Your heart may say just do it, but the math may show something else
Published: February 2014
More than almost anything else, a mortgage seems to put the “personal” in personal finance. There’s plenty of emotion and psychology surrounding the loan that secures the primary asset for many Americans. About half of older Americans still have a mortgage, according to the most recent Survey of Consumer Finances conducted by the Federal Reserve.
But the Internet teems with stories, often filled with exclamation points, from younger mortgage holders, vowing to pay off their loans aggressively, lest they repeat the sins of homeowners a decade ago and find themselves owing more than their property is worth.
Add to that urge a dollop of moral imperative. Isn’t debt, after all, what got this country in so much trouble recently? And isn’t a mortgage almost always the largest debt on one’s books? For those with the savings, writing one large but final check is an enticing way to relieve any anxiety of possibly not being able to make payments in future years.
The impulse to pay off your mortgage, especially in one fell swoop, often arises from an urge to simplify your financial life. There is irony in this, since the emotional dimension can complicate what should be a straightforward decision. After all, for a fixed-rate mortgage—the most popular way to finance a primary home purchase—the math couldn’t be clearer: The amortization schedule is the same today as when the first mortgage payment was made. You, the borrower, write a check for the same amount every month. As the years go by, the interest payments decrease and more of that monthly check is applied to the principal.
So why wait? Well, for a start, many—though far from all—financial advisers counsel against prepaying a mortgage. Although we enumerate the disadvantages below, they’re all intertwined.
Less liquidity. By keeping your mortgage, and the cash you might have used to retire it, you’re creating a better personal balance sheet. Yes, it will be one with another liability (your mortgage) but also one with more in assets (cash). By eliminating your mortgage with the cash, you also limit your ability to address an unexpected expense or investment opportunity.
Borrowing costs. If you decide to borrow against your paid-off home in the future, perhaps by taking out a new mortgage, it could very well end up costing much more. Interest rates, already at record lows for more than four years, are likely to go higher in the years ahead. A rise in interest rates from January’s 4.5 percent for a 30-year $200,000 mortgage by just one percentage point will result in a monthly payment that’s $128 more. And other forms of borrowing, such as home equity loans and home equity lines of credit, generally charge higher interest rates than traditional mortgages. Also, credit standards are much tighter than they were before the housing collapse that began in 2006. Ten years ago you could easily get financing with a FICO score in the mid-600s. Today the average score for completed mortgage loans is 732, according to the mortgage-technology firm Ellie Mae. If you need to tap home equity during your retirement, your credit score and income profile might be quite different from what it was in your preretirement years.
Opportunity costs. Even if you consider your home as an investment, albeit an illiquid one, the long-term increase in residential real-estate values trails those of other traditional portfolio investments. For example, the historic returns on real estate have been less than that of stocks (not to mention investment-grade bonds, after the 1970s). Even before the housing bubble and subsequent crisis, home prices nationwide rose about 6 percent annually from 1975 though 2002, compared with a return of 14 percent for stocks. Putting that money to work in your brokerage account means that it’s more likely to outperform your home’s increase in value in 10 years.
Inflation hedge. You’ll be making payments on your current mortgage in future dollars, which will actually cost you less in real dollars in the years ahead. So, for example, if there’s an annual inflation rate of just 2 percent during the next 15 years, the last payment of $1,000 on a new 15-year fixed-rate mortgage will only “cost” $743 in today’s dollars.
Taxes. Those who are near retirement are more likely to be paying less in mortgage interest—possibly so little that, barring other deductions, the mortgage interest and other itemized deductions are no longer more than the standard deduction. (Less than half of all borrowers use the mortgage-interest deduction, according to an analysis by the Pew Charitable Trust.) But if you live in areas where home prices are significantly higher than the national median ($196,200, according to the National Association of Realtors), you’ll still be making interest payments that will exceed the standard deduction until about the 23rd year of a 30-year mortgage, and likely getting the tax advantage that comes with it.
And more taxes
Have you maxed out your retirement contributions? The money you might tap to pay off your mortgage could instead be used to max out your tax-advantaged plans. This year individuals ages 50 and older can contribute $23,000 to a 401(k) plan and $6,500 to an IRA. For savers in the 25 percent federal tax bracket, contributing the maximum results in an extra $5,750 and $1,625, respectively, to grow unencumbered by federal taxes.
And the tax savings may compensate for those mortgage interest payments. We compared what would happen in two situations. In the first, a couple writes a $46,000 check to pay off the last four years of their $980 monthly mortgage payment, thereby saving $6,000 in interest. In the second, the couple continues to make their payments as scheduled and instead invests that $46,000 in their 401(k) accounts.
Since opposites attract, we had one spouse invest significantly more conservatively than the other. It turns out that asset allocation might influence your decision about whether or not to pay off a mortgage. After four years, the conservative spouse investing in a CD will have only about $2,000 in interest income to show for his $23,000. But the more aggressive partner who manages an 8 percent return will have earned $8,300.
So for extra-conservative investors—those who have two-thirds or more of their holdings in low-risk investments, such as cash and investment-grade bonds and bond funds—paying off a mortgage quicker might be the smarter move, since they most likely won’t realize a gain that’s in excess of the 3 or 4 percent interest rate that they’re paying on the mortgage. But for most investors, the reasons to stick with their mortgage loan make more sense in the long run.
Reverse mortgages should be a last resort
Apart from the other disadvantages of prepaying a conventional mortgage, we think that a reverse mortgage should be a last resort for the cash-strapped. An extra layer of fees makes those compounding loans one of the more expensive ways to tap your home equity. And new rules from the Federal Housing Administration have made them more difficult to obtain. Prospective borrowers, who must be 62 or older, now must demonstrate that they will be able to cover the property taxes, insurance, and other costs of maintaining the residence.
Even if you still qualify for a reverse mortgage under the new, stricter guidelines, see if there are other less costly financing options first. Consumers Union, the advocacy arm of Consumer Reports, recommends looking into local government grants or an interfamily loan, where other family members advance the homeowner money and use the property as collateral. In essence, the latter would be a “private reverse mortgage,” allowing you to keep the home in the family.
This article also appeared in the March 2014 issue of Consumer Reports Money Adviser.
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