En español | Tens of millions of Americans can earn a risk-free 3 to 6 percent annual return by paying down their mortgage. Can it get even better? Yes, it's quite often tax-advantaged as well. If you have enough money in the bank or in investments to do it, consider the logic behind my claim and why you rarely hear this advice.
First, it's important to understand that a mortgage is merely the opposite of a bond. When buying a bond or bond fund, you are lending money to corporations or governments that, in turn, pay you interest and your principal back, unless there is a default. Minimizing the risk of default is why bonds should be boring. When taking out a mortgage, you are paying a bank or other party principal and interest, which must be paid back irrespective of whether your house appreciates.
Let's take an example of a consumer with a $100,000 mortgage at 4 percent annual interest and who is in the 30 percent marginal tax bracket (combined federal and state). He or she could invest in high-quality bonds such as the iShares Core U.S. Aggregate Bond ETF, or a five-year CD, both yielding about 2.25 percent. By doing so, they would earn $2,250 before taxes and $1,575 after taxes.
If they instead paid off their mortgage, they would save roughly $4,000 in interest payments, possibly lose out on $1,200 of interest deductions, and have a net savings of $2,800. So I make the case that the consumer comes out at least $1,225 ahead by paying off the mortgage. The consumer pays more in taxes but, much more important, makes more money after taxes.
In many cases, I've found the consumer isn't even getting the full value of the mortgage deduction. If their income is fairly low, they'd do better by taking the standard deduction instead of itemizing their deductions. If they have high income, tax law hits them in other ways, such as phasing down the mortgage deduction. So paying down the mortgage is tax-neutral at best and often tax-advantaged.
Faulty arguments against paying down the mortgage
Here are three of the most common arguments I regularly hear to counter my advice.
- A more balanced portfolio of, say, 60 percent stocks and 40 percent bonds can earn more than what you'd gain by paying down your mortgage. Though this may be true, it is more a case of comparing apples to oranges. This argument is analogous to taking out a margin loan on your brokerage account to buy more stocks. You might earn more if your stocks go up, but I would not recommend it, even though margin loans are often at lower rates than mortgages. Also, I've heard this argument for decades and, so far this century, bonds have outperformed stocks. Borrowing to buy more stocks has backfired.
- You don't want to put more money into the house. While I agree with this statement, it's irrelevant. I'm not suggesting a house remodel here. Again, paying down the mortgage has no impact on the price you ultimately sell your house for.
- If you don't fully pay off your mortgage, your monthly payment typically will not change. This statement is also true, but it's not the full picture. Because a much greater proportion of the monthly payment is going toward principal as you pay down your mortgage, the mortgage is paid off much sooner and you still save the interest payments.
The one valid argument for not paying down the mortgage, assuming you have the money to do so, is that you may need the cash to live on. Once the mortgage is paid down, it's not so simple to borrow the money again. Though there are ways to get access to cash, such as a home equity line of credit, you should feel comfortable about not needing the money you'd use to pay down the mortgage.
Once the mortgage is fully paid off and the consumer still has income, I recommend continuing to make the monthly payments to a savings or investment account.
In deciding whether this advice is right for you, keep two things in mind:
- Neither banks, brokerage firms nor financial advisers benefit from this advice. Banks want you to keep paying them monthly interest on your mortgage. Brokerages and financial advisers would rather have you invest with them the money you'd use to pay off your mortgage. This is why the conventional wisdom you often hear from the financial industry is to keep your mortgage.
- Think about it: Have you ever met anyone who regretted paying off their mortgage?
So if you have enough access to liquid investments and you don't mind cutting my industry out of profits, consider paying down the mortgage.
Author's note: In full disclosure, I've twice taken out a mortgage from a credit union, then deposited 100 percent of the funds in CDs at the same credit union. In effect, I borrowed money and lent it back to the same credit union at a higher rate. These virtually risk-free opportunities are rare.
Allan Roth is the founder of Wealth Logic, an hourly-based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.