Would paying off your mortgage be a smart use of your money? Mortgage rates are so low these days that home loans seem like a bargain. But when you dig into the details, it turns out that paying off your mortgage—or paying down your mortgage if you can’t afford to pay it off entirely—often still is a savvy money move.
Most homeowners no longer take a deduction for mortgage interest from their taxes. Because of tax-law changes that took effect in 2018, nearly 90% of taxpayers are expected to take the standard deduction—eliminating one of the big benefits of having a mortgage. And although mortgage rates are enticingly low—many homeowners are paying 3% to 4%, or even less with recent rates—yields from high-quality bonds are even lower, making them less attractive as an investment.
The Vanguard Total Bond Market Index Fund recently yielded just 1.17%, for example. If you have a mortgage and also have bonds in your portfolio, you’re essentially borrowing money at a rate that’s probably between 3% and 4% in order to earn around 1% from that bond component of your portfolio, a bad financial strategy. You likely would come out ahead if you took at least a portion of the money you have in bonds, certificates of deposit (CDs) and/or money-market funds and used it to pay off all or part of your mortgage.
Of course, a big portion of your investment portfolio may consist of stocks, so you may be thinking, Selling bonds to pay off the mortgage would leave me with a portfolio dangerously weighted to stocks with not enough bonds. But in reality, it would have much less of an effect on your portfolio balance than you might imagine—more on that below.
Financial planners rarely recommend paying off a mortgage, but I believe that’s because many of them are compensated either based on a percentage of the assets under management or on commissions from investment transactions. When clients use their assets to pay off their mortgages, financial planners typically earn less.
The Faulty Arguments Against…
When people argue against paying off a mortgage, they tend to raise the following points, none of which hold water, in my opinion…
My investment portfolio is earning more than my mortgage rate, so I’ll come out behind if I pay off the mortgage. Reality: You won’t come out behind when you take risk into account. Your investment portfolio is earning more than your mortgage rate because your investment portfolio likely includes stocks and/or other volatile investments. That does not necessarily mean you should be selling off your stock portfolio, but be aware that it could decline in value for long periods of time. In contrast, paying off a mortgage that has a 3% or 4% interest rate is like investing in a risk-free money-market fund paying an after-tax return of 3% or 4%. That’s a much better return than you’d actually get from a no-risk investment—money-market funds generally pay 0.75% or less these days. If some portion of your portfolio is in high-quality bonds, CDs or other fixed-income investments, it’s the risk-adjusted after-tax returns on the bonds that you are considering selling that should be compared to the potential upside of paying off the mortgage.
Your mortgage is effectively a negative bond in your portfolio—it’s akin to a bond that you have issued, where you are paying interest rather than receiving it. So the outstanding balance of the mortgage should be subtracted from the value of your bond portfolio when calculating your fixed-income exposure. With that in mind, take a new look at what your relative allocations are between fixed income and equity, and consider what they should be.
Of course, you could sell off part of your stock portfolio instead of or in addition to part of your bond portfolio to raise money to pay off your mortgage, if that results in a better mix between fixed income and equity. That mix will depend in part on your risk tolerance and age. Keep in mind that you can think of having a mortgage as essentially borrowing money to invest in the stock market and pledging your home as collateral—a strategy most people would consider too risky if they took the time to look at it this way.
If inflation shoots up, I’ll be happy that I have a low-rate mortgage. Reality: If you also have money in bonds, those bond investments would decline in value if inflation shoots up, offsetting any upside in having the mortgage. So selling off bonds to pay off your mortgage will not leave you any worse off if inflation suddenly skyrockets.
How to Decide
Questions worth considering when deciding whether to pay off a mortgage…
Can you do so without sacrificing necessary liquidity? If having money in CDs or low-risk bond funds helps you sleep at night, then you might reasonably keep this emergency fund and not pay off your mortgage. But consider that what you really need in case of emergency isn’t cash—it is access to cash. That access could alternatively be provided by tapping a home-equity line of credit (HELOC) that you previously established or by selling stocks. Neither of these strategies is perfect—a lender could cancel your HELOC, for example…and selling stocks could trigger a tax bill—but between the two you should be able to weather an unexpected financial storm at least as well as you could with perhaps six months’ worth of expenses stashed in an emergency fund. And paying off your mortgage doesn’t mean you won’t have bond investments or an emergency fund forever—set up automatic monthly transfers from your bank account to an investment account in the amount you previously paid on your mortgage, and you can quickly rebuild your cushion.
Can you pay down your mortgage by tapping tax-advantaged retirement accounts? You can, but you’ll likely have to pay taxes and possibly a penalty (if you are under age 59½) for using these funds. That may not be worth it.
Do you have other debts? If you have credit card debt or other debts with higher interest rates than your mortgage on an after-tax basis, pay off those before paying off your mortgage.
Does your mortgage have a prepayment penalty? These are rare, but some mortgages impose an added fee if the loan is paid ahead of schedule. Ask your lender if you would face a prepayment penalty and, if so, when it disappears—most prepayment penalties apply only during the early years of the mortgage.