21 Jun 2019
Susan and Bob came to my office to discuss their financial situation. They proudly announced, “We have no debt; we even repaid our mortgage.”
Like many clients, Susan and Bob had bought into the belief that no debt is good debt. However, unlike credit card debt or other consumer debt, your home mortgage is actually good debt that can be used to your advantage.
There are two criteria to consider when assessing whether debt is “good” or “bad”:
• Will what is being financed last longer than the loan?
• Will the loan enable you to earn more in the future?
Credit card debt is often used to purchase short-lived items, such as evenings out, entertainment and vacations. And with interest rates in the teens and beyond, keeping a credit card balance clearly detracts rather than adds to your future earnings. It is bad debt.
Financing your home with a mortgage, on the other hand, meets the criteria for GOOD debt. Your home is a long-living asset that will last years longer than a 30-year mortgage. Since the interest on mortgages of up to $750,000 is tax deductible, the after-tax cost of the mortgage is substantially lower. If you are in a 22% tax bracket, a 4.625% mortgage rate actually costs you less than 3.75% after taxes, while stock market returns in the coming years are predicted to be 6% or higher.
In many cases, it is actually less risky to have a mortgage than to repay it. Here are four reasons not to pay off your mortgage:
1) If you put your excess cash into repaying your mortgage, you will lose the chance to earn higher returns and benefit from compound growth by investing in the stock market. In our above example, investing $100 a month would net $25,000, after capital gains taxes, in 15 years: higher than the savings from paying $100 towards your mortgage over the same time period.
2) It is riskier from an asset allocation standpoint to have a home paid off when you have few other assets. Many of my clients have home mortgages that are less than 50% of their home’s value, often making the equity in their home the greatest asset they own. For those of us who lived through the housing recession of 2008, this risk of “having too many eggs in one basket” is all too real. The lack of diversification can have devastating results if real estate values were to drop precipitously and you have no cash cushion.
3) You may compromise your liquidity. Never prioritize repaying your mortgage over having an adequate emergency fund. Most wage earners should have at least 10% of their annual income in a cash reserve; if you’re self-employed or retired, you should have an even higher amount. If you were to encounter adverse circumstances, such as loss of a job or disability, you may be unable to easily tap into your home equity and may instead be forced to take out costly loans.
4) A mortgage represents a buffer against inflation. When you have a fixed-rate mortgage, your mortgage actually becomes cheaper to pay over time in an inflationary environment, as the value of your money erodes but the monthly payment stays the same. In a worst case scenario – where interest rates actually drop, you can always refinance your mortgage without penalty.
For many, the smartest choice for your excess cash is to build a diversified investment portfolio. Over time, you will likely benefit from higher returns, years of tax breaks, and your mortgage payments will be relatively less expensive as inflation rises. A fee-only financial professional can help you determine the right amount of mortgage debt for your particular situation.