Monday, December 12, 2011

Should mortgage be paid in full before retirement starts?


Last week, we were able to refinance our house for pretty attractive interest rate, and we face the 30 years of payments ahead again, as we just started. Conventional wisdom says that lower interest on your loan is better, especially if the loan is a big as mortgage usually is. Simple calculation will show you that you are saving tens of thousands, and there is quite unclear if such low interest will ever be on the real estate market again. May be yes, may be no. In any case, if the interest drop is significant, reasonable fees you pay for refinancing are justified.

But refinancing is not the main topic for this post. I would like to discuss with you if the mortgage should be paid earlier if possible by writing each month a check which is bigger than your required minimum payment. There is no straightforward answer, as it all depends on the amount of payment, income, your ways to spend money, your lifestyle, your retirement plans, and more other circumstances. But, we will try to bring together some related considerations for you to decide.

First of all, start viewing on your monthly mortgage bill not only as inevitable evil, but also as your savings. For most people, a mortgage is the biggest monthly bill. Although few realize it at first, their mortgage also represents one of their biggest savings each month. Since a part - a growing part - of every mortgage payment represents the repayment of principal, part of that big monthly bill is actually savings.  At the end of the typical 30-year mortgage, you'll own your home free and clear.  Depending on what happens to the value of your home over that time, you might find yourself with quite an asset.

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Reasons Why Paying Off the Mortgage Early Is a Good Idea

There are a lot of people who think that paying off your mortgage early is a great idea and there is some valid reasoning both financial and psychological to support this approach. Yes, there is a psychological aspect of money that differs for each person. Money isn’t all about math for most individuals. Some are good at separating emotion from money and treating their finances as a business with little emotional attachment, but that’s not common in my experience. For some people, eliminating debt is preferred over maximizing money. For one, less or no debt can reduce stress, which improves your health.

Here are some of the reasons they give for paying extra:

  • Paying less interest on the mortgage: When you pay extra on your mortgage principal it ends up meaning you’ll shave months or years off of your mortgage, and you’ll save thousands of dollars in interest. For example, on a 300,000 dollar mortgage over 30 years, with an interest rate of 5%, you’ll end up paying over 309,000 in interest.  Cut that to a 15 year mortgage and you’re only paying 143,000 in interest. Cutting the payment term in half leads to significantly higher monthly payments, so that is out of question to many consumers, especially if the mortgage amount is high. However, even small additional sum you add to your check will cause direct deduction of your principle leading to the faster mortgage pay rate, and lowering the amount of total interest you’ll have to send to the mortgage company!
  • Less risk, more peace of mind: With less debt on your balance sheet, you have less risk in your life. You’ll have less to worry about when your only bills are food, taxes and other necessities. Add to that having the burden of debt removed from your shoulders. The psychological benefit of being free of debt isn’t to be underestimated. And speaking about retirement coming, think if will you be able to pay the same amount after retirement, as you are paying from your monthly paycheck. And what if you will get unemployed in your pre-retirement years, when finding a new good-paid job, or any job will be much more challenging due to your age?
  • More freedom: When you don’t have a mortgage payment when you retired you’ll have more freedom. Don’t want to take any job at retirement to meet your financial obligation, do not want to count on your grown-up kids’ financial help – you don’t have to because your monthly debt obligations are next to zero. Instead do something you love! You can afford it! You may be able even to help your kids yourself, if you want to.
  • Eliminating debt is a sure thing: While investing in the stock market isn’t a sure thing -having a paid off house you can live in IS.
  • Extra money to save, invest and give: When you have a paid off mortgage  you’ll have a lot more money left over every month that you can use to save invest and give. Can you imagine how fast your nest egg would grow if you had no debt obligations - including a mortgage?
  • More equity on hand: Paying off your mortgage means you’ll have more equity in your house, which could lead to a bigger reverse mortgage (a way for the 62-and-older crowd to turn their home equity into lump-sum or lifetime income, if needed).

The benefit of having a paid off mortgage can’t be understated. With no mortgage, and no other debts you’ll be free to pursue things that you enjoy. You’ll be able to work less doing things you enjoy. You can take the money you’ve saved in interest and build wealth. 

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Reasons Why and When You Don’t Want To Pay the Mortgage Off Early

There are those that say that while it’s a nice idea to pay your mortgage off early, there are reasons why you shouldn’t.
  • Liquidity of your assets and flexibility: One argument against paying off the mortgage is the idea that putting all your extra cash into your mortgage means you’re going to have a lot less liquidity in your assets, and if a situation is to arise where you needed money fast, your money would be all tied up in your house. This is very important and valid argument, and the reason why you need to have certain emergency fund, from which money can be pulled out anytime if needed.
  • Higher returns by investing your money: Many people argue that you would get higher returns on your money if you simply invest it. If you can get 7-8% on your money, you will end up coming out ahead. On the other hand, there is risk with investing as well, and there aren’t guarantees. Ben Stein advises: “Generally speaking, if you have a very low mortgage rate, it is better to invest the money than to pay off your mortgage. It's an interesting fact - the rate of return on your mortgage is the interest you're paying on it. If you have a 6 percent mortgage and you're paying it off, you're earning 6 percent. If you can earn more than 6 percent in the stock market, you should probably put it in the stock market. But, on the other hand, pay it off in an expeditious way. It's good to have it paid off, or at least mostly paid off, by retirement time”.
  • You miss your employer’s company match to your workplace retirement plan. If, for example, your employer matches you dollar-for-dollar on the first three percent of your contributions to your 401(k) plan, then you’re throwing away free money, if you decided to stop contribution to the plan in favor of making extra mortgage payments. If our employer matches even half that amount, then you’re still passing on a sure-fire 50% return on your money. Opportunities like that don’t come up too often. Take advantage of them when you can.

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  • You have other debt that accrues at a higher interest rate than your home loan. It definitely makes no sense to pay off a mortgage at the moment when you are carrying credit card debt at a higher interest rate. When you pay off a credit card with a 15% interest rate, for example, then every dollar of debt you pay off earns you an instant 15% return. Simple calculation helps to understand that the high interest loans should be paid first.
  • You owe significantly more on your house than it is currently worth. If your mortgage is upside down, the fact is you are more susceptible to foreclosure if you lose your job or suffer some other hardship that prevents you from making your payments.

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  • Inflation works for you: As inflation goes up by 3-4% annually, by not paying off the mortgage and paying it over time, you’re essentially paying less for the same amount of house every year. You pay the same today to live in the house that you do 30 years from now.
  • Tax deduction:  You can deduct the interest you pay on your mortgage, on your taxes. However, keep in mind that the true tax benefit is limited to the extent that your itemized deductions exceed the standard deduction, which in 2010 is $5,700 for single taxpayers and $11,400 for married taxpayers; those age 65 or older get an additional $1,400 (if single) or $1,100 (if married) deduction each. Also, mortgage payments progressively consist of more principal and less interest. Thus, the amount you can deduct declines each year. The bottom line: The mortgage-interest deduction can be valuable, but don’t overestimate it.

Summary

While there are multiple considerations as whether pay or not the mortgage early, I personally adapted several rules, which work for me and my family:
  • The mortgage should be paid in full by the retirement age, or even earlier for at least couple of years.
  • Do not put all eggs in one basket: try to get multiple assets in your retirement portfolio, and closer you get to the retirement age, less risky it should be.
  • The highest interest loans should be paid first.



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