MoneyWatch Editor-in-Chief Eric Schurenberg recently wrote about Why You Shouldn't Pay Off Your Mortgage (and Why I Did Anyway). Great article, great advice, but being the most argumentative person on the planet, or so I've been told, I thought I'd present the opposite viewpoint. You'll see later on that we are really in agreement.Why you should pay off your mortgage - Faulty Argument #1
If I had a dime for every time I've heard the argument that you can earn more in your investment portfolio than your mortgage rate, I'd be a very rich person. The logic behind this argument is flawed as I'll explain.
Two keys to successful investing are to set an asset allocation and stick to it. Whatever mix between stocks and fixed income you select depends on your willingness and need to take risk. For this example, we'll use a moderately risky portfolio of 60 percent stocks and 40 percent bonds.
Let's say the investor has a $500,000 portfolio (taxable), and a $100,000 mortgage. We will assume his mortgage rate is 4.5 percent and his high quality bond fund, Vanguard Total Bond Fund (VBMFX) is paying 3.0 percent. Finally, let's say this person is in the 33.33 percent marginal tax bracket, between state and federal.
Key to this analysis is to compare like asset classes. While I can't predict how the home value will go up or down, I can predict something more important - the home's value won't be impacted by the financing. We must then compare the mortgage to the bond portion of the portfolio.
The first part of the analysis shows that the mortgage interest has an annual cost of about $4,500 before tax or $3,000 after taxes. Many advisors would point out that the Total Bond Fund's three percent yield nets you that same three grand return. They seem to forget to mention that the bond fund is taxable and that you only net $2,000 after taxes. And the bond fund has risks, especially if interest rates rise. The argument is even stronger if you are being phased out of your itemized deductions and not getting the full tax advantage of your deductions.
Other Faulty arguments Everyone from advisors to mortgage brokers stands to benefit from you having a mortgage. In addition to faulty argument #1 - you can earn more with your investments, there are a couple of other self-serving arguments.
Faulty Argument #2 - You need a year's worth of cash - I'm a conservative guy and agree you may need access to a year's worth of cash. That doesn't mean you need to have the cash, however. If you pay off your mortgage, you should be able to get a virtually no cost home equity line of credit. Make sure the bank doesn't have the unilateral right to cancel or lower the line. This gives you a virtually free insurance policy.
Faulty Argument #3 - You have more protection against creditors with the mortgage - I recently received an email from a financial planner stating that creditors would be less likely to go after your home if you have a mortgage on it. Give me a break - in the example above, the consumer has a $500,000 portfolio if he doesn't pay the mortgage off and a $400,000 portfolio if he does. I asked a few lawyers who they would rather sue and the larger portfolio always won over the house much harder to sell.
Finally, why I took out a mortgage Ten years ago, we moved from Aspen, Colorado, the most expensive town in America, to Colorado Springs, Colorado, where home prices were one-tenth as much. This allowed us to pay cash for our new home, which felt really good. Then, about three and a half years ago, I noticed Pentagon Federal Credit Union had a no cost mortgage at five percent at the same time as a five year six percent CD. We took out a mortgage and told the credit union to keep the cash, carving it up in smaller amounts to stay below the NCUA insurance limits.
So we borrowed money at five percent that we loaned back to the credit union at six percent. That one percent spread was nearly arbitrage. It gets even better when I tell you that last year, the credit union allowed me to pay half a point to lower my mortgage rate from 5 percent to 3.875 percent.
I think Eric Schurenberg did the right thing by paying off his mortgage. Unless CD rates increase significantly, I'll be doing the same thing when my six percent CDs mature. And if you are considering doing the same, remember two things.
1. Are those telling you not to pay it off profiting from that advice?(Picture by Renjith Krishnan)
2. Have you ever met anyone who said they regretted paying off their mortgage?
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