Paying down or paying off your home mortgage is a great investment.
Tens of millions of Americans can earn a risk-free return, typically between 3 and 5 percent, by just paying down or paying off their mortgage. Not only that, but it’s often tax advantaged as well. Let me explain.
First you must understand:
- Mortgage: borrowed money where you pay an entity principal and interest.
- Bond: money you lend where an entity pays principal and interest.
Because of the above, I think it’s foolish to borrow money at, say, 4 percent only to lend it out via a high-quality Barclay’s aggregate bond fund at 2.2 percent. Though you may say the mortgage provides a tax deduction, don’t forget the bond is also taxable. In fact, it’s more tax advantaged to pay off the mortgage if:
- You are a low-income earner and part of the interest puts you just above the standard deduction (meaning you are only getting a tax break on part of your interest).
- You are a high income earner paying the new 3.8 percent Medicare tax and/or phasing down on your itemized deductions (meaning you aren’t getting the full benefit of the deduction).
I frequently get advisors protesting that the bonds in the tax-deferred accounts aren’t causing taxes to be paid. While I agree that tax-deferred accounts are the best wrapper to locate bonds, investors do ultimately pay taxes on the bond earnings when the funds are eventually withdrawn.
Sometimes I even get pushback that paying down the mortgage reduces the tax deductions and causes more taxes to be paid. While true, it’s irrelevant. Quitting your job, giving your money away and living under a bridge really saves in taxes, but isn’t something I recommend. A much better goal is earning more after taxes, which paying down the mortgage accomplishes.
Why Paying Down The Mortgage Is Risk Free
I also have clients saying they don’t want to put more money into their house. I tell them I agree and I’m not recommending a remodel. Paying down the mortgage has nothing to do with how much the home will appreciate. Paying down a 4 percent mortgage just gives a risk-free return no matter how real estate prices change.
The Only Reason Not To Pay Down The Mortgage
Obviously, everyone’s situation is different and the one thing that is lost by paying down the mortgage is liquidity. You can’t just get that money back if you need it. That’s where a home equity line of credit (HELOC) comes in. A HELOC gives you the right to borrow the money should you need it. It’s important, however, to read the fine print to make sure the bank or credit union can’t just unilaterally lower or eliminate your line, just when you need it.
Why This Advice Is So Rare
If the logic of earning a 4 percent risk-free return is so compelling, why is this advice so rare? I think the answer is simple: Everyone profits from you having a mortgage. Banks and other financial institutions make money from your interest payments, while financial advisors lose money if you pay down the mortgage.
For example, to an advisor charging 1 percent of assets under management, telling you to pay off your $300,000 mortgage would result in him losing out on a $3,000 a year annuity he is currently earning.
What This Means To You
Like all of my writings, this isn’t meant to be specific advice, as there are always exceptions to any piece of advice. But there is compelling logic for this seldom-delivered advice. And how many people do you know who say they regretted paying off their mortgage?
Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for CBS MoneyWatch.