[Editor's Note: The following post originally published on WCI Network partner, Physician on FIRE and is about a frequently discussed topic on this site — paying off debt as quickly as possible.]
Debt free by forty. That’s the goal I set. I liked the sound of it and at some point in my mid-thirties, I realized it was a possibility for us.
When I said debt-free, I didn’t mean having a zero or positive net worth with assets equal or greater than debts. I meant I didn’t want to owe nothing to nobody. Positive net worth, zero debt.
My decision wasn’t based on mathematical modeling. I didn’t cycle different scenarios through a spreadsheeet.
It was a personal decision. A psychological decision. Nothing more.
I had taken on some serious debt and paid some serious interest. While chipping away at my student loan debt, I added a half-million dollar construction loan. With an initial interest rate above 5%, I was on the hook to pay more than $25,000 a year in interest on that loan alone (getting some of that back as a tax deduction at the marginal tax rate).
I wanted to be done paying interest. I wanted to truly own the things I pretended to own and I wanted it to happen by my fortieth birthday.
It almost didn’t happen.
The Math Behind Paying Off Your Mortgage
For the most part, I ignored the math, although I knew in my head what the consequences of mortgage payoff would be.
our “starter home”
At a 5% interest rate and a 40% marginal tax rate, I was effectively paying about 3% a year on the principal. This was true because I had itemized deductions.
If you take the standard deduction, which will be much more common with the increased standard deduction resulting from the Tax Cut and Jobs Act, you are paying the full mortgage interest rate, getting no deduction on the interest you pay.
If your itemized deductions barely surpass the standard deduction, you’re essentially deducting very little of your mortgage interest. It’s good to know where you’re at with deductions.
Back to the math, where I had plenty of itemized deductions. Assuming the principal that I owe is working for me and invested in my portfolio, I would need at least 3% returns in a given year to break even on carrying the mortgage.
Perform better than that (should happen) and carrying the mortgage wins. Underperform 3% returns (tough to get a guaranteed 3%) and mortgage payoff wins.
The math is simple. With today’s low (but climbing) interest rates, I would say carrying the mortgage wins more often than not from a probability standpoint. From a psychological standpoint, being debt-free is a state of being that has significant value that’s much more difficult to quantify.
I chose the option to be debt-free and haven’t regretted it one bit.
The Math Behind Paying Off Student Loans
The other heavy debt burden carried by many of us are student loans. The payoff calculations are similar, but not identical for the high-income professional.
In the lower tax brackets, student loan interest is tax deductible. The deduction is phased out at an adjusted gross income of $70,000 to $85,000 for individuals in 2019 (double that if married, filing jointly), an income most physicians will exceed.
Just like the tax filer who takes the standard deduction pays full fare for mortgage interest, those of us with strong salaries pay every penny of our student loan interest without a tax benefit.
If your loans are at 6.8% and you are not pursuing a loan forgiveness plan like PSLF, you should consider refinancing your loans. Otherwise, at that high interest rate, you would need returns exceeding 6.8% to break even on carrying those.
I had consolidated my student loans to a low interest rate, but chose to pay them off with a lump sum that came in the form of a signing bonus a few years shy of my fortieth birthday.
The Plan to Be Debt Free
Every goal needs a good plan, and mine evolved as our situation changed. We actually moved a couple of times and bought a couple more homes. It’s a long story.
For several years, we steadfastly refused to give up our dream home even though we were living and working a couple of states away. We had long term renters, we had seasonal renters, and we even used the place some ourselves. Eventually, though, we realized we were holding on to the past which was making life in the present more difficult and potentially jeopardizing our future as we were basically hemorrhaging money. I had been funneling all my locums earnings towards the mortgage, but the balance was around a quarter million, and wasn’t going to disappear soon.
Meanwhile, we bought the home we currently live in for half of what we put into that dream home, paying cash. When I was about 39.8 years old, after about a year and a half on the market, we finally sold the one-time dream home for a $200,000 loss plus realtor fees. 4,000 square foot waterfront homes don’t sell as well after the only hospital in town shuts down.
i do miss those sunsets
The day we closed was one of the worst and best days of my life, financially speaking. We lost a ton of money that day (or at least realized the loss). We also became free.
Although I could have considered us to be financially independent based on the home equity, it didn’t feel real until the home was sold and the money was in our hands.
A couple years earlier, I paid off the last of my student loan debt with a lump sum payment from a generous signing bonus. When we sold the house 10 weeks shy of my fortieth birthday, we were officially 100% debt free.
Should You Pay Off Your Loans or Invest the Difference?
Many a blog post and forum thread has been written addressing the question, and I could fill a page with links to the
various discussions on the hot topic. I won’t do that to you, but here are a few:
- WCI Forum: Mortgage vs taxable investing
- WCI Forum: Pay off mortgage or invest extra funds
- Bogleheads: Anyone regret paying off mortgage?
- Bogleheads: To pay or not to pay off mortgage?
- Bogleheads: Investing vs. Payoff Mortgage
Ultimately, the answer depends on a number of factors. Some are simple math. Are they high-interest loans? Is the interest tax deductible and are you in a high tax bracket? Do you think you can get a better return elsewhere?
What do you think? Are you debt free? What sacrifices did you make to become that way? Was it worth it? Comment below!
Congratulations POF on becoming debt free. Excellent write up as usual. This is a debate that goes on in my head all the time, the timeless debate of whether to invest or pay off the loan or mortgage first (when I finally have one). When I started out, and that was August last year, my thought was to always use leverage and invest instead of paying off my low-interest student loan – 2.8% and definitely never consider mortgage worth paying off. I even wrote about it.
Perhaps the bull market has something to do with it, as I always feel like I can easily beat interest less than 5%.
By December, my student loan interest started climbing, the company changed and started getting letters about interest rate hike. I got mad about the loan and my job turned out to be more rewarding in terms of income than I expected, so I paid off my student loans. So we are officially debt free.
We rented initially as we wanted to supersize our savings and pay off debt. Now that student loan debt has been paid off, we are in the process of buying a home, so will see how the mortgage one goes. Perhaps, I will change my mind on that one too.
Another great benefit of being debt-free is that debate goes away for the first time in your life. 🙂
2.8% is not a terrible risk-free return. MMF only pays 2.5%, and that’s pre-tax.
When I chose to pay off my mortgage (28 years early) it simply was because I realized, for *me*, that if the market went down, I would feel that pain deeply, if I still owed money on the house. I pulled the money out, payed it off and was done.
It was a great decision *for me*.
I think it is often overlooked….that the market or any investment has no guaranteed return. Paying off the mortgage is a guaranteed return. Guaranteed. Let that sink in…..
It is equally guaranteed that if you have a mortgage, you *will* have to keep paying it, no matter the job situation, no matter the economy, no matter how you feel. Guaranteed…..(let that sink in also).
Good post.
I almost paid off my 15 year 2.75% mortgage 5 years ago. Remaining balance was 200k. I decided to buy vanguard index funds instead. My return is light years ahead of what I would have gotten if I paid off the loan. Plus, I can easily pay it off still if I want, but I choose not to. In addition, in Illinois where I reside, yearly property tax is about 15k for a 500k house. Even if I pay off the mortgage, I NEVER really OWN the home due to taxes. Let that sink in.
The local government doesn’t foreclose nearly as quickly as a bank holding a mortgage. Typically a couple of years versus 3-6 months.
https://www.nolo.com/legal-encyclopedia/state-laws-property-tax-sales
Great post! Wanted to add another factor (in favor of mortgage payoff) for high income individuals. When running the math of payoff vs. investing, you can’t just compare your mortgage interest to the market interest to compute the interest arbitrage difference. High income professionals are also going to be subject to the Net Investment tax which is an additional tax in investment returns (capital and ordinary gains, dividends). That tax is on top of all the other taxes. So the interest rate variance needs to be large enough to offset the additional tax.
Another factor is controlling the amount of cash one needs to generate on a monthly basis. Any mortgage payment by definition will be a large chunk of monthly outflow. That debt (cash flow) needs to be serviced with high enough (taxed) income. If one has the ability to control the cash flow (work part time, etc.), not having that monthly payment greatly accommodates that. The reduced income is not taxed at marginal rates vs. effective rates.
I’m 100% in favor of paying off the mortgage ASAP. I saw my dad struggle with debt with his business, and decided I was never going to live that way. Selling my soul to a state subsidized med school scholarship program, I had little school loan debt. I worked 5 years in a rural area from 98-2003 and we paid off our $90,000 mortgage in 2 or 3 years. Retired the school loans as well. We then bought a $154,000 house and paid it off in two years or so.
One secret to this was marrying the right person. Husband eschews debt as well. Neither one of us wants that monkey on our backs. Also, we have no children, although we were spending thousands on fertility treatments at the time. We fully funded retirement plans as well and just lived simply.
I realize the debate on investing versus mortgage pay down is never ending and there is no right answer for every situation. However there are several factors I rarely see addressed in the discussion.
1.) People who get psychological satisfaction from paying off a mortgage should understand they are not truly debt free. They still owe yearly debt for property taxes and home insurance, which, depending on the home value and state of residence, can be substantial.
2.) Over the long term, say 20-30 years, the value of investments will almost surely increase due to compounding and (hopefully) market appreciation, while the burden of mortgage costs will decrease due to inflation.
3.) People who have a paid off mortgage and anticipate selling their home at some point in the future have real value in their home equity, whether to upgrade to a nicer place or downgrade to use the money for other purposes. Retired couples who have bought their last home won’t find this equity useful except for certain circumstances (eg. desire to leave extra money to heirs, need to sell and move into an assisted care facility, source for an emergency home owners loan or reverse mortgage).
Thanks for a thoughtful post.
1. Silly argument. Thats like saying you have debt for food you’ll eat in the future. That’s a bill, not debt.
2. Agreed. A fixed mortgage can be an excellent hedge against inflation.
3. Agreed. It’s not the easiest to use. But it DOES serve a purpose just sitting there. It eliminates interest payments and rent payments.
Agree with WCI on your first point re: property tax… its an expense as opposed to debt- the difference is you don’t pay interest on the former as opposed to the latter.
This is semantics and probably not worth arguing about, but try not paying your property taxes and see what happens. To me, a debt payment is mandatory while expenses are optional. Also, property taxes tend to go up with time not down, so could be considered a form of “interest”. Not a major point in the mortgage pay- off versus investment debate, just an observation.
Try not eating and see what happens. Does that make groceries a debt? Property taxes are nothing like debt.
I totally agree with the post. We paid off our mortgage awhile ago for 2 reasons.
First is to have full equity on primary home, which is one of the best protected assets (main reason) for us in Florida (I think).
Second, We can use the equity as HELOC for emergency fund. Creditors will think that bank still owns our home so they don’t try too hard to get us, lol.
I take mortgage on my office building, which is owner occupied. I pay 1-2% higher rate than primary home mortgage, it is 4.5% 10 years loan, and put that money to stocks. 4.5%-1.6% (37% tax bracket) = 2.9% interests, compared to vanguard total stock fund yield, I am happy so far.
Do both. Not either/or. We always maxed all tax protected retirement accounts in index equities. Whenever I felt the need to decrease risk, we just paid down the mortgage as opposed to buying bonds.
I look at us being debt free as analogous to having bonds in our portfolio. It’s a low, guaranteed return. It decreases our monthly cash flow needs to a pittance as we get close to my military retirement. Between the house paid off and the military retirement, I feel quite free to have 100% of our IRA’s, TSP, solo401k, spouse 403b&457b, and taxable accounts all in equities – and have done nothing other than that since 1992.
As WCI repeatedly says – the advantages of being wealthy are not having to optimize every penny.
Not a bad way to think about debt- it’s a negative bond. Hard for some people to stomach the loss in a down market though since you psychologically “forget” those are your bonds.
Too true. I wouldn’t be so cocky about this except that I had no trouble staying fully invested through every down market since 1992. I guess my point is the down market bothers you less when your monthly expenses are low. The housing down markets bother you a little less also. No mortgage means you can lose house equity but you can’t be “underwater”.
Another well written post PoF. Congratulations on being debt-free. As someone who is just beginning a big fat construction loan, I cant see the light at the end of the tunnel yet. Your dream home was beautiful, though… I’m sure you guys really enjoyed it while you were there.
We did! Another couple is enjoying it now, and that’s OK.
We were planning to build a place this year (technically, pay a bunch of other people to build it) but realized in the place we want to be, buying “used” gives a far greater value. So we’re shopping for a home to buy with cash again. Selling our current home will make it an easy swap. Current mortgage rates are awfully attractive, but I don’t plan on going down that road this time.
Cheers!
-PoF
We bought a house in a low cost of living area directly out of residency. We paid off student loans and the mortgage in 3 years. A few years later for family reasons we moved to a medium to high cost of living area and purchased a 4 bedroom instead of a 3 bedroom. The house was 3.5X more expensive than our first. Also the job paid less.
In the first home we sent most extra money toward paying off the debts. After they were paid off extra money went toward a taxable account.
In the 2nd home, aside from having a 15 year fixed mortgage, we are otherwise taking no extra steps to pay off our mortgage early, instead just making the monthly payments. Now the extra money is going to a taxable account.
It was hard to transition from a debt conquering mindset to a debt is useful mindset. There is anxiety associated with this. Once in a while I look to see if we could pay off the mortgage by liquidating our taxable, HSA, and cash. It would be doable. But what happens if this new job doesn’t work out? I would have a lot of equity, but no liquid assets to make a transition. That also causes anxiety.
Right now I think the best way to get rid of my anxiety is to shoot for complete financial independence. And the fastest way to do that is likely through moderately frugal living and investments. In 5-10 years we will likely make the decision to pay off the mortgage, at which time we would also have a good amount of liquid assets.
Paying off a mortgage early is somewhat of a luxury. I am early in my career and choose not to afford it yet. If I only saved 20%and put the rest towards the mortgage I could have it paid off in 4-5years. I have a 15 year mortgage and hopefully 10years from now I will be in a place where a little more leverage is not really helping and I can afford that luxury.
Paying off a mortgage early and becoming debt free feels great, but I would say is something that should happen beyond those first 5 years of “living like a resident” after other aspects of one’s financial “house” are in order. Spend the early years after residency knocking off the student loans, maxing tax-deferred accounts and building up taxable investments. After 8-12 years, at which point one’s career and practice situation are likely well established, financial independence is near and plans to stay in the home are clear, then start aggressively paying off the mortgage if desired. We went the route of a 30-year fixed mortgage to minimize monthly payments but after about 10 years paid it off over the next 3 years. After we already had built up a sizable nest egg that had been compounding for years.
Agreed. We paid our mortgage off as multi-millionaires 11 years out of residency.
One thing I never hear talked about: if you pay off your debts, suddenly your life/disability insurance is worth more.
Or you just need less of it.
I totally understand the math, and I benefitted from an extremely low, adjustable rate, especially in the 10 years after the financial crisis, but the day I no longer had a monthly mortgage payment was the day I was no longer hostage to the debt. I saw my dad struggle to keep up with payments on his mortgage/HELOC, and my sisters and I had to subsidize my parents cash flow in his final years. He was unable to retire, despite battling cancer for 25 yrs… I don’t ever want to do that to my kids.