Should I pay off my mortgage?

Many people misunderstand or misrepresent the benefits of mortgages, and they get the key points wrong. But if you read this article with an open mind, then by the time you finish, we believe you will shift your thinking from “Should I pay off my mortgage?” to “How can I get a bigger mortgage?”

Most people buy a home because they think it will rise in value over time. If you were certain it would fall in value, you might not buy it and possibly rent instead. In fact, your home’s value will rise and fall many times during the next 30 years – you just won’t get monthly statements showing you how it’s doing. Yet, the eventual rise (or fall) in value will occur whether you have a mortgage or not. Your house’s value will be unaffected regardless of whether you’re paying off your mortgage or carrying a bigger one.

That’s why owning your home outright is like having money buried under a mattress. Since the house will grow (or fall) in value with or without a mortgage, any equity you currently have in the house is, essentially, earning no interest. You wouldn’t stuff $10,000 under your mattress, so why stash $400,000 in the walls of the house? Having a long-term mortgage lets your equity grow while your home’s value grows.

Everyone wants to build equity. It’s the main financial reason for owning a house. You can use the equity to help pay for college, weddings and even retirement. Mortgages are bad, many people say, because the bigger the mortgage, the lower your equity.

But think about it differently. Say you buy a house for $300,000 and you get a $250,000, 30-year, 3% mortgage. Your down payment ($50,000 in this example) is your starting equity, and you want that equity to grow, grow, grow.

By making your payments each month, your loan’s balance in 20 years will be just $86,699. This supports the contention that equity grows as you’re paying off the mortgage and that, therefore, the faster you pay off the mortgage, the faster your equity will grow.

But this thinking fails to acknowledge that this is not the only way you will build equity in your house. That’s because your house is likely to grow in value over the next 20 years. If that house rises in value at the rate of 3% per year, it will be worth $541,833 in 20 years! You’ll have nearly a quarter-million dollars in new equity even if your principal balance never declines!

Mortgages, in fact, are often the cheapest money you will ever be able to borrow. Unlike high-interest credit cards or personal loans, mortgages typically have a lower rate and even a fixed rate, helping to ensure that money remains cheap for the next 10, 15, 30 years.

This allows you the opportunity to put funds elsewhere, such as savings or retirement accounts, which could be growing in value at a higher interest rate than it’s costing you on the mortgage. But more on that later in this article.

A question people often have is, “Should I pay off my mortgage or invest?” But those two choices aren’t mutually exclusive.

The interest you pay on loans to buy, build or substantially improve a qualified residence (up to $750,000) is tax-deductible if you itemize your deductions. The deduction is taken at your top tax bracket. Thus, if you’re in the 35% tax bracket, every dollar you pay in mortgage interest saves you 35 cents in federal income taxes. You save on state income taxes too.

Say you’re in the 32% tax bracket and you get a 3% mortgage. That loan costs you 2.04% after taxes. Meanwhile, say you invest money and earn 3%. Your profits are taxed at only 15%, meaning your after-tax profit is 2.55%. Thus, even if your investments earn no more than what you pay for your loan, you’re still making a profit!

When you lock in a rate for a mortgage, you lock your monthly payment for the next 30 years – assuming you don’t refinance or take out a home equity loan.

But over time, that payment becomes cheaper relative to your income – especially if yours is a fixed-rate loan. Payments on such loans will never rise, but incomes usually do.

So as your household income rises over time, your mortgage payment has less of an impact on your overall finances.

Chances are, if you own a home, it is worth much more than it was 10 years ago.

But what if you’re worried that your home’s value will fall?

Should you sell the house before that happens?

That’s not an ideal solution. It’s your home, after all. You have roots in the community. And where would you move? No, selling may not be a practical idea.

If you’re worried that your home’s equity is at risk, you can protect it without having to sell. Simply get a new mortgage and pull the equity out of the house. It’s the same concept as selling, except that you don’t actually have to sell.

Here’s how the idea works: Say you bought a house for $200,000 with no money down (meaning you owe the bank $200,000). Further say that prices have skyrocketed and houses in your neighborhood have been selling for $500,000. You fear that prices will fall, dropping your home’s value to $400,000.

If you sell now for $500,000 (assuming that you can, and ignoring real estate commissions and other selling expenses, and pretending that you still owe the bank the full amount of the original $200,000 loan), you’d pocket $300,000. But you don’t want to sell your home, so instead refinance and get a new loan for $500,000. You now have the $300,000 in hand – just as if you had sold the house.

Obviously, this is an extreme example simply to prove a point. But the real point is that you have options.

Do you still think, “I should pay off my mortgage?” Let’s consider the wealth creation side of this decision.

Mortgages can allow you to create more wealth than you otherwise would.

These two points are related, and together they offer you important benefits to carrying a mortgage.

As mentioned in Reason #6, people get big mortgages on their first home simply because they don’t have a choice. You’re excited about buying a house, and even though you don’t have much money, you have a good income (or two). Some years later, with a growing family, higher incomes and newfound equity in the house, you’re ready to move up to a bigger home.

Let’s say you net $300,000 from the sale of your old house and you’re ready to buy a new home for $300,000.

Should you use all your cash and make a $300,000 down payment? Or should you place only $60,000 down, which is 20% of the purchase price?

If you use all of the $300,000 to buy your new home, your monthly mortgage payment would be zero.

If you make the smaller down payment of $60,000, your monthly mortgage would be $1,011, assuming a 3%, 30-year mortgage.

This explains why so many people prefer to make big down payments when they buy houses. A big down payment translates to a small monthly payment (and in our example, the monthly payment would be zero).

But the people who are trying to ask you to choose between big monthly payments and small monthly payments are posing the wrong question.

The correct question is not about the amount of money you want to pay monthly, but the amount you want to invest. Again, it’s all about wealth creation, not debt elimination.

Would you rather invest:

$240,000 right now, as a one-time-only deposit

Or

$1,011 a month, every month, for the next 30 years?

Obviously, you’d prefer the strategy that results in a higher profit. Everything being equal, regardless of the time period, investing a large amount now can produce better results than investing small amounts over long periods.

Thus, while a low mortgage payment lowers your overall expenses, it also lowers your overall wealth.

But in order to invest that $240,000, you’d have to be willing to accept the higher monthly payment. Where will you get the money to do that each month?

You’ll find the money from two places. First, increase your paycheck. Remember that the new loan payments are almost entirely tax-deductible interest. That means you don’t need to have as much money withheld from your paycheck. Ask your tax preparer how best you can file a new IRS Form W-4 at work to increase your exemptions; this will reduce the amount of taxes that are withheld from your paycheck, boosting your net pay. Yes – you’ve just given yourself a raise! And you can use this increased paycheck to help you pay for your new mortgage payment.

Second, if your paycheck isn’t enough, simply make periodic withdrawals from the investment account you’ve just created. Soon enough, as your income rises, you won’t need this crutch; your income will become enough to handle the cost, as referenced in Reason #6.

In fact, getting a big mortgage and using investment proceeds to help you make the payment is superior to getting a small mortgage and having no proceeds to invest.

To help explain this, let’s introduce you to Nervous Nick and Smart Sam.

They have the same income and expenses, and are in the 24% tax bracket. Each has $100,000 in cash; each wants to buy a $300,000 house.

Smart Sam gets a $240,000, 30-year mortgage at 3%. He makes no extra payments (and definitely isn’t wondering, “Should I pay off my mortgage?”). But Nervous Nick takes a different approach. Nick hates mortgages and fears that if he has a mortgage, he might one day lose his house. He doesn’t quite understand how that could happen, but someone told him that mortgages are bad and he believes them, so he goes with a small mortgage. That means he uses his entire $100,000 in cash to make a down payment. His mortgage is therefore smaller than Smart Sam’s – $200,000.

Nervous Nick also gets a 15-year loan instead of a 30-year loan, because he wants to get rid of his mortgage as quickly as he can, and he figures the 15-year loan will let him get rid of his loan in half the time. Nick also knows that this garners him a lower interest rate, because lenders charge less for 15-year loans than they charge for 30-year loans. So while Sam is paying 3%, Nick is paying only 2%.

Nick, in fact, is so obsessed with getting rid of his mortgage that every month he sends an extra $100 to his lender. He knows that the more he sends in, the faster his loan will be paid off. So, compared to Sam, Nick has a smaller mortgage, a shorter mortgage, a lower interest rate – and he’s adding money to each payment.

Smart Sam’s monthly payment is $1,012. Thanks to amortization, 59% of Sam’s payment is comprised of interest. Thus, on an after-tax basis in the 24% federal income tax bracket, Smart Sam’s payment costs him $862 a month.

Meanwhile, Nervous Nick’s payment is $1,387 a month. But only 24% is interest, because Nick’s loan is for 15 years. The shorter the term, the more principal he must pay each month, and principal payments are not tax-deductible (only the interest is deductible). So even though Nervous Nick is paying more per month than Smart Sam, he’s deducting less. Nick’s after-tax cost, therefore, is $1,304.

Thus, Smart Sam is paying $442 less per month than Nervous Nick. But Nick doesn’t mind the extra monthly cost because he knows he’ll get rid of his mortgage quicker.

So for the next five years, Smart Sam makes his monthly mortgage payments. And instead of sending an extra $100 every month to his lender like Nick does, Sam invests that $100 in the stock market. Then both men lose their jobs unexpectedly, causing their income to fall. Sam will be in a much better position than Nick. Why?

Nick’s been busy paying down his mortgage; the outstanding balance is only $134,000. He might have lost his job, but still must make his monthly mortgage payment. So it doesn’t matter that his mortgage balance is $134,000; what matters is that his mortgage payment of $1,387 is due at the end of the month.

This is a real problem for Nick, because with no job, he has no income. He also has no money, because he’s given every available dollar to the bank in the form of extra loan payments. Nervous Nick’s nightmare is coming true – he’s about to lose his house!

Although Sam’s mortgage balance is higher than Nick’s, Sam is in a much better financial condition. He’s not in the same predicament as Nick, because Sam has lots of savings. First, he gave the bank a smaller down payment, enabling him to invest $40,000. Based on an average annual return of 7%, that money grew to $56,102.

Sam also took advantage of the fact that his monthly payment was $442 less than Nick’s; he invested that money too, which is now worth $31,121. And instead of sending $100 a month to his lender like Nick, Sam added $100 to his investments; those investments are worth $7,041. All told, Smart Sam has $94,264. So even though he’s out of work, he’ll be able to make his mortgage payments for another six years!

The irony is that Nick, who wanted to pay off his mortgage so he wouldn’t lose his house, is about to suffer the fate he was so desperately trying to avoid. This demonstrates why it is so important to minimize both your down payment and your monthly payment. By doing so, you retain more control over how you save or invest your money.

By keeping control over access to your money, you maintain liquidity. After giving money to your lender, you lose control of it and the only way to get your money back is to sell the house.

This reveals a fatal flaw in the logic that some people believe in about mortgages. Sure, owning a home mortgage-free is an appealing concept, but it is unrealistic. Paying off your mortgage is great – if that’s the only thing you need to do with your money. But what about paying for college? Saving for retirement? Caring for elderly parents? Paying for major repairs? Especially with the pandemic’s effect on the job market and people’s financial stability, the added flexibility and liquidity of having free cash and a big mortgage has its advantages.

The fatal flaw of those who make you wonder, “Should I pay off my mortgage?” is that they may not be considering everything else going on in your life. If you succeed in paying off the mortgage quickly, you might fail in paying for college or covering costs in the event of a job loss, medical problem, marital issue or other family concern.

We encourage you to rethink that the only important financial decision is paying off a mortgage. Life is more complicated than that, and by realizing this, you can see that trying to pay off the mortgage like Nervous Nick is actually a risky thing to do. Instead, the smarter and more efficient approach to wealth creation is to carry a big, long mortgage and don’t rush to pay it off!

You want to eliminate your mortgage so that you don’t have to make any payments in retirement. Unfortunately, even if you somehow pay off your mortgage, you won’t eliminate your payments.

Paying off your mortgage means you no longer make any principal or interest payments. But mortgages are known as PITI, and we’ve only addressed the P and the I. Let’s not forget about the T and the other I – or the M and the R.

We’re talking of course about taxes and insurance. Even if you manage to pay off the loan, you’ll still have to pay property taxes and homeowners insurance. Thus, your goal of “getting rid of the monthly payment” is impossible, because even if you eliminate the mortgage, you’ll still have tax and insurance payments.

And as long as you own your house, you’ll have maintenance and repairs to contend with as well. So don’t bother trying to make your mortgage go away. Stop wondering whether you should pay off your mortgage. Instead, your focus should be to create wealth so that you can comfortably afford the cost of living in, enjoying and owning your home.