By: Mike Earl, CFP®, CPWA®
“Why pay off my mortgage when I know the long-term rate of return on stocks should significantly exceed my mortgage interest rate?”
We are unique as financial planners in that we encourage our clients to rapidly pay off their mortgage (in 15 years or less), even if it means a slightly reduced amount of money being added to the portfolio during those years.
A good goal is to have 100% of your debt (including the mortgage) paid off by age 45. If you’re looking for a BHAG (Big Hairy Audacious Goal), shoot for age 40.
As Stephen Covey wrote in The 7 Habits of Highly Effective People: begin with the end in mind. In the book, Covey asks you to envision your own funeral. What do you want people to say about you? What do you want your legacy to be? How did you handle your money? Were you generous in giving of your time and money to others?
If we begin with the end in mind when it comes to mortgages, we should all agree the endgame is to have no debt at all. When we ask clients to share their plans for retirement, no one ever says: “if interest rates remain low, I hope to carry a 30-year mortgage until I die.” If you want to have your mortgage paid off eventually, then why not get there as quickly as possible?
The question of investing vs. paying off the mortgage early is a false dichotomy: the two options are not mutually exclusive. Why not invest 15% or more of your income and pay off your mortgage in 15 years or less?
In our experience, the sooner a client pays off the mortgage, the more quickly they are able to build significant wealth.
Other salient points on the topic of paying off the mortgage:
Some people say they will take out a 30-year mortgage and invest the difference between that payment and the 15-year mortgage payment. But here’s the rub: very few people actually do that. When you take on a 15-year mortgage, you are forced to pony up for that larger payment (larger than the 30-year payment). Contrast that with a $300 per month automatic investment plan. It’s all too easy to cancel that automatic investment plan.
When you get on a path toward paying off your mortgage in a relatively short-term, you set a benchmark for when you want to be 100% debt-free – even if you decide to move to a different home. For instance:
My wife and I know we have 104 payments left on our 15-year mortgage (but who’s counting?). If we decide to buy a different home, we have agreed to not increase the term of our current mortgage. Since we only have about 8 ½ years left on our current mortgage, any future mortgage would need to be paid off in February 2027, which is the scheduled payoff date for our current loan.
Contrast that with someone that has 26 years left on a 30 year mortgage. What’s the big deal about switching to a new 30-year mortgage?
What about the tax deduction of mortgage interest? Let’s say a married couple will pay $10,000 of mortgage interest this year. Their marginal income tax brackets are 22% Federal and 7.85% state of Minnesota, for a total marginal rate of 29.85%. We’ll round that up to 30% to make the math easy. This means they pay the bank $10,000 of interest (gone forever) and receive a $3,000 rebate on income taxes. That couple is still out $7,000. Wouldn’t they rather be debt-free and invest that $7,000 for long-term growth in their liquid portfolio?
Homes are an asset, but they not an investment. Allow me to restate that emphatically: do not think of your home as an investment. As we have written in the past, the long-term rate of return on residential real estate is just 3.19% (dating back to 1890). The real rate of return (adjusting for inflation) is a paltry 0.417%. We think home ownership is great. But remember that your home costs you money every year, it grows in value quite slowly relative to stocks, and it’s illiquid (you can’t write a check on the value of your home, unless you’re taking on more debt!). Remembering those facts could help you keep your home purchases more modest than when thinking of your home as a “great investment.”
If you can get your home paid off by age 40, 45, or even 50, it frees you up to crank up your savings rate significantly. With no mortgage payment to be made – and being in peak earning years – you can really accrue capital at an awesome rate.
Another objection to the 15-year mortgage: “What if I lose my job and can’t make the 15-year mortgage payment?” If you lose your job and can’t pay the 15-year mortgage payment, would you really have been able to make the 30-year mortgage payment? This is where a healthy emergency fund should come into play. Furthermore, doesn’t this objection provide even more incentive to be 100% debt-free as quickly as possible? If you have no mortgage, getting laid off is going to be a lot less traumatic.
What does this mean to you, our client?
You have one major goal in this area of personal finance: get debt-free as quickly as possible. Ideally by age 45.
1) The 7 Habits of Highly Effective People: Powerful Lessons in Personal Change, by Stephen R. Covey.
Because The Wealth Group, Austin B. Colby & Associates is independent of Raymond James, the expressed written opinions above are our own and not necessarily reflective of Raymond James’ opinions.