Why You Shouldn't Pay Off You Mortgage (and Why I Did Anyway)

I paid off my mortgage a few months back. I can give you more reasons that was a bad idea than I can reasons it was a good one. (And MoneyWatch explained last year why you shouldn't pre-pay your mortgage.) But like my colleague Stacey Bradford, I took off my financial wizard robes for the day and paid if off anyway. Was that smart? Or just chicken? You decide.

Let's start with the reasons not to do what I did.

You need the liquidity. You should have enough cash in a safe, readily accessible account like a money fund or bank account to support your family for at least six months. Money tied up in your house isn't safe and it sure isn't readily accessible. Liquidity wasn't an issue for me, but if paying down your mortgage would bring you below the six-month cash threshold, don't do what I did. Use the cash you'd be applying to the mortgage to build up your cash reserve instead.

You could probably do better investing the money elsewhere. A 30-year fixed-rate mortgage today costs less than 4.5%-ridiculously cheap by historic standards. Since mortgage interest is deductible, let's call it 3.0% after federal and state taxes. So paying off the mortgage is the equivalent of earning a measly 3% after taxes. Couldn't you do better than that by keeping the mortgage and investing in stocks?

You might. But is it even necessary to mention you might also do a lot worse? "Consciously or not, when you own both a mortgage and a stock portfolio, you're acting like a hedge fund," says Brad Barber, a professor of finance at the University of California, Davis, Graduate School of Management. "You're playing the market with borrowed money." When you put it that way...

The monthly return from paying down the mortgage, on the other hand, is a sure thing. So the fair comparison is not with stocks but with other close-to-sure things, like Treasury bonds or CDs. That makes the mortgage payoff look a little less dumb. I know of only a handful of CDs paying 3% before taxes. Treasury bonds don't even come close.

The one exception would be when the saving alternative is a 401(k). There the company match, which might typically be 50% if your company offers one, can make the return on a conservative stable-value fund competitive with the payoff you get from wiping out your mortgage. Where else are you going to get an immediate 50% return, guaranteed? Of course, if you're already contributing as much to your 401(k) as the company will match (and you are, aren't you?) that option isn't available.

You expect inflation. A fixed-rate mortgage is a good hedge against inflation. You pay the lender a fixed number of dollars, even as inflation makes each dollar less valuable and puts more dollars in your paycheck. If you expect hyper-inflation the last thing you'd want to do is pay off your mortgage--as long as you were sure you'd keep your job.

You expect housing to rebound. If housing prices bounce back, having a mortgage boosts your equity even faster than the market lifts the price of your house. Say you have a $500,000 house with a $400,000 mortgage. Over the next five years, assume the price rises to $600,000. Your home has appreciated by 20%, but your equity has doubled, from $100,000 to $200,000. It's the magic formula that minted millionaires by the bushel during the real estate bubble.

The problem is, while inflation and a housing rebound may seem likely sooner or later, they're no sure thing. Deflation has ruled the Japanese economy for two decades and real estate is still drastically below its peak in 1990. It's a long shot to happen here, but would you bet the house on it, if you had the choice?

So why did I do it? The logical explanation is that I had enough risk in my portfolio, and as for the low-risk portion of my money, it made no sense to borrow at 3.0% after taxes and invest it at 2.2% in, say, Treasuries. That would be acting like a very dumb hedge fund.

But there's a less rational reason too. Like a lot of post-crisis Americans, I've had it with debt. I don't want to be beholden to a bank and in an uncertain world I'd rather not have the certain obligation of a mortgage payment every month.

I asked Meir Statman, a behavioral finance professor at Santa Clara University about this caution, expecting a lecture about "availability bias," or the exaggerated fear of a bad event simply because it is fresh in memory. (Financial writer Jim Grant calls the current financial version of availability bias "2008 on the brain.") Instead, I was relieved to hear Statman admit that he'd paid off his mortgage too. "Maybe you could earn a higher return by arbitraging the difference between your mortgage and the stock market," he said. "But you have to ask yourself what your money is really for," he said. "Personally, it gives me satisfaction to know that I own the four walls around me. Satisfaction and peace of mind are a kind of return, too." Yes, they are.

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