One of the best feelings and positions in life is to be financially free. Financial freedom found from building sizable savings and being debt free can happen at any age with the proper planning.
One of the biggest questions you’ll face on your path to financial freedom is whether or not you should pay off your home mortgage. There is no black and white answer for everyone as the answer depends on a variety of variables, as with most financially related questions.
Below is a handy decision guide to help you discover whether or not you should pay off your mortgage.
1) Do You Have Other Debt Besides Your Home?
If you owe on your car, have credit card debt, or other loans it’s best to pay those debts off first because these are usually “unsecured” loans which carry a much higher interest rate than your home mortgage. A home mortgage is considered to be “good debt” because it helps to establish good credit and it may be an asset that appreciates in value unlike a car or boat, so always pay off “bad debt” before considering paying off your mortgage. It’s not uncommon for “bad debt” to cost you 7-11% in interest and when you pay it off it’s like making a return of 7-11%, guaranteed. Where else can you get a deal like that?
2) What’s The “Real” Interest Rate On Your Home Mortgage?
The interest you pay on your home mortgage may be one of the few things you can deduct off of your tax return each year, greatly lowering the true interest rate you’re paying on your loan. Say you have a fixed rate rate loan at 4% and you’re in the 25% tax bracket and you qualify for the mortgage interest deduction, the true interest rate you’re paying to the bank is 3%. 3% is seriously cheap money and odds are good that you’ll make more than 3% on your other investments.
3) What Are You Earning Vs. What Are You Paying?
If the effective interest rate (after taking into account the interest deduction) that you’re paying on your mortgage is 3% – 4.5% and you can earn 5% or more from your investments then it doesn’t make financial sense to payoff your mortgage. Think like a bank and keep more money in your pocket. Banks make money on the “spread”, the difference of what they loan money out minus what they’re paying you on your deposits. In other words, if you’re effectively paying 3% on your mortgage and you can make say 5% on your investments then your “spread” is 2% (your investment return versus the cost to keep your mortgage is +2%). The higher and the more stable return you can make on your investments the better the “spread” is in your favor.
4) How Much Have You Saved?
If your house was paid off today would you have enough savings to carry you to and through retirement? A good rule of thumb is that your investments and savings should be at least double the value of your home (assuming it was paid off). So, if your home is worth $300,000 you should have at least $600,000 in investments after paying off your mortgage, after all your home can’t feed you in retirement, but your investments can.
5) Could Your Mortgage Payment Be Paid For You?
The purpose of working to save money is so someday your money works for you. With a solid investment income plan in place, it’s possible that your investments can make your mortgage payment for you. I was discussing this very thing recently with clients of mine. They had a fixed mortgage payment of around $1,000 per month, so we carved out a slice of their investment portfolio and positioned it for income, approximately $203,000 with a income yield of 6.2%, so they would earn roughly $1,000 per month without touching their principal. The goal is that eventually, the house will be paid off, but they still have their $203,000 plus any potential growth earned in the meantime, theirs to enjoy or to pass onto their loved ones…a much better solution than paying off their home.
If the effective interest rate (after taking into account the interest deduction) that you’re paying on your mortgage is 3% – 4.5% and you can earn 5% or more from your investments then it doesn’t make financial sense to payoff your mortgage. Think like a bank and keep more money in your pocket. Banks make money on the “spread”, the difference of what they loan money out minus what they’re paying you on your deposits. In other words, if you’re effectively paying 3% on your mortgage and you can make say 5% on your investments then your “spread” is 2% (your investment return versus the cost to keep your mortgage is +2%). The higher and the more stable return you can make on your investments the better the “spread” is in your favor.
4) How Much Have You Saved?
If your house was paid off today would you have enough savings to carry you to and through retirement? A good rule of thumb is that your investments and savings should be at least double the value of your home (assuming it was paid off). So, if your home is worth $300,000 you should have at least $600,000 in investments after paying off your mortgage, after all your home can’t feed you in retirement, but your investments can.
5) Could Your Mortgage Payment Be Paid For You?
The purpose of working to save money is so someday your money works for you. With a solid investment income plan in place, it’s possible that your investments can make your mortgage payment for you. I was discussing this very thing recently with clients of mine. They had a fixed mortgage payment of around $1,000 per month, so we carved out a slice of their investment portfolio and positioned it for income, approximately $203,000 with a income yield of 6.2%, so they would earn roughly $1,000 per month without touching their principal. The goal is that eventually, the house will be paid off, but they still have their $203,000 plus any potential growth earned in the meantime, theirs to enjoy or to pass onto their loved ones…a much better solution than paying off their home.
One last word of caution, it’s easy to decide to payoff your mortgage because “it feels better” but be careful anytime you confuse a critical financial decision with an emotional feeling. The best feeling is knowing you’ve made the right decision for you.
This is an article Rob Russel wrote for Forbes Magazine
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