement-savings vehicle: When it comes time to retire, they’ll cash in their equity and downsize to a smaller place. However, the past several years have taught many homeowners that’s easier said than done. Many haven’t been able to sell when they wanted, and they also haven’t been able to receive anything close to the prices they hoped their homes would fetch. The lesson is that downsizing or moving from home ownership to renting might be a component of a retirement plan, but staying diversified is key. Pairing home equity with more liquid stock and bond assets can give you a lot more flexibility to ride out downturns in the housing market.
4. How much is your mortgage-interest deduction saving you?
Many homeowners assume that it’s wise to hang on to their mortgages because of the tax deduction they can take on their interest. But as noted earlier, that deduction shrinks as the years go by because home loans are front-loaded toward interest payments. For people who have been able to pay down a mortgage for many years, they might be overestimating the amount of taxes they’re saving by having a mortgage, and itemizing deductions might not be saving them much versus the standard deduction.
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