As advisors, who have forged close relationships with our clients, we tend to get a lot of questions above and beyond our core area of investment advice. We are thankful for these ‘off-topic’ questions as frankly these questions tell us our clients trust our advice.
I’m Greg Farrell, Vice President, Senior Portfolio Manager at Howe & Rusling, and in today’s episode of StreetSmarts, I want to address a very common question we hear, ‘Should I pay off my mortgage’?
99 out of 100 times, this question is more of an emotional driven feeling than a financial question. Most people asking just want the freedom from debt, and when they are asking, they are looking for reassurance it might financially make sense. This is where the conversation gets interesting.
Having a long background in the credit world, mainly making decisions of whether to provide a loan to a customer or not, I’ve been on the other side of this fence and hence have some strong opinions. My usual instinct is NO, don’t pay off the mortgage early, but understanding the emotional pull, I ask questions.
The first question is why….and the response 95% of the time is, “I have extra funds and just want to do it”.
Knowing now this a principally emotionally driven, I have to start asking the technical questions, the first being ‘what’s your interest rate?”
Given interest rates have been below 5% for over a decade, odds are most people have not only a favorable interest rate on their mortgage, but they likely have a fixed rate mortgage. This wasn’t always the case, as from the 1980’s until the financial crisis of 2007-2009, adjustable rate mortgages were the norm. During that period of time, I myself had 7 different mortgages, all some type of adjustable rate. The problem was adjustable rate mortgages helped contribute to the financial crisis, for as interest rates were rising leading up to the crisis, monthly payments started to get beyond some people’s cash flow. However, that’s not the case for the past 10 years, as the vast majority of mortgage holders refinanced at lower, fixed rates.
With a low rate, the question is can those extra funds do better than the expense of the interest rate? Given the average return of the S&P has been around 6.7% per year since 2000, the answer is your funds likely will do better invested than giving to the bank.
My next question is ‘so you will never have a need for the funds you will give back to the bank?’ The answer to this is impossible, as given a pandemic we are all living through, no one knows the future.
I’m all about financial freedom, but financial freedom doesn’t have to mean debt free. Malcom Forbes, finance magazine magnet, talked about the power of leverage. Mortgages are leverage, allowing you to reach goals, by using someone else’s capital. Why would you want to give up this fundamental of financial power?
As mentioned, having been on the lending side of the equation, my biggest issue with paying off a mortgage early is you just lost control. While I have many friends who are bankers, bankers typically aren’t your friend. They have a job to do, and that job is to protect the funds of the bank. When someone wants to payoff their mortgage it seems all those nightmares of non-stop questions and document after document submission required when they applied for the mortgage are now long faded memories. Let’s be clear, you worked very hard to get the bank’s money, and with a blink of an eye you just want to give it back to them; trust me, if you ever want it back, it won’t be a blink of an eye on their behalf. It will be relentless question after question, 300 signatures, and fees… I think I’m making my point.
In terms of some arguments as to why you should pay off a mortgage, the change in the tax code limiting itemized deductions had some impact. However, if your mortgage is big enough, you can still itemize. Furthermore, tax codes change like babies’ diapers…. constantly, as nothing is permanent regarding taxes. The real promoters of the financial advantage of writing of mortgage interest wasn’t financial advisors, it was realtors. Think about it, who did you hear about writing off your mortgage interest from? Your advisor, your banker, or your realtor? Plus, the larger the mortgage usually meant a more expensive house.
On the positive, more personal side of paying off a mortgage, peace of mind is usually top, with extra disposable income each month being next. But I’d argue the extra disposable is a factor of budgeting, of the ‘extra’ funds which were going to be used to pay off the mortgage, and those extra funds still should be invested to offset the cost of the interest and hopefully are incrementally garnering some extra capital appreciation.
With all this said, if you are someone who still wants to pay-off your mortgage, I’d urge you to consider the following compromise. Consider making annual lump sum payments. Most people believe that it they add extra principal to their mortgage each month, they will pay off their mortgage faster – which they will. But in reality, the annual lump sum method pays off the mortgage off even faster, which baffles logic but the math proves it every time. With a single lump sum payment, it gives you a full year to make some return on your money, and if something dire comes up, you aren’t out of pocket.
This topic is a tough one to debate as it is so emotionally charged. The bottom-line is if the option exists, don’t give a bank your hard-earned money, because if you ever need it back, it’s theirs now and they make the rules. Thanks for listening to today’s StreetSmarts on paying off your mortgage, and as always, we welcome your questions.