Ask The Gourmet
As a financial planner, I get asked certain questions a lot. One of the most common is some variation of "Should I Pay Off My House". Of course, the answer depends upon your specific circumstances. With that in mind, here is a guide to whether or not you should pay off your house.
Should I Pay Off My House Early
Sometimes, when thinking about a big concept it can be illuminating to evaluate the two extremes. Who do you think is in a better position? Someone who has owns their $500,000 house free and clear, but has no other money, or someone who has a $500,000 mortgage on their house, but has $500,000 in the bank?
The first person, has no chance of retiring. How will they pay for groceries or gas, or even the necessary up keep on the house? The other person, however, may have a pretty good shot depending on their lifestyle and expenses. Likewise, the first person is ill prepared for a financial emergency where the second is in a much better position to weather a setback whether it is a six month layoff, or replacing a furnace.
In real life, of course, no one ends up at either of these extremes, but it does illustrate the concept that advisors call "dead equity." Dead Equity, sounds much worse than it is. Basically the concept is that although the equity in your home counts toward your net worth it is relatively inaccessible. The only way to use the equity in your house is to take out a loan. So, how do we decide?
Are You Behind?
Do you owe back taxes? Do you have credit card balances? Are you 63 years old and have $23,000 in your 401(k)? Do you have $50,000 in student loans? Do you have four daughters who will be starting college in the next couple of years and no money saved? If you are behind, then get caught up before you pay off your house. Having your house paid off will not help you catch up. Do the simple math. How much sense does it make to pay off a 6% loan (your mortgage) when you have a 12% loan (your credit cards)? Pay off your other debts first. Then, use the savings from those monthly payments to pay extra on your house if after reading the rest of this article that makes sense for you.
The Extra Money Myth
Some people think that by not having a mortgage payment they will have extra money each month that they used to send to the mortgage company. On paper this is true. In real life, your world expands to meet the available resources. For 99% of people, two years from the day you pay off your mortgage, your monthly expenses will be such that you couldn't get through the month without those extra dollars. Basically, the extra money is gone. For the lucky few who are great savers, that may not be the case, but if you aren't a great saver today, you won't be a great saver tomorrow. If you can save $1,000 a month now, paying off the mortgage might let you save more each month. If you can barely squeeze $400 a month in savings right now, you won't end up saving that extra monthly money. Trust me.
The Home Equity Line Catch 22
People looking to pay off their home look to the idea of a home equity loan as their "safety net." The problem with that idea is that nobody wants to loan money to people who need their safety net. For example, Bob owns his $800,000 free and clear. Bob loses his job and over the course of five months uses up most of his savings. He goes to the bank to get a $25,000 home equity loan only to be turned down or offered a high interest rate. Why? He has tons of equity in his home, that loan isn't even 5% of his equity. Well, to be blunt, how is Bob going to pay the loan back? Without a job how can he expect to make payments? An equity loan is still a loan, no matter how much equity you have. They expect you to pay it back, and the number one question is how will you do that? The only answers are with your income, or with your savings. Of course, if Bob had the savings, he wouldn't need the loan. From the bank's point of view, they are in the same boat as Bob. The only way to get their money back is to sell the house.
Even if you can get the loan it still doesn't make sense. Now, you have higher monthly expenses (the loan payment), plus you are losing money (paying interest) on YOUR SAVINGS! Does this sound like sound financial strategy?
The Reverse Mortgage Myth
One of the least understood concepts in all of finance is the reverse mortgage, and yet, a lot of people count on it as "their plan."
For starters, the businesses who offer reverse mortgages are not non-profit, good Samaritans, running a charity for people who pay off their houses. They are businesses looking to turn a profit just like everyone else. How do they make a profit? They profit by giving you less money for your house over the time you are alive than they can sell your house for on the day that you die. The spread is their profit, and it is the number one thing people forget when they think about a reverse mortgage.
How much money you get for a reverse mortgage then is a function of two things. One, what your house is worth, and two how long you will live. To get an idea of how this works, let's pretend we have a crystal ball. If you have an $800,000 house that you own free and clear, and you will die next year, then you could get a reverse mortgage for around $720,000. What? Why only $720,000? Well, that gives the company a 10% revenue stream. Sound too high? Well, keep in mind that in order to get their money they have to file a bunch of legal paperwork, plus pay a real estate commission, and taxes, and closing costs. When you think about it, 10% might be too low. What if you are going to live for 5 years? Well, to get a 10% lump sum, plus to make 6% or so per year on their investment (you wouldn't invest in something unless it was paying at least 6%, not when you can get 5% in a CD or online bank account right?) you are only going to get around $500,000. If you are going to live 10 years, you'll get even less money.
The problem is that they don't have a crystal ball, so they are going to have to build in some padding just in case you live longer than expected. In other words, unless you are in your 80s or in bad health, don't expect anything over 50% of your home's worth for your reverse mortgage. Oh, and by the way, your kids get nothing when you do this.
Do not ever plan on a reverse mortgage. It is a last resort only.
The Security of Having Your Home Paid Off Myth
This is the big one. Everyone who thinks about paying off their house thinks about security. Well, sooner or later your "security" will need the roof replaced. Your "security" will need new carpet, or new air conditioning, or new cabinets. Paying off your house is security if and only if you have cash to back it up. Cash is security. You can't eat your house or the equity in it. First, make sure you can eat (with your cash), then pay off your house.
Pay Off Your Home With A Lump Sum
When people retire or inherit money it can come in a big chunk all at once. When this chunk is bigger than the mortgage, people start to wonder about paying off the house. The first thing you should do in this case is review your financial plan. (This is why you want to already have a trusted financial advisor BEFORE you end up in this situation.) Your financial plan should spell out your goals and how to achieve them. Assuming your goals have not changed, you are looking at a blueprint of what to do with your money. Use that extra money to fulfil that goal of sending your kids to college. Use that extra money to shore up your retirement nest egg, or to buy the ski condo, or to pay off your cars. You might need some help turning monthly savings amounts into lump sums but otherwise, I always tell people if these are still your goals and dreams, then let's use the money to get you the things you want. Money is worthless. The things that money buys are what we want.
If your financial plan is already set, and your cash reserve is in place, then you CAN payoff your house, but...
Your Mortgage Is Cheap
We like the idea of paying off our mortgages because it is one of the biggest monthly expenses for most of us. But that doesn't mean it isn't cheap.
Your mortgage costs you less than your interest rate. One of the few tax deductions actually usable by the average working American is the home interest deduction. For every dollar of mortgage interest you pay, you get a deduction up to $1 million dollars in interest. (If you ever get to the point where you pay $1 million in interest, trust me, we won't be having this conversation.) So, if you are in the 20% tax bracket, your mortgage actually costs you the interest rate minus 20% approximately. (Yes, the actual math is slightly different.) So if you have a 6% mortgage then 20% of 6% is 1.2% leaving you an after-tax interest rate of 4.8%. If you can find somewhere to earn better than 4.8% then paying off your mortgage is dumb. If you are in the 30% tax bracket then the number is 4.2%. I can think of about a dozen places to earn better than that without breaking a sweat.
If you have read the rest of Finance Gourmet, you know that I don't believe life is lived on a spreadsheet. Just because the numbers say it might be dumb to pay off your mortgage doesn't mean you won't feel better when it is gone. The key to the mortgage versus cash question is to do both. How? Try and keep it equal. If you have $200,000 in equity, try and have $200,000 in cash (savings and investments). When the housing markets are going up, you are likely to be losing this battle. Many of my clients found themselves with $200,000 in equity just a few years after buying their houses without paying any extra. So, in that case, stick with saving and investing. When the housing markets are a little less frothy, things will be different. Yes, you can count your 401(k) and IRAs. Just make sure you have a big enough cash reserve before you pay any extra toward your house.
So, how do you pull off this balance in real life? First, you need to know where you stand. If you have $100,000 in your 401(k), $30,000 in your emergency fund, and $20,000 in other savings, then you have $150,000. If you have $80,000 in equity, then it is time to start tipping the scale. Don't sell your investments to make this move, instead shift the balance toward your mortgage. If you have been saving $1,500 into your savings, then move it to $1,000 and add $500 to your mortgage. Keep in mind that over the long term, the real estate market will do a lot of the work for you no matter how bad things look at the beginning of 2008, so don't go crazy. Also, look to build up your extra "pay off". That is, build up $20,000 in "extra" savings and then write a check for $20,000 to your mortgage one day. Why? Because if you can build up $20,000 in extra savings, then you know you aren't using money you can't afford to use.
Pay It Off Early And Smart
Nobody is saying not to pay extra money each month to your mortgage if you can afford it. If you are saving money each and every month (you should be), then by all means send some extra to your mortgage. I tell everybody to round their mortgage up to the next $100. If your monthly payments is $1928, then send in $2000 every month. This extra money goes right to the principal, and makes the interest for every subsequent payment lower which means when you pay extra once, you pay extra every time!
If you get a raise, or money seems to be coming a little easier bump it up some more. $2100 in the case above. Take it a small amount at a time, and you won't put yourself behind the eight ball. In the mean time build your savings and investments.
Trust me, "Should I take $180,000 from my big investment account to pay off my mortgage?" is a great conversation to have, no matter what the final answer.