September 27, 2019Individual Investment Management

One of the most common questions I get from prospective or current clients is whether to retire a mortgage early. Since it comes up often, it's worth writing this month's note on the subject. Here are a few "rules" when it comes to making this decision:

Rule #1...Cash is not a "cost-free" transaction.
There is NO such thing as a "cost-free" way to pay for anything. You either use someone else's money (and pay interest), or you pay cash (self-financing). In the case of paying cash, the "cost" of self-financing is the lost opportunity to invest those dollars in other growth assets. This also means you lose the ability to compound those assets as well. With rates at historic lows, you have the chance to borrow cheaply and use your own money to invest in the economy long term. This has historically proven to yield a higher investment return than what is "earned" by paying off a house early. Your rate of return on retiring a mortgage can never exceed the rate of the mortgage itself - not a good long term decision.

Rule #2...Liquidity is underrated!
One of the hallmarks of any financial crisis (read: 1929, 1974, 2008) is that people over-extend their liabilities and forget about maintaining ample cash reserves. Paying off a mortgage early artificially depletes your cash reserves and puts you at increased risk. In many cases during times of financial stress, an extra 60-90 days of cash reserves can provide you enough time to weather a severe downturn or job loss.

Rule #3...Home equity pays 0% - always.

Many people confuse the value of their home with the equity inside of it. The value of your home will rise or fall regardless of your mortgage. Increased value of a home can only be realized by selling the property. Building equity in a home quickly doesn't earn me any additional money if I paid off the mortgage - it just concentrates more of my assets in a single asset class (residential real estate) and raises my risk.

"Many people confuse the value of their home with the equity inside of it."

OK...I promised an exception...
Yes I did! If you're close to retirement, have a decent cash reserve, and the house is close to paid off, I as a planner would give that mortgage payoff my blessing. An example is helpful at this point:

A couple I recently sat with was trying to decide if they should retire their mortgage. A brief look at their standing revealed the following:
Months left:  32 months
Balance:  $51,300
Cash Reserves:  $120,000
Months till retire:  48 (estimated)

This couple had not accelerated any payments in the past - rather they had used previous years earnings to fund retirement accounts and investments. This gave them time to build assets toward retirement. However, the couple was considering the payoff because they were thinking of starting a part-time business after retirement. In this case, it made sense for the couple to use cash reserves to pay off the note.