[Editor's Note: This is one of my regular columns from MDMagazine which was inspired by Stephen Nelson's 2014 post Why Early Mortgage Repayment Makes Sense for High-Income Investors. It seems appropriate to mention something about standing on the shoulders of giants with this blog as much of what I write about has been said before in other ways and other places. At any rate, today we're going to be talking about paying off your mortgage early. Regular readers know I have mixed feelings (and an update) on this topic, of course, and this post is pretty much written from just one perspective. Remember it's titled “6 Reasons the Rich Should Pay Off Their Mortgage Early” not “YOU Should Definitely Pay Off YOUR mortgage early.”]
Most Americans have a financial goal to have a paid-for house. Many would even like to pay the house off in less than a standard 15-30-year time period. However, the truth is that most Americans probably shouldn’t be paying off their mortgage early. This is because they usually have a better use for their money. On the other hand, it is far more likely to be the right move for a wealthy, high-income professional. This article will detail six reasons why.
Why The Wealthy Should Pay off Their Mortgage Early
1. Compare to a Taxable Account
Joe Average has a household income in the $50,000-100,000 range. He is almost surely not maxing out a 401(k) ($18,000 employee contribution if under 50) and a backdoor Roth IRA for himself and his wife ($5,500 each). That would require a 29-58% savings rate, which is extremely rare at any income, but particularly for the middle class. Thus, if he chooses to pay down the mortgage with his extra funds, he is by definition passing up the opportunity to have tax-protected growth for decades, an extremely valuable benefit.
A high-income earner on the other hand, especially one who saves enough to now be wealthy, is probably maxing out all available tax-advantaged retirement accounts. So when she considers paying down her mortgage, she is comparing that to investing in a fully-taxable, non-qualified investing account, which is not nearly as good a deal.
2. Higher Tax Rates
Even if a low earner is investing in a taxable account, she may pay very low taxes on those earnings. If she is in the 10% or 15% bracket, she pays a rate of 0% on her long-term capital gains and qualified dividends. A high earner, however, is paying at least 15% on those earnings, and possibly as much as 23.8% (not including state income taxes.) This lowers her after-tax return such that her mortgage starts looking even more attractive.
[Update July 2018: This becomes even more significant now with the higher standard deduction, as most people, including many high earners, are no longer itemizing their mortgage interest, raising the after-tax yield on paying off the mortgage.]
3. Lower Marginal Utility of Extra Wealth
Many advisors recommend carrying low-interest-rate debt on purpose so you can invest instead and hopefully earn a higher rate. Aside from the obvious error of not comparing apples to apples risk-wise (they should be comparing the after-tax mortgage interest rate to the after-tax return on a very safe investment such as treasury bonds, CDs, or a municipal bond fund), they are ignoring the marginal utility of wealth.
4. The Ultimate Luxury Good
]Many times the wealthy buy something simply because they can and they enjoy the extra bit of luxury it affords. That might mean flying first class, driving a Lexus instead of a Toyota, or carrying around a Birkin bag. A paid-off home can also be a luxury good. The wealthy simply don’t have to leverage their home in order to reach their financial goals, so they choose not to, because they can. As debt-elimination guru Dave Ramsey likes to say, “The paid-off home mortgage has taken the place of the BMW as the status symbol of choice.”
5. Deflation Protection
A fixed-rate mortgage provides inflation protection. If inflation goes up, it becomes easier and easier to pay that debt. However, a mortgage is a big risk in a deflationary scenario. All of a sudden you are paying that debt back with more and more valuable dollars, all while your income is dropping. The wealthy are likely to have better inflation protection already in place than the middle class. These may be investments such as stocks, real estate, I bonds, and TIPS. Also, the businesses that the wealthy own and the jobs they typically have are generally better inflation hedges than the less secure and less lucrative jobs Joe Average holds.
6. Lower Advisory Fees
Average Joe generally can’t afford good advice, which often isn’t available until a portfolio reaches a size of $500,000 or more. He is left to his own devices or perhaps the “advice” of a commissioned mutual fund salesman or insurance agent. A wealthy high-earner, however, often engages a fee-only advisor who charges a fee, often 1% or more, of the assets under management. Every dollar invested increases those fees. But a dollar that is paid toward a mortgage does not. That has the effect of increasing the “return” on the money used to pay off your mortgage by 1%.
A Reason for Both High and Low Earners
Another great reason to pay off debt, whether student loans or a mortgage, is that it increases your financial freedom and allows you to take risks and take advantage of opportunities you would not otherwise be able to do. However, this aspect really isn’t any different for high earners than for low earners.
Now we're in the CoronaBear downturn. It's been 3 years since we paid off our mortgage. I don't think I've ever regretted it, but I'm particularly grateful not to have that expense these days.
They even let you keep the uniform when you get out
In conclusion, whether you pay off a mortgage or invest is always an individual decision and many factors should be considered. However, all else being equal, a wealthy high-earner should be much more interested in paying off her mortgage than someone with a five-figure household income.
What do you think? Did you pay off your mortgage early? Do you plan to? Why or why not? Comment below!
Yes. I was glad to be debt free. I also was paying 10k per year in interest that I don’t now. Lower living expenses gives me freedom to cut back at work. The equity has also appreciated but that is just icing on the cake.
Even better than paying off a mortgage is starting without one. This is the route we chose when making our most recent move 2.5 years ago to a low cost of living area.
We found a great home, offered cash (putting ourselves in a good negotiating position) and were able to close quickly with fewer forms and fees.
Thank you for clarifying the Pease provision as an effective increase on the marginal income tax rate. I see this misunderstood, even on other personal finance blogs, and used as a reason to avoid charitable giving, which I find bothersome.
Best,
PoF
I agree. Lots of people, including Congress who implemented them, don’t understand the real effect of it.
The Pease deduction is only an increase in your marginal tax rate only if you have enough deductions.
Consider a family living in a state with no state tax and low charitable contributions. You can without a doubt create a scenario where donating $1K does not get a tax deduction because of Pease.
While its true that the Kitces article on the Pease law does a great job of showing why tax deductions like mortgage interest still have some value for higher income earners, what remains noteworthy is: Everyone today is buying/refinancing at lower and lower interest rates, paying less and less annually in mortgage interest. Meanwhile the standard deduction goes up annually (with inflation, which is admittedly low), meaning that the value of the mortgage interest deduction has been declining a great deal as these two numbers trend towards each other. So in general the interest deduction is a lot less valuable than most people think.
It all depends on the person, of course. I give enough money to charity and pay enough in state taxes that I won’t be anywhere near the standard deduction any time soon. I think my itemized deductions were high five figures last year, maybe more.
Instead of comparing the paid off mortgage to taxable accounts.. Would it be a fair comparison with real estate investment properties? would it still make sense to pay the mortgage off early vs leveraging the surplus funds for rental properties i.e. appreciation, cash flow, depreciation, principal payed off by the tenants? Wouldn’t the ROI potentially far exceed what can be done in taxable accounts, REITs, etc? I’ve went from paying the mortgage off aggressively to investing surplus funds into taxable mutual funds as I believe the WCI does.. With the intent to pay off mortgage.. To now considering buying more investment property? I think Mark Koehler makes a good point and financial strategy to buy one property a year.
Yes, the ROI of a leveraged investment that goes up would potentially exceed that of paying off a mortgage. Whether that levered investment is stocks, bonds, real estate or whatever it’s the same principle. Of course, that’s ignoring risk. Once you calculate that in it might not be such an attractive trade-off.
The point of this article is the comparison is different for a wealthy high-earner than more middle class folk.
Nice post WCI. Reasons 3 (Marginal Utility) and 5 (Deflation Protection) resonate the most with me. I found thinking in absolute dollars instead of comparative rates helped me decide to pay down mortgage. In 2010, we were paying over 18K in interest. In 2015, after refinancing and paying down the principal, we were at 8K. At some point, I’ll probably just decide the annual interest is worth the liquidity and stop prepaying, but I am not there yet.
I think one thing that is difficult to change is the mindset. We as a society are so accustomed to mortgages that they are viewed more as a monthly bill like the water bill then a major debt like student loans. Obviously a debt is a debt but it still takes a bit of a change in approach/general mindset.
Absolutely. Now people with solar panels might not have an electric bill any more, so I guess that’s similar.
FYI….ROI on good Solar Panels depends on what state you live in and how much your electric bill is along with what any local rebate will be. Fed rebate ends this year. My ROI on Solar will be about 8-9 years. However in a place like California where electricity is very expensive, solar ROI would likely be half that or less.
I have a feeling all those that rushed in to buy solar, but more so those that leased will regret that decision, or those companies will go bankrupt as massive defaults and new owners refusing the lease comes online.
The rates are terrible and have large built in yearly increases. Technology will continue to improve and drive costs down faster than anticipated, and in ten years it will be much cheaper for something much better. Plus just other people buying will end up decreasing the cost of peak electricity for everyone else as well, decreasing the value proposition in the first place, good for all. Interesting stuff out there on slope of moores law for different techs and solar in particular.
For us, in CA, and including the federal tax credit, the payback time for solar panels was about 3 years. I realized that solar panels are coming down in price as the years go by, but with that quick of an ROI, and a potentially expiring tax credit, does it really pay to wait until then?
Cali is a different market than anywhere else I think. Your electric costs are super high, and buyers seem to value the solar panels, unlike most here. (I’ve know people that actually see solar on a house and don’t even want to make offers because of it.) I would still run the numbers, and use about half of what they say you will produce as it’s more accurate with clouds, shade from a palm tree, the dust that collects on them etc. I’ve not once got the amount of electricity that they claimed I would.
ROI on solar only makes sense with rebates, otherwise it’s a 25 year recoup usually, and I ran my numbers in a southwest sunny state. Most people wont even be in their house long enough to recoup the initial outlay.
Run your own numbers, but for me it didn’t make sense financially. There are other reasons to do it, but financial may not be one of them.
Deflation, historically, doesn’t last very long, maybe a few months to a year. Pre-paying a mortgage to protect yourself from an unlikely or short term event, would could be expensive. Physicians are largely protected from the main downside of deflation which is job loss. Long term inflation is a more likely scenario and low rate, fixed, long term mortgage is an excellent inflation hedge. I manage my mortgage like an investment. If Stocks in my taxable are up and I can reap the profits in the 0% cap gains bracket, I have the option of paying down the mortgage with these funds.
Why would I expose more Home equity to creditors?
In such a low rate environment, why wouldn’t I want to lock in these low rates for as long as possible? I can’t exploit these historic low rates in my bond investments, but I can on the borrowing side.
Stock and bond investments can be tax loss harvested, a drop in Home value cannot.
Okay, I’m going to argue with you and Sam for a bit. Not because I think the points you’re making are stupid (they’re not, and I obviously have mixed feelings on the subject in my current financial situation as discussed here: https://www.whitecoatinvestor.com/my-quest-to-become-debt-free/) but I think there is some fallacy in the arguments. Remember we’re talking about wealthy, high-earners here.
You are suggesting that deflation protection isn’t worth much but that inflation protection is a much bigger deal. I agree with your basic premise that inflation is more likely than deflation. But my point is this: If you’re wealthy, this mortgage is a relatively small part of your financial world. For example, my mortgage is just over 10% of my net worth. Paying it off isn’t going to give me much deflation protection, and keeping it isn’t going to give me much inflation protection. And besides, just as a doctor’s income is pretty protected in a deflation situation, it is also pretty protected in an inflation situation.
Now, you bring up some weird idea where you can reap the profits from stocks in taxable at 0%. I would respond that a wealthy high-earner can’t reap profits at 0% and that’s what this post is about.
Regarding the asset protection issue, remember this is about wealthy high earners who are already maxing out their retirement accounts. Their choice is unprotected home equity (in most states, obviously in Texas or Florida paying that mortgage down is even better) or unprotected taxable investments.
The fallacy with your low rate environment is that assumes rates are going to go up. I would point out that people have been saying rates much go up ever since 2009. But they haven’t really moved. In fact, they are even lower now than 5-6 years ago. And Japan’s rates have stayed low for decades. Rates don’t HAVE TO go up in the time you have left on your mortgage. There’s no exploiting a low rate fixed mortgage if rates never go up.
From a total part of your financial portfolio it makes sense, as well as freedom and ability to just do whatever, there is no better place to be than debt free. Maybe once you’ve put together a nice nest egg and are filling all other buckets this does start to make more sense…I will have to see when those days arrive.
We have differing opinions on this in different scenarios, with mine mostly being tied to the normal situation of inflation, and the probability that you live in the same house for 30 + years. I realize people do this, but just cant see that as a reality for most people.
I also cant get over what seems to be a behavioral irrationality of making an effort to pay today, in order to save yourself from a discounted (in real terms) payment in the future. When phrased how it mathematically is, no one would choose that for most things (obviously not counting freedom and associated other values, etc…).
Agree that rates do not have to go up and would further argue they will not (much), and certainly not to the level of anchor bias the boomers have from the 80s which they seem to believe is the correct level. It is really reflecting the slower rate of growth and risk in the developed world now, it can go up some, but doesnt make a lot of sense for it too outside some new thing that vastly changes the world. However, you dont exploit a low rate mortgage with its rate relative to future higher rates, but by it in relation to compound inflation which even when low adds up. Otoh, if inflation is severely muted you are entirely correct.
Good point on the state dependent scenarios as that definitely changes things.
I meant cumulative, not compound.
When I read #5 about deflation I couldn’t help but think about how the economics of healthcare today (e.g. declining reimbursements) may amount to a sort of doctor-specific deflation to many. I have tended to assume the worst – that I am making more today than I will 5-10 years from now – in which case having a paid off mortgage will be a big deal. Now if I’m wrong then I’ll be pleasantly surprised (and wealthy). But if I’m not wrong then I’ve paid the biggest expense of my life when I had the money to do so, which is a big thing not to have to worry about.
Excellent point.
This is our exact view. Our income is potentially the highest it will ever be right now over the next few years, so we are stuffing all our retirement accounts, college accounts, and paying the mortgage down aggressively (even though we are just above 3% on a 15 year) with the mindset that we may not be able to do this is 3-5 years (wife ‘retires’ from corporate America, decisions to go part-time at a young age, sell one of the businesses, etc).
Knowing the plan we still struggle with the decision on a monthly basis it seems, so reading this article and comments was fantastic.
Agree with this.
One big fallacy in most folks mind is the illusion that you can be a homeowner and be debt free at the same time. This is not possible due to property taxes. As long as you own a home , state, cities and municipalities can and do exercise their rights over your wealth to pay for their debts.
Historically including the recent booms / busts, residential properties appreciate apron 1 % annually. Additionally, depending which state you live in, and homestead laws, equity in your house could be accessed by creditors. Finally, if you or your spouse get ill and requires nursing home or ALF, state will count equity in your house as an factor to determine if you will qualify for financial assistance.
Under current tax laws for high wage earner their is no financial benefit of not having mortgage other than piece of mind. For some this maybe reason enough to pay it off early.
Give me a break Sam. If you stop paying your mortgage, the mortgage company institutes foreclosure proceedings within about 3 months and you’re out in 6. If you just paid your tax bill and then hit some financial calamity, you’ve got 12 months covered already. Then it’ll probably take your city another 2-4 years (5 in California) before selling your house on the courthouse steps for past due taxes. Besides, the tax bill is generally many times smaller than the mortgage bill and far easier to pay in the event of calamity. In fact, it’s probably smaller than the rent on a 2 bedroom apartment in the same town. Granted, there are some very high property tax areas, but that’s the case in mine.
The creditor issue I discussed in my reply to Mark.
The nursing home argument is bizarre. We’re talking about wealthy people here. They can self-insure their long-term care.
I disagree that “there is no financial benefit of not having a mortgage other than piece of mind.” That’s just minimizing your opponent’s argument. There are many benefits- more freedom in taking a job that pays less, better cash flow, eliminated risk of foreclosure by a bank, deflation protection, additional buffer or opportunity via a HELOC/home equity loan etc etc. Lots of benefits. Whether they outweigh the benefits of keeping the mortgage depends on your perspective. I hope to soon be in a position where it simply doesn’t matter what I do with my mortgage because it is a tiny piece of my financial life, like the brand new boat I bought last year or the brand new SUV I bought last month.
I do not get your point in the first paragraph, so no need for us to revisit it.
By Rich I assume you mean typical physician. Many “rich” folks cannot afford to pay 90 – 135K out of pocket for 10 – 20 yrs for NH stay (Patient with severe stroke who survives first 3 months, could expect to live for many decades post stroke). I know more than handful well to do folks that have seen life saving dwindle. Most physicians wealth is tied up in retirement accounts. When they tap into them to pay off NH expenses they then get slapped by taxes.
Long term care insurance is another issue all together. I don’t even want to open up this can of worms. Just google it.
I find you to be very knowledgeable , but you lack insight into issues that impact retirees or senior citizens. this maybe due to your focus on people of working age. Do a blog on how to pay for a long term nursing home stay, and I am sure you as well as most of your readers will be shocked to learn how ill prepared they are.
First paragraph of my post or my comment? It would seem if you don’t get the point that it would be useful to revisit.
No, I do not mean the typical physician when I talk about rich. The typical physician is broke. I’m talking about someone who can afford to pay $100K out of pocket for several years for long term care. I don’t need to Google long term care, I’m quite familiar with it. In fact, I’ve written a post about it: https://www.whitecoatinvestor.com/long-term-care-insurance/
Not to be argumentative, but shouldn’t our discussion focus on “typical physician” and not just the super rich. After all, it is the masses that need help.
Sure. I could do a post called 5 Reasons Typical Doctors Should Not Pay Off Their Mortgage Early
1. Student loans – No sense in paying off a 3% mortgage when you have a 7% student loan
2. Retirement Accounts – Maxing retirement accounts gives you more asset protection, lower taxes, and higher retirement spending than paying off your mortgage.
3. Credit Cards – Might as well pay off that 13% credit card instead of a 3% mortgage
4. Car payments – That non-deductible 4% car payment is a better place for your extra cash than a deductible 3% mortgage
5. No Extra Cash – Who are we trying to kid? The typical physician doesn’t even have extra cash so this isn’t even a discussion. Check out this email I got today: https://www.whitecoatinvestor.com/forums/topic/living-paycheck-to-paycheck-on-300k/ The typical physician should go listen to Dave Ramsey’s nightly show for a couple of weeks until he realizes that his only pathway to financial independence is to pay off his dumb debts and spend much less than he earns. Then he can come back here and start working on the finer points.
I know you might have meant this last post as satire but I actually think a post like that would be helpful to a surprising number of your new readers (even if very repetitive/generic for many more tenured readers or fans of Bogleheads). Segmenting physicians by where they are in the their life or earnings cycle is done sadly too little
We paid off our mortgage about 20 years ago and haven’t looked back!
It took a lot to do so — buying a house that was less in price than we could afford, putting all salary increases and bonuses against the mortgage, and even starting a small side business to pay it off.
But we got it done and the house appreciated, allowing us to buy a bigger place when we moved to another state.
I can’t imagine having had a mortgage all those years and paying all that interest. How do people do that?
Kind of seems silly doesn’t it. It’s like my wife said when we were talking about financial independence earlier this week- we hit that figure a lot sooner with a paid off mortgage. Look at the numbers. Let’s say we spend $10K a month and have a $3K mortgage. Let’s also say we have $2.1M in retirement savings and $200K left on that mortgage. Let’s say I get a $200K windfall. If I put it into my retirement kitty, that gives me another $8K a year in spending. I’m still not FI. But if I put that $200K toward the mortgage-Voila, we’re financially independent.
This is a good example of a cash flow/liquidity way of looking at it. Investing in the market is definitely not very cash flow heavy in anything but the very long term. Real estate can give you immediately more cash flow, with lower possible capital appreciation.
Thats one of the bigger differences in RE vs. stocks to me, the temporal natural of the cash flows.
I look at a mortgage like a negative bond. If you pay off your mortgage, it’s like buying a taxable bond with the same interest rate. Anyone who owns bonds should be happy to pay off the mortgage. They’ll get a guaranteed return and improved cash flow.
I wonder if the people who are in favor of keeping their mortgage are so enamored of it that they will take out another mortgage after their first one is paid off?
As for the argument about owing real estate taxes: Where I live ( expensive part of California ) my real estate tax bill is about 1/3 of what a 2 bedroom apartment would cost. So if I couldn’t afford the tax bill, I would need to live in cardboard box.
A paid off mortgage means that you have a large line of credit available in the event that you need a lot of money fast. You can also take out a mortgage again if a great real estate deal comes along that you want to finance quickly, and buy the other property for cash, without worrying about getting approved.
A heloc is a great source of emergency money. However, if the argument was as opposed to investing the same sums, I dont really see that as a benefit. A large taxable account means you have that same large fund of accessible money as well, in a easier to access account.
Sure, I agree, not a compelling argument either way, but the HELOC isn’t callable, and a margin loan is. Again, we’re assuming that the investor is wealthy, so all of these arguments are not going to be compelling. If you have enough money, you can do what you want.
There’s no doubt that mathematically it’s better to borrow at a low rate to invest at a guaranteed higher rate. However, there are no guarantees. I would never buy stocks on margin, and as I see it, borrowing against my house and using the money to invest is buying stocks on margin,even if the mortgage isn’t callable if the market tanks. But I don’t have a compelling argument against keeping the mortgage.
But tell me, once it’s paid off, will you take out another mortgage, assuming rates are still low? Why not refinance now and take out the maximum loan you can? If you won’t keep the mortgage forever, then we agree that the mortgage should be paid off. We’re just arguing about how quickly to pay it down.
You can think of it how you want but a taxable account in lieu paying off mortgage is not the same as margin. No one is going to call or just plain sell those assets because of a market swing, or force you to infuse cash because the margin went more than 100% above what you had. Its more than a stretch and at some pointyou can call everything “on margin” or leveraged.
That vacation in the future or doughnut you’ll eat on the weekend is leveraged against your future production, at some point it becomes absurd. Most of us went far into debt to become physicians in the first place, the concern over being “on margin” needs to be tied to its risk levels. Student loans for a great job, that sucks but its totally worth it and you’d be leaving lots of money on the table if you didnt do it. Same with a mortgage, etc…Now leveraging your stock account 3x to trade oil or taking payday loans, yes youre playing with fire. It’s like listening to doctors ascribe the same level of urgency to the common cold and a stroke, it makes little sense.
We are simply arguing how we would pay it off. Im just saying let inflation do the heavy lifting. Your paying with money that in the same time frame over the same terms would grow on average 21 times in the market, to save yourself the equivalent of a 50% off payment at the end of those 30 years.
This doesnt mean you should take a bunch of mortgages or never pay it off, but it does mean that early on it should be placed in the right spot in the order of priorities, and its shortsighted to defer getting retirement started (first dollars worth the most) in order to achieve this first. Paying down your mortgage is more like a savings account with a nominal return. There is nothing wrong with that, and if you have the means at some point it should probably be done if its a hassle to you.
To answer your question, yes of course I would. If someone is going to give me a tax deferred amount of money at a great rate and let me pay it off over 30 years when I have better uses for the money I absolutely would/will. If when Im 80 some shortsighted bank will give me a mansion on the beach with a mortgage I’d take it as well, whats the big downside? Then again I have little problem with investing on margin either, I havent yet but fully have a plan in place to do so slowly and as safely as possible (nothing crazy, just arbitrage between div/distri and margin cost).
The “leverage” comment was specifically referring to the difference between borrowing money from the house via a HELOC, vs taking the money from your investment account. If you pay off the house and have a HELOC, you can borrow money that won’t be subject to a margin call. If instead you keep the mortgage and borrow against the equities, as you suggested, you will be subject to a margin call.
I agree that paying off student loans and investing for retirement should take precedence over paying down the mortgage, but again, this post was about wealthier investors, not new grads.
You wrote: ” Your paying with money that in the same time frame over the same terms would grow on average 21 times in the market, to save yourself the equivalent of a 50% off payment at the end of those 30 years.” I’m not sure what you mean. If you invest, say, 100k at 7%, vs investing the payments on a 30 year mortgage at 7%, at the end of 30 years the total would be exactly the same. In other words, if the interest rate is the same, paying down a mortgage and instead investing the monthly payments will return exactly the same as keeping the mortgage and investing the amount of the mortgage as a lump sum. The only difference in the amount you get by doing one vs the other is due to a difference in interest paid vs the return on the investment. And if you compare paying the mortgage to the return on bonds, then paying off the mortgage will give you a better return.
Ah, yes. And I agree, but that isnt typically mentioned here but its a good point. As a new grad I see this push among newer grads but think they should get a couple years contributions flowing first.
As for the difference in investing vs. mortgage being the same, it actually wouldnt be exactly the same. Although the calculations are a bit more complex due to the amortization, its really a difference of compound vs. simple interest. Also losing what little tax benefit there is etc…
Anyways, its a bit of a moot point if its the last thing youre doing and are already wealthy. You can get tax free muni funds in the range of 7+ percent though (tax equivalent yield), more volatile than simply bonds but when you look at real, real returns they are nice.
Paying down a mortgage isn’t simple interest. Every extra payment reduces the percentage of future payments that go to interest. That’s a compounding effect.
Paying it down is not simple but a mortgage is, and kind of what I meant by the complexity introduced by amortization, but its also not just compound either. Its really a simple interest loan but arranged in a way that has some peculiarities, and once you start making extra payments, that makes it even more interesting. Your reducing the overall interest payments you’ll make, a fraction of the known overall total if paid on schedule.
Its your principal that compounds when you pay extra, cutting down future interest payments, so when varying the principal payments it behaves sort of like a compound interest, even though it is not. This is actually quite a nice thing that banks allow no penalty and reduction of interest on prepayments like this.
This when delved into deeper can get very messy, usually because we focus on the wrong stuff. I think your negative bond comparison works good here though.
I agree that the comparison between yields is complicated by the possibility that the investment yield might be tax free, as in a retirement account or municpals, or partly tax advantaged in index funds, as well as the possibility of the mortgage interest being deductible. That needs to be taken into account.
However, I believe that you’re mistaken about loans not compounding. Loan interest would compound, if the interest as not being paid off each month. If you use a mortgage calculator to determine monthly payments, on say a 30 year 7% mortgage, and compare a lump sum investment of that amount at the same 7% vs a monthly investment of the mortgage payment, also at 7%, you would find that after 30 years the amounts are identical. So, no difference between paying off the mortgage and investing the payments vs lump sum investment, so no difference in compounding. Of course, a difference in rates between mortgage and investments will still persist.
I think Im maybe missing it. In a mortgage, though arranged in an odd way called amortization, the interest is simple. You can reduce the overall interest by paying more principal, which does have a somewhat compound forward effect reducing the overall interest for the remainder of the mortgage.
However, the interest itself does not compound since it is paid in full every month. I assume we are just simply talking about different things. Its actually a complicated thing and just when you think you have it figured out you say too much and confuse yourself, kind of like time travel.
So, for your example a 100k mortgage at 7% has a total interest cost (your upper limit of possible savings) of $139,508 over 30 years paid on schedule (plus the 100k principal). A 100k investment over 30 years at 7% interest will grow to $761,225. Those numbers are not the same. Your total possible savings of paying cash today instead of ever paying a cent of interest is the above amount.
Your principal is entirely different as you cant save yourself from paying that with extra payments so I simply disregard that entirely.
I made the same mistake the first time I looked at the numbers.
So, the $139,000 is what you invest, not your yield. You’re investing 139,000 in payments, and yielding 100k in equity, due to negative interest yield. But that’s not a relevant number.
The way to look at this is to compare two options: Investing 100k in one lump sum, and letting it grow for 30 years at 7% (compounding interest 12 times a year), while at the same time taking out a $100,000 mortgage at 7% , which will have you paying $665.30 every month for 30 years. At the end of 30 years, you will have 100,000 in home equity, while the investment grew to $811,649.75.
The alternative is to buy the house for $100,000 cash, and invest $665.30 each month, at 7%, with interest compounding 12 times a year. At the end of 30 years, you will have $811,649.75. So either way, assuming the same interest rate ( which of course is hypothetical) you will have $100,000 in home equity and $811,649.75 in index funds. Hence, there’s no inherent value in one choice vs the other. Investing a lump sum and paying down the loan slowly will give the same result as paying the loan with a lump sum and investing slowly. In both cases, the same interest rate will result in the same outcome. So, whether you call it compound interest or amortization, or something else, the two choices result in the same financial outcome. I’m confident that student loans will behave the same way. They accrue interest daily, after residency, but there too, all the interest is paid off before it compounds.
I see what youre saying, though I think looking at it both ways it makes great sense. One for total amount and the other for amount of interest you could avoid.
I think I assumed we were in an either/or situation for clarity. In either situation it comes down to FV and inflation and your personal goals of course, none of these are bad choices.
I am encouraged that a comment thread led to hearing of what the other person was thinking, so often its just missed. Good stuff.
Great point. I viewed paying off mortgage as a cash investment (like bonds, vs stocks)- just was concerned it isn’t as liquid as bonds! So we delayed until I was sure I’d not regret the amount I’d paid ahead of time when some unbudgeted expense hit us.
Great article. My only disagreement is that I think Investing in a paid mortgage should be compared to investing in REITs and stocks, not bonds. Property values are more similar in trends to stocks instead of bonds. I would expect a higher expected return for stocks than the current prime rate, even when you include capital gains tax.
I respectfully disagree. Mortgages are very different from REITs and other stocks. Paying them down has a fixed rate of return, like bonds. The mortgage has nothing to do with the property it is taken out on. What you do with the mortgage doesn’t affect how the property appreciates or depreciates, or with its dividends (saved rent.)
The typical appreciation for an unleveraged property is 1% a year, but that doesn’t include maintenance costs which are typically 1-2% a year. The real win with owning your house is the saved rent. That’s where most of your return comes from.
Starting off replies with “Nope” is a little aggressive 😉
I’m feeling aggro today! 🙂
I agree! Did you have too much caffeine today? Getting all excited over when to pay off the mortgage! Remember the picture you once posted….”I’ll be there in a minute honey, somebody on the internet is Wrong!”
I did start lifting weights again after months off, maybe it’s roid rage.
Scenario: a 30 year old physician (MFJ) takes a 30 year mortgage. He is self employed. Say he makes 200K. He puts all mortgage “pre-pay” money into a taxable account. He reaps all the asset protection and interest deductions over the next 20 years. His taxable account is in all stocks and appreciates considerably (the most likely scenario) . He continues to fund his solo 401k, HSA and IRAs to the max keeping his taxable income MFJ below 76k. At this level his cap gains rate (at federal level) is 0% which is very hard to beat. Pays off the mortgage at his option. If inflation and rates skyrocket, he doesn’t.
Another scenario: Pays down the mortgage somewhat and takes out a HELOC (no re-financing fees) and transfers the funds to the mortgage. Now he is not amortizing anymore but paying (and deducting) interest only. My bank offers HELOC rates in the 3,5 % range with periodic “deals” of 1.75%. A play on short term rates staying low for next 10-15 years.
What asset protection are you talking about from investing in a taxable account?
Starting with a $200K gross income and getting down to a taxable income below $76K is quite a feat. Not impossible, but pretty unusual among docs. I mean, even with maxing out an individual 401(k) and family HSA and buying health insurance premiums, you’ve still got to come up with another $55K in deductions between mortgage interest, property taxes, state taxes, and charity. I think there are few docs that would choose to have just $76K to spend while maxing out an individual 401(k) in the long-run. Counting the HSA and a couple of Roth IRAs, that’s a 34% savings rate.
After reading through dozens of these taxable vs mortgage payoff threads. I still like the concept of splitting the difference and paying some extra principal to ensure payoff before retirement with the rest/bulk to taxable account. This amount may differ whether you’ve decided on a 30 year fixed, 15 year fixed, or shorter ARM.
Other factors surely play a role. Will you need a large taxable account to live off and perform Roth conversions in early retirement? Do you have a defined benefit cash balance plan that really makes this a CBP vs taxable vs mortgage decision. Many argue that maxing ALL retirement accounts should always come first for high earners but is there a limit on this rule?
With our first “attending house”, we settled on a 30 yr jumbo (now refinanced at at 3.5%), with extra monthly principal payments to make it a 20 year term. Hopefully, I’ll soon be able to convince my wife that we have enough taxable account cushion that it is safe to switch to a 15 year fixed or ARM.
I fully understand that my tax effective mortgage rate is somewhere in the 2s (depending on how one wants to consider “loss” of standard deduction in the formulas). I also realize I am highly likely to outperform this return in my 80/20 taxable account, but hey what can I say I’m a sucker for debt free by day 1 of retirement.
When I present to physicians, one question I ask these days is, “How many of you were told to finance with a 15-year, and not a 30-year mortgage, when you were starting out?” Almost all hands go up among peak career physicians.
That advice is, for most young physicians, demonstrably wrong. Consider: A 30-year mortgage might cost 4% today, after tax in a moderately high bracket 2.7%. The 15 year at 3.5% is 2.2%. That is the after-tax return you receive on every dollar you put into the mortgage. Period, Known to the penny. Not very exciting.
Meanwhile, if you have any school loans, perhaps $185k if you are typical young doc starting out, those loans cost 6.8% and are non-deductible. Economically, it can’t possibly advantage you to carry a 15-year mortgage and have less dollars at the margin to pay loans, when you could carry a 30-year and put the difference into quicker education loan paydown.
Again, all of this is subject to calculation, and the potential benefit of optimizing debt paydown and savings is enormous, perhaps $1 million or more over a high-income lifetime, controlling fully for lifestyle.
Or, alternatively, they could live like a resident for 2-5 years, pay off the student loans, THEN buy the doctor house on a 15 year fixed with a 20% down payment. Worked well for us. Of course, then you’re left with the dilemma of whether or not to pay down a 2.75% (perhaps 1.5% after tax) fixed mortgage.
Agree that its just plain best not to buy period at the start and put yourself in any kind of tight situation, and when/if you do buy, make it something simple and much below your ability.
Maybe a clarification post on what order these things go in.
Both good points.
In our case we could also have saved about half a point on our mortgage with 15 year, I want to say it was 2.75 vs 3.125, so only .375% savings, which was only tempting when you look at payments over the life of the loan (and I don’t plan on staying in the house for 15 or 30 years). Knowing the student loans were a priority, the lower 30 year payment was the smarter move, particularly just starting out and my wife starting residency. The minimal interest saving has a much smaller impact than the dramatically higher monthly payment, and we likely wouldn’t have qualified to refinance the student loans with the higher 15 year payment.
My friends who I know took a 15 year loan didn’t have student loans, and the ones who took 30 year loans had huge student loans and I suspect couldn’t afford a 15 year payment to begin with.
Yes it can make sense to do a 15 year. The interest rate on your student loans is higher, but you’re essentially leveraging the entire mortgage not just your monthly payment. If my student loans are 3% higher than my mortgage, I’ll pay 3% yearly on the amount I pay down my dent in the form of opportunity cost. Say I pay $50,000 a year that’s $1500. If my mortgage rate difference bw 15 and 30 yr is 1.5% but my mortgage is $750,000 I’m paying $11k extra in interest so that a fraction of that $50,000 I’m paying in loans/mortgage is at a lower rate.
Can you clarify what you’re trying to say? it is not coming out entirely clear to me. Why the morbid fascination with the leverage of a mortgage, of course the whole thing is leveraged, the difference is the monthly cash flow and what better uses it may have (cc, other high interest debt, student loans, etc…).
Lets remember mortgages are tax advantaged so the rate is lower than advertised and you can rid yourself of it if need be by selling or foreclosure. A student loan is about the worst kind of debt in regards to these other things, some cant even be discharged by death and theres no tax benefit. The difference in a 15 and 30 year mortgage is minimally to do with rates, especially at todays low levels, its really about cash flow and how fast you prefer to be equity positive.
However, if you expand on your numbers and clarify a bit maybe I’ll understand what you’re trying to say.
Interesting perspective!
Thanks for the reminder that mortgage interest phases out 🙁 🙁 🙁
Seems like as the income goes up, the whole concept of “good debt” goes out the window.
At least mortgage notes are still better than student loans.
Of course maximizing ret plans takes precedence over paying off a mortgage
IT IS SWEET to pay off one’s mortgage-priceless emotionally
I love the back and forth of this topic. Shows how different opinions are out there. It’s also been awhile since there has been a topic I was interested to read the discussions about. That being said my favorite part was when you mentioned that if you are using a financial advisor and investing in your taxable instead of paying off your house don’t forget to add their 1% fee into your calculation.
I was told not to pay extra towards mortgage but just keep adding to taxable but after you look at bonds vs mortgage the rates are pretty similar. Add in the 1% fee you are losing and it’s a no brainier pay of your house because it’s like buying bonds but with a guaranteed better return.
You dont have to have only bonds in a taxable, and nothing is guaranteed not even a house. Paying off a mortgage is peace of mind, cash flow, having lots of options, a feel good thing to some, and more akin to a savings account that coincides with inflation rather than any particular investing corollary. Actually I dont really understand what seems to be a deep desire by many people to define it in such terms. Its not like a bond, reit, index, swap, option, etc…its like paying down a mortgage.
It is like a negative bond.
That does fit better.
Paying off your mortgage is personally satisfying. Most people are bothered by debt. It is simply a great feeling when you make that last payment. I think saving and investing and paying off both mortgage and student loans are all a part of the same thought process. There are many ways to achieve FI and I would do what is psychologically comfortable for you. The sooner you get these things done the better your later years will be.
My thinking with regards to this paying off the mortgage. This is not the correct thinking, this is just my thinking.
These are the two extremes (we are talking about physicians here:)
1) When just starting out, I would rather build a nice nest egg than to pay off my mortgage as quickly as possible. I would hate all of my wealth to be stuck in a house. Plus getting some funds to begin compounding as early as possible can be just as satisfying if not more than a payed off house.
2) As wealth increases eventually even a small arbitrage in interest makes very little difference in your financial well being. For example a person has been able to build a $5Million nest egg. Do you think arbitraging an extra couple of hundred bucks a month is going to make any difference? I think probably not.
And then there is everyone in between.
Me personally I would rather build my wealth to some ideal number I have in my head than to put extra in a 2.75% mortgage. Once that ideal number is reached, I will be closer to the other end of the extreme and feel adding money on the loan is a better idea. BTW, that ideal number for me is my ability to live relatively comfortably if I chose to retire without some of the luxuries I would prefer to have.
Good points. I think I’ve come to the conclusion most of the disagreement here isnt on the concept, but that people at point number 1 are arguing against those at number 2. Its a temporal and net worth disconnect.
Excellent points. This whole post is all about # 2.
Somewhere along our journey from Point 1 to Point 2, we stopped seeing paying off the mortgage as an investment decision. I’m not exactly sure how or when it happened, but the house has now just become a consumption item to be paid off like a car or boat.
I think there is a great deal of apples-to-oranges comparison going on here. Here’s how I look at it as a financial advisor:
1) First off, as Jim Dahle has said time and again, you are best off living like a resident for a few years before buying a house, and using the resulting free cash flow to pay off your loans up front. Over a lifetime, less house leads to more wealth, almost without exception. (Almost. Some places have historically seen appreciation that builds wealth, but not many.)
2) Once you are in a house, with a mortgage along with other debts and opportunities, this really is subject to numerical analysis. “I think I’ll do some of this and some of that,” as several folks suggested, will demonstrably be sub-optimal.
3) Comparisons need to be like-to-like. Paying down a mortgage results in a compounding, risk-free return. So does paying down education loans. The after-tax return on paying a 6.8% student loan is more than twice that of paying a dollar of mortgage principal. Therefore get a 30-year mortgage and pay down student loans quicker.
4) The leverage associated with a mortgage is one kind of risk, and the risk/benefit of real estate ownership is a separate risk. You have the latter whether or not you are carrying the former. The bigger the proportion of your net worth in your home, the lower your likely long-term accumulation.
5) Comparing ANY debt paydown option to investing is apples-to-oranges. You are comparing a known, predictable return (debt paydown) to an unknown return (stock market). That doesn’t mean stocks are bad, just that they are two different animals.
6) In comparing mortgage paydown to after-tax investing, we use capital markets assumptions based on Shiller CAPE. Prospective returns were 2x to 3x higher in March of 2009 than they are today. The rational sequencing decision is thus different today.
We tell our clients that optimal sequencing of savings and debt paydown can drive a difference in terminal value of functional net worth of between 20% and 50%. That is controlling for lifestyle expenditures.
Could you expound on your point 6 comparing mortgage pay down to after tax investing from your perspective? I am interested in how you view paying down mortgage vs. investing in bonds outside of tax advantaged accounts. Thanks.
Good question. Two moving parts:
1) What is the nature of the risks involved? For example, paydown of a mortgage produces a risk-free return equal to the after-tax interest cost. For example, a 30-year 4.0% mortgage might have an after-tax cost of 2.6%. Buying a thirty-year tax-free bond yielding 3.5% would produce a higher after-tax yield, but involve much more risk. (30-year bonds can be as volatile as stocks.) With rates near historic lows, I would be reluctant to choose a risky 3.5% over a risk-free 2.6%.
Note that the bond and the mortgage are effectively two sides of the same transaction. With mortgage, you are a borrower. With bond, you are a lender. But the risks are not symmetrical. If rates rise, the borrower keeps her nice low rate, and the bondholder/lender’s loan value declines. If rates decline, the borrow can re-finance.
2) What about stocks instead of mortgage paydown? This is a more difficult question. Stock returns are less predictable and a large component of returns is often capital appreciation. We use Shiller CAPE to project stock market returns. (Robert Shiller of Yale, shared the 2014 Nobel Prize for Economics for his CAPE research.) In simple terms, Shiller’s work shows that expensive markets produce lower returns, and cheap markets produce higher returns. So back in March of 2009, we projected long term returns north of 10%. At that point, we would rather buy stocks than paydown a mortgage. Today, Shiller CAPE suggests about a 4% average return from U. S. stocks over the next decade. At current prices, I’m earning a pre-tax 4%, perhaps 2.8% after tax. Hardly compelling vs. the mortgage paydown.
Of course, maxing out a pre-tax retirement plan produces immediate tax savings, plus (in many cases) a match. The economic return of a dollar saved to a 403b with a match, for someone in a 33% bracket, could literally be above 72%. Obviously, the compelling first choice.
My overall point is that optimal sequence can be more precisely determined than the discussion here suggests, and that the sequence of investing/paydown can have a profound effect on terminal portfolio value at retirement.
Something I forgot to add. Non-economic benefits can be real and valuable. Being debt free is a great goal. Not to be preferred over being materially wealthier, in my opinion.
These are great points and very eye openeing. When you look at it even closer if you are using an advisor charging a 1% AUM fee then it seems like paying off the mortgage might be the best way to go at this time. Once again it’s all about risks and rewards. I feel like as physicians many of us will make enough to retire well as long as we don’t make crazy investments We don’t need a 15% return. I’ll stick with paying down the mortgage with part and investing part into taxable.
We paid off 20+ years early in time to have no mortgage- only tax and insurance- payments once husband retired. My investor brother wanted us to max out a refi and invest that in stocks under his guidance. This opinion kept us from paying off for a year or two: He asserted we’d definitely make more money in stocks, after taxes, than saved in interest after taxes. But the tanking market of ’08 and what I considered a depression and some deflation (most prices are so sticky you only see it in how desperately restaurants are discounting meals) made clear that he would be wrong for several of the years remaining in our mortgage, and perhaps overall.
Another thing that kept me from paying off ASAP was the impression that every house I’ve sold, I basically walked away having written a check. It’s like someone tells the buyer and realtor how much I owe and that’s about all I get- some deflation and definitely no appreciation in home value for the two we’ve sold so far. So I felt if we were likely to move we’d lose more money with a paid off mortgage than not. Anyone agree with that theory of mine based on N=2?
Anyway now our monthly ‘rent’ is $300 not $2500 or 3000 so it’s made it easier to juggle money with one worker then another not earning doctor pay. The vagaries of the market would’ve kept one of us at work- not what we apparently really want- had we still had a mortgage.
Also my house is not an investment, it’s where I live. Sure I invested a few hundred $K to have dirt cheap rent, but our preference for housing would demand we spend at least what that amount would earn at 10%!!! to pay rent elsewhere. So the value of paid off is 10% to us? Hard to calculate value of being able to paint the walls weird colors and put in permanent landscape features. And keeping the mortgage we’d only be getting .5-7% in bonds, or stocks in good years, on the amount invested.
Drawbacks: no tax break for charitable deductions since we no longer top the standard deduction without mortgage interest, and no excuse to make husband go back to work. Bunching up some of my planned giving to max it out to all the recipients one year every few to get a little tax relief that year. So the organizations badger me more in the lean years.
Anyway WE are the real target of this piece, and guess we chose as we did for financial freedom and security. Of course our student loans and consumer loans were long gone and retirement savings goals met.
Realtors leek info all the time, but that seems a silly reason to not pay off a mortgage to me. Remember the value of the home and the value of the mortgage are not really related when it comes to making financial planning decisions after the initial purchase.
Sorry, I’m new and still learning. You had sd mentioned it would be more advantageous to pay off a mortgage in states without income tax (ie Florida and Texas). Is that because you can deduct mortgages on state income tax or for another reason? Thanks!
I guess that would be one reason, but a bigger one is the asset protection you get on home equity in Florida and Texas.
Thanks!
My wife and I recently purchased a home using a 30 year fixed jumbo mortgage at 3.8%. We are both nearing retirement and plan to live here forever, baring some.medical catastrophe (always a possibility). We have a significant retirement nest egg in a taxable account and an IRA, both invested in a diversified Vanguard portfolio that has historically yielded 7-8% (obviously no guarantees). We could have paid cash for our house by using our current assets but a fixed mortgage at today’s historically low rates seemed preferable to me – mortgage tax deduction particularly early on in the amortization schedule, likelihood that our investment returns will exceed the mortgage rate, and the probability that inflation will increase at some later date allowing us to make our mortgage payments in devalued dollars. Since we plan to live in our current home until death or the nursing home take us away, the equity in our property has little value to us, although it may matter to our heirs. We could pay off the mortgage any time, but where is my reasoning going wrong?
First, “yield” does not equal “return.” You probably meant return, but it’s an important point to remember when interacting with the financial industry.
Second, I don’t think it’s nuts to continue to invest instead of paying down a low rate fixed mortgage. But I’ll probably still pay my mortgage off somewhat early due to behavioral issues even though mathematically it may not be the right thing to do. The main issue is that I would go on a heli-skiing trip instead of investing with the money that didn’t go toward the mortgage. Is that okay? I guess, but it definitely clouds the issue.
Thanks. Good clarification on the difference between yield and return. I’d probably go fly fishing in Belize rather than heli-skiing, but I get your point.
Interesting comment about Belize.