Photo: Flickr/Kate Hiscock
Now for a somewhat controversial subject, at least in financial planning circles: paying off your mortgage early.A great deal of conventional wisdom says you should never pay a mortgage off early. I’ve gone against that conventional wisdom. Twice.
I don’t know if that means I lack conventionality or I lack wisdom, but it seems to have worked out well.
First, I’ll explain why I thought it was a good idea, and then I’ll address some of the common arguments against paying your mortgage off early.
Finally, I’ll give you some advice about what to consider if you face this decision.
It seemed like a good idea at the time… and still does
When I reached the point in life where I started to accumulate some meaningful savings, I was confused about what to do with it. It happened to be at a time when both the stock market and the bond market had made huge runs, and I didn’t fancy the idea of putting the money into an overpriced market.
My wife and I discussed it and, without hesitation, she asked: why not put it into the mortgage?
Why not? Well, I was aware of a few reasons why not – but more on that in the next section. Personally, though, when I thought about the choice between putting money into some overheated financial markets or putting it into the roof over our heads, it seemed logical to do the latter.
What we got out of it immediately was a feeling of satisfaction and peace of mind. We’ve always looked at debt as something that you don’t simply try to manage, but something you strive to get out of as soon as possible.
That may sound terribly old-fashioned, but years later, having witnessed a housing crisis in which too many people lost their homes because they had failed to build equity, I can tell you I’m even happier for having played it safe.
Why not? Here’s why not…
The following are three reasons financial planners often give for not paying off a mortgage early, followed by my arguments against those reasons.
- You’ll lose the tax deduction. Yes, mortgage interest is tax deductible, but do the maths. If you have a 4 per cent mortgage and you’re in a 25 per cent tax bracket, you’re effectively paying 4 per cent to save 1 per cent. Also, the deduction on interest you pay will be somewhat offset by taxes on what you earn by having the money invested instead, which leads to the next point…
- You’ll miss out on investment opportunities. This was a popular argument in the 1990s when investments seemed to go straight up. It holds less water now. While mortgage rates are low at around 3.5 per cent, CD and savings account rates are even lower. Bonds are below 2 per cent across most of the yield curve. As for the stock market, well, let’s just say it’s had a rough decade. You can take your chances, but remember that by investing borrowed money, you are essentially leveraging your portfolio, which increases your risk level.
- Don’t tie up liquidity. This is a fair argument. A house is an asset, but not a very liquid one, and you shouldn’t put so much capital into it that you have no money left over for unexpected expenses, emergencies, etc. On the other hand, when people have liquidity, they tend to find a way to spend it. Putting money into your house helps to make sure that money saved stays saved.
Questions to ask before acting
Of course, virtually no financial advice applies universally. Facts and circumstances matter greatly. Here are three things to consider before you pay off a mortgage early:
- Are there prepayment penalties? Actually, it’s best to ask this question before you sign up for a mortgage. If you can minimize prepayment penalties, it will give you more options down the road.
- Is your income solid? This is essential for making sure you don’t run into a liquidity problem by putting too much into your mortgage too soon.
- Have interest rates fallen or risen? If interest rates have risen (and assuming you have a fixed-rate mortgage), you might do better by investing at higher rates while continuing to pay a low rate on your mortgage. If rates have fallen, you face a choice of paying down the mortgage early or refinancing, which leads me to my final suggestion.
Not sure? Consider a hybrid strategy
If interest rates have fallen since you got your mortgage, consider a hybrid strategy of refinancing to a shorter-term mortgage. This will allow you to get an even lower interest rate (15-year rates are lower than 30-year rates) and pay down your mortgage faster without immediately tying up your liquidity.
In the end, as you ponder this decision, just remember that having these options is an opportunity, not a problem.