[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!
I think the decision to pay off a mortgage (or not) should not be made in the vacuum of “Damn, I just don’t want the monthly payment anymore, and I desire the release from debt.” I do think it should be made in the total context of the overall financial history and situation. As a result, it becomes an exercise in tensor calculus with many inter-dependent differential equations: state tax, federal tax, retirement accounts, non-retirement accounts, deferred retirement accounts, predictions of tax rates at RMD time, and so on. Below is my reasoning for paying off one mortgage (yes, it was a feel good thing), and for not paying off another.
We paid off our first home, a modest one in a state with a flat rate income tax. We had maxed out the tax deferred/preferred retirement accounts and then took a new position in a state with an exorbitant income tax, planning on buying another modest home.
But alas, the ’08 crash happened and it was not easy to sell the old house, and the new area was full of realtors and sellers who hadn’t quite figured out that the market had tanked. So we rented for a year, nice place on a lake, for $1000 a month. The owner wanted to sell the house for $750,000 (worth about 1/3 that), but was content to rent it for cheap. The mortgage, interest and whatnot 15F/4% would have been $4400, and the annual interest over $24000, initially. Even with tax deductions it was still cheaper to rent. My CPA brother in law whined that we were throwing away our rent money. But the crash was catching up, foreclosures were becoming common and the million dollar mansions were plummeting.
The pre-approved mortgage officer was in cahoots with the Realtor who learned the precise number of the pre-approval from his bank buddy and showed only mansions at the max of what we could afford. We finally dropped him and went off on our own. We found our mansion, owner financed, and now own two houses, one free and clear generating regular rent, in the prestigious university town, the other we live in which does have a mortgage. The price dropped on our mansion which means my $12000 rental investment returned $500,000 or so in terms of asking price reductions as the ’08 crash finally brought the locals to their senses, and now property values have re-appreciated adding a tad more to that. My university city home has also re-appreciated to its former glory, with time from listing to sale of about 3 weeks in that community and its rental income reduced my net rental outlay to about $2000. Our retirement was set, all deferred accounts maxed, but what to do about the mortgage in the house we live in?
I planned for and did retire this year to start a research firm (grants pending review, and all patents in hand), I decided not to pay off the mortgage which still has 7 years left. I did this because I am now able to fully deduct the mortgage interest from both state and federal taxes. In the course of thinking about paying off the mortgage or keeping the cash, an important issue is that in 8 years, when I reach the magical and dreaded Required Minimum Distribution Age, I figured out I will have a big tax problem.
Since my 401k has an in plan Roth Conversion feature, and I’ve maxed out the Roth backdoors on in the past, I can use that mortgage deduction to minimize the costs of doing a phased conversion over several years, and reduce the non-FICA taxes on my new (and very, very low) salary that I will place in the Roth directly as I no longer need the back-door. This will allow me to substantially reduce the RMD taxable income, adjust my MAGI to optimize the tax value of my situation. Then in about 5 years (with 3 years left on the mortgage), it will be time to decide whether to pay it off or not. Or sell it and downsize. Unless of course President Trump eliminates the income tax, World War III starts or the three headed invaders from Alpha Centuri have landed and the situation is well in hand…for them…
Personally, I’m ambivalent about paying off the mortgage. It’s always been much more a personal finance psychology problem than a math problem to me. I like the idea of owning our home outright (regardless of taxes, insurance and maintenance costs). Not from the status symbol mindset that Dave Ramsey talks about, but mostly from a belief that only cashflow producing assets should be financed (e.g. real-world business, real estate, e-commerce site). The mortgage is an unfortunate exception because of the sheer amount of money that’s required.
If you’re going to be cash poor in retirement, owning a fully paid off home doesn’t seem wise. OTOH, fifty and even hundred year mortgages have been around in Japan for a couple of decades since real estate has become so expensive. The mortgages are handed down to children as part of their inheritance. That’s not ideal either, but maybe it’s better than being a family of perpetual renters.
For those who actually have the choice (which I’ve learned is a tiny percentage of people who ever comment about this evergreen financial question), the pay-it-off now or invest-the-money decision is mostly about hard to quantify things like personal cashflow, cash on hand, mostly liquid assets, risk tolerance, future income, foreclosure probability, etc. Those aren’t thing that are easily plugged into an online calculator for a simple yes/no answer.
Anyone care to comment on how the recent tax law $10,000 cap on total of MI, prop tax, and state/local tax affects above calculations? Assume it shifts it towards prepay of mortgage as interest is essentially non deductable above 10k, and property and/or state taxes are very much over 10k for most of us.
Old thread I know but I didn’t see any comment regarding this
The $10,000 cap doesn’t apply to mortgage interest. But with a higher standard deduction, many people are better off with the standard deduction than mortgage interest.
Any thoughts would be appreciated – on paying off the 3.75% fixed 30-year mortgage vs. major remodel of our fixer-upper, bought 5 years ago? The amounts are equal, and we’re at a crossroads. Whichever one we do, we’d have to save for 3-5 more years to do the other. There is a little pressure to remodel in 2-3 years (might need new roof, kids will probably outgrow their tiny shared room). Retirement accounts fully funded each year, no other debt. Would be so nice to be debt-free, but looking for other thoughts to consider.
If the house is not adequate for your needs, you need to move or renovate. But if you don’t need to do it for two years, why not pay off half the mortgage and start saving up for the remodel and do it in 2 years?
That’s true, it doesn’t have to be all one or the other at once…