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.
Original article: Should you pay off your mortgage?
By Chris Horymski
February 28, 2014 4:00 PM
