Mortgage Pay-Off Debate
I despise the fact that people are being fooled by the banks to pay their mortgage loans off as soon as possible. The premise of getting out of debt is being advertised, pushed, and praised everywhere. It forces people to use thirteen’s payment in attempt to save money while, in fact, they are losing their cash.
It may sound controversial to your beliefs and your knowledge. Isn’t getting out of debt a right thing to do? Yes, indeed. However, this is a “special” kind of debt that I want to discuss again.
As I reflected it in my previous article, smart couples rather pay the minimum of their mortgage loan than accelerate the payments. The whole debate comes to a simple formula:
Saving on mortgage loan by speeding up the payments vs. investing cash and getting better return
I want to present you one more real-life example to prove my point.
Bill and Lori Smith are in their very late fifties. Their combined income is $200K. They can easily make their monthly mortgage payments of $2,370 on their new house. However, Bill has gotten worried about their $363K mortgage balance, and he is thinking about paying extra $1,400 each month in order to save on the total balance and get to the retirement without the debt.
That would be exactly the situation that I have called “house rich - cash poor”.
If you look at their 30-years mortgage loan, they probably did not expect paying it off, but later Bill has changed his mind. Let’s use some math to calculate the outcome.
Considering the mortgage-interest tax deduction, Smith’s effective interest rate will be around 3%.
What does it mean?
Basically, it will give them 3% guaranteed return on their money if they will pay off the entire mortgage loan due sooner. It would be so-called “simple interest” because they have no opportunity to reinvest their money, not to mention the inflation can “eat” that 3% easily.
Now, let’s assume that Bill and Lori have decided to choose a different road for saving. There are three common ways to generate the return better than 3%:
- To invest in the diversified portfolio (with a mix of bonds and stocks) that over the same period of time will generate at least 6% average return (in the best-case scenario, it could be over 8-10%).
- Invest in dividend-producing stocks and bonds and use the DRIP (dividend reinvesting plan) that will use the power of compounded interest (when you earn the interest not only on principal but on the added dividend payments, too, each month or each quarter).
- Combine both methods.
Paying that extra $1,400/month toward the mortgage would save the couple near $140K in interest with their 3% return but investing the money instead would generate $280K (with 6% return).
The smart way would be to use the IRA accounts to grow money. This way, they would get $280K in their retirement account. Upon retirement, they would pull money for their mortgage. Another benefit is that they would likely pay lower tax rate upon withdrawal.
Get it? I hope so.
Needless to say, they don’t have to use entire $280K to pay the mortgage off (and give a nice pile of cash to the bank) but rather continue monthly payments. This money may generate nice income to supplement their Social Security checks (with 6% average return, it is the same $1,400 a month, so they need just $1,370 to add for their monthly mortgage payment). Imaging if their return on investment is even higher or they use DRIP…
My point: I’d rather be house poor but cash rich because I can use MY MONEY to generate compounded interest than to LET THE BANK HAVING MY MONEY to generate more money in the bank.
Some of you may argue that in the retirement years, the paid-off mortgage is a big deal and a piece of mind, not to mention that 6% return is not guaranteed. I don’t argue. Different people have different priorities. However, there is something that is called a COMMON SENSE. The math doesn’t lie.
I have recently joined our friends to celebrate July 4th. There were three other couples around the table. One of them is living in the townhouse with $250K paid off mortgage. Just consider it: there is a quarter of million cash that is not used to generate money. It’s like dead money at this point.
What would be your choice?
- Sell the townhouse and use the part of proceeds to buy a smaller place like apartments
- Take the equity line to buy the apartment and place renters to get a positive cash flow
- I would not pay off the house but rather invest my cash and generate better return
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DISCLAIMER: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before following any investment strategies or rules mentioned or recommended.
Author's Note: Please excuse any typos. I assure you that I will do my best to correct any errors if they were overlooked.