Grace Dunklee Cohen wasn't going to take any chances with the last payment on her home in Henniker, N.H. in 2003. She very carefully wrote the check and put “final payment” on it. Then she went to the post office just to make sure. “When I put it in the box,” the divorced mother of two says, “I had a moment of gratitude and just a tremendous feeling of freedom. It was a very uplifting moment for me.”
But was it the right thing to do? Is paying off a mortgage early a good idea or a fools errand? Sometimes the answer to that question depends upon whom you ask.
Michael S. Rosenbaum is a mortgage loan originator at First California Mortgage Company in San Diego. He says the American dream is to take out a mortgage on a home, pay it off and retire.
“The bottom line is, from cash flow perspective if you can reach retirement and not have a $2,500 a month mortgage payment, it makes a big difference,” Rosenbaum says. “It is like having that $2,500 as income.”
But, on the other hand, Rosenbaum says it isn't difficult to find investments that outperform the historically low interest rates on mortgages. Sure, paying off a current mortgage would save 3 percent or higher, depending on the mortgage's rate. But finding an investment that returns more than 3 percent is not a difficult task.
“Right now money is so cheap,” he says. “It becomes the difference between how much money you can make on your investments versus how much you are paying in interest on the other side. If you do it right, you can get to the end of the term and just pay off the loan in one lump sum.”
David Rae, vice-president of client services at Trilogy Financial Services in Los Angeles, says for most people, their mortgage is the single biggest payment they make every month.
“People don't like to have that big debt there,” he says, “they don't like to have that mortgage payment.”
But if people pay their mortgages off, he says, they lose the tax deduction. They lose flexibility.
Once a person stops working, it is also very difficult to refinance, Rae says. “All of a sudden you have this big asset that isn't producing any income,” he says, “and you don't really have any access to get the money out of it.”
Bruce Ailion, a real estate agent with Re/Max Greater Atlanta, also worries about people coming up against “lightning strike events” and not being able to get money out of the house.
But for most financial experts, it is all simple math. Todd R. Tresidder was single, had a large income as a hedge fund manager and bought a nice condo.
“I was just determined to be out of debt,” Tresidder says. “I was going to throw all my income at it and pay it off in a really short period of time.”
He did it in less than two years. But it ended up costing him more than a million dollars, he says.
It turns out the other investments he made did really well and doubled the next year and, compounded, have increased in value to this day. All that extra money he put into the condo, didn't. “I lost a fortune,” he says.
He went from a “pay off your mortgage” advocate to a “never pay off your mortgage” advocate. But not for long.
It isn't easy to decide to pay off a mortgage early or to invest that money instead. Just comparing the interest rate on the loan versus a projected interest rate on an investment isn't enough. People have to watch out for pre-payment penalties. Other factors include the mortgage tax deduction — and how much interest a person is still paying versus principle. A person could also get a deduction by paying the house off early and then, instead of paying thousands in interest to a bank, pay that money to a good cause and get a deduction that way.
After Cohen sent off that last check at the post office, she felt free to do more with her money.
“A staggering amount of the total cost of the house is interest,” she says. “I don't know why people don't look at that. When you think about it, there are a lot of better ways to invest your money than in interest. … If you want a deduction, take the money and put it to a good cause. Then you feel good about it and get the charitable deduction instead of paying interest to the bank, which really benefits nobody.”
And, as Cohen said many times in her interview for this article, this freedom gives her a wonderful feeling.
This is why Tresidder, the founder and financial coach at Financialmentor.com, even after losing a fortune paying off his condo, isn't as demanding about not paying off a mortgage these days. He wrote an article on the subject and determined that there are two big answers to consider when deciding the question of whether to pay off a mortgage early.
Emotion and math
“There is no right answer,” Tresidder says. “There is the mathematical answer and the emotional answer.”
The mathematical answer is people should do whatever gives them the highest return. Which would mean, he says, that people would rarely pay off their mortgage early. “If you have a mortgage at current interest rates of say 4 or 5 percent, odds are the long-term return from investing, unless you are very incompetent, will exceed that,” he says.
But life isn't that simple because there is also the emotional answer.
“The assumption that we all value maximum mathematical expectancy from our money is not true,” Tresidder says. “We have all kinds of different emotions tied to our money. We have all kinds of different goals. And for some goals it makes sense to pay it off early, for others it does not.”
If, for example, people's primary goal is security, Tresidder says getting out of debt is a good idea. “So in that sense, it makes sense to pay off the mortgage early,” he says.
This means the answer is different for different people. If the goal is maximum wealth, the analysis of the situation is going to be different than if the goal is maximum security.
But even if someone has the goal of paying off the mortgage early, that doesn't necessarily mean that goal should trump all other financial goals.
First things first
Tresidder says other more important goals could include maxing out a 401K plan at work. “Some companies offer a 50 percent match on that 401K,” he says.
That is an automatic 50 percent return on an investment.
The same approach should be taken with other retirement plans.
High interest debt also should be paid down first — such as credit card debt.
The danger of paying off a mortgage early is that the money becomes illiquid, tied up in the house. In an emergency, a person may be forced to get a loan to get that money out of the house. This is one of the main dangers Ailion and Rae were concerned about.
This is why Tresidder and other experts recommend keeping three to six months of cash in a liquid, easy-to-access emergency fund.
“There are dimensions and complexity to this,” Tresidder says. “I'm not even being rational myself.”
Tresidder doesn't want to pay off his mortgage early, because he can get a higher investment return. But, on the other hand, he doesn't want to pull equity out of his house to increase his investment capital either. “You can't have it both ways,” he says.
And yet he does.
“I'm as irrational as the next guy,” he says. “This is a values-based decision and it is going to be shaped by your past history with debt as well as investing.”
People who have had a bad experience with investing (2008 anyone?) may feel that paying down their mortgage is the only secure thing they can do. “That is fully shaped by their losing money in their investing,” Tresidder says. “It is really important to see how your values are shaping your choices. We are not computers, and this is not a fully rational decision. Some people approach it as simply a mathematical expectancy decision of whatever gives the highest investment return. That is incredibly naive.”
Understanding that there are multiple valid ways to approach the question can help when spouses disagree as well. One may want security in the home, the other may want financial freedom. “It isn't like they are opposites,” Tresidder says, “but they can result in arguing over which one is the appropriate approach to take.
Settled and secure
Terry Moore in American Fork, Utah and her husband were on the same page. When Moore's husband became very ill, they planned for her to take the proceeds from his life insurance and pay off their home. After he died last November, Moore made a money transfer to the credit union that held the mortgage.
“Everyone says, 'Don't you feel wonderful now that you paid off your house?'” she says.
Because the money came from the life insurance, Moore says she doesn't feel the elation other people might feel. One financial counselor was initially concerned when he heard she had paid off her home, but Moore thinks it was the right thing for her. “I feel like I'm hedging my bets,” she says. “It's done, it's off my plate and I feel good about it.”
For some people, it is strictly mathematical money augmentation. For others, it is about security and risk aversion. Tresidder says it doesn't have to be an all or nothing proposition, people can do a little bit of both if they wish. A person can pay off a mortgage a little faster while still investing other funds.
But every month, when a mortgage payment doesn't come due, Moore, Cohen and many others smile. “I'm satisfied,” Moore says, “I'm deeply satisfied, settled and secure that it was the right thing to do.”