Why pay off your house?

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sscritic
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Re: Why pay off your house?

Post by sscritic »

avalpert wrote: why not? If you could get a mortage at 0.25% and 30 year bonds were paying 12% would you not do it? Is there really 'no way' you would consider it or is it just a matter of finding your breakeven point?
And under the same circumstances, would you sell all your bonds to pay cash for your house rather than take a mortgage?

The nice thing about the "if you sold all your investments today, would you buy back the same things" analysis is that you have to look from both sides, why hold what you wouldn't buy. I like the same type of analysis for the house mortgage investment question. If things were reversed, would you go back to what you have today? It's not just would you mortgage the house you have, but would you buy the house you have without using a mortgage?

As I stated in another thread, the borrowing is really to support the investments, not the house. Here are your choices:

1) House, debt 0, investments X.
2) House, debt Y, investments X+Y.

You have the house either way; the debt is what lets you have as much invested as you do.
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Clearly_Irrational
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Re: Why pay off your house?

Post by Clearly_Irrational »

Lars_2013 wrote:I've seen lists similar to this several times and I don't understand why the order of priority is based on the type of debt rather than the after-tax interest rate. Is the assumption that the after-tax mortgage interest rate will always be your lowest-cost debt? Or is there something else that I'm missing?

I'm asking because we chose to take a very low-interest rate car loan from our credit union rather than withdrawing investments and have been prioritizing pre-paying on our 4% mortgage ahead of pre-paying on our 1.5% car loan. (Our after-tax mortgage interest rate is pretty close to the 4%. We itemize, but are just on the edge of it being worthwhile, even after considering property taxes, state income taxes, and charitable contributions in addition to the mortgage interest. In a few years I suspect the standard deduction will be better for us due to interest decreasing over time and the standard deduction rising with inflation.)
Paying off debt is about two different considerations, first the interest rate you're paying and second the cash flow that's tied up. Yes, mathematically if nothing in your environment changes then paying off the highest interest rate first is the most efficient. However, life happens and having maximum free cash flow gives you a lot of flexibility that you wouldn't otherwise already have. Additionally, if you're going to be paying things off in interest order you need to calculate the after tax numbers or you're not making a fair comparison. Finally, there is psychological value to paying off debt that encourages you to continue and not rack up additional debt.
bobbun
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Re: Why pay off your house?

Post by bobbun »

It's interesting to me that as often as this topic comes up, people continually conflate paying off a mortgage vs. paying down a mortgage. These two things are not the same. A mortgage has both a cost and a risk. The cost is the amount of interest you pay. The risk is a type of liquidity risk--if you don't have sufficient cash on hand when the mortgage is due, you may lose the substantial amount of money you have tied up in the house due to foreclosure.

When you pay off a mortgage in full, you're eliminating both the cost and the risk associated with the debt. The philosophical discussion between whether it's more valuable to have low-cost leverage on your portfolio or the comfort of debt-free living makes perfect sense in the context that you could pay your mortgage and chose to or chose not to.

When you pay down a mortgage in part, without the funds to pay in full, the situation is different. You reduce the cost, but you have actually increased your risk, both because more assets are at stake in a foreclosure and because you have reduced your liquidity (this assumes you didn't recast). That liquidity could have been used to meet future mortgage payments and forestall foreclosure should events go other than as hoped. You're not living debt-free, nor are you able to do so, so the values discussion is somewhat moot.

As an alternative to a partial prepayment, you could reduce the (net) cost and reduce the risk, even without enough cash to pay off the mortgage entirely, by offsetting the mortgage with a bond position. Put the extra amount you would pay towards your mortgage into a bond fund, and when you have enough, pay off the mortgage in a lump sum. The cost of the mortgage is effectively reduced by earnings on the bond fund, and your risk is reduced because you're increasing your liquidity.
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Ketawa
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Re: Why pay off your house?

Post by Ketawa »

bobbun wrote:It's interesting to me that as often as this topic comes up, people continually conflate paying off a mortgage vs. paying down a mortgage. These two things are not the same. A mortgage has both a cost and a risk. The cost is the amount of interest you pay. The risk is a type of liquidity risk--if you don't have sufficient cash on hand when the mortgage is due, you may lose the substantial amount of money you have tied up in the house due to foreclosure.

When you pay off a mortgage in full, you're eliminating both the cost and the risk associated with the debt. The philosophical discussion between whether it's more valuable to have low-cost leverage on your portfolio or the comfort of debt-free living makes perfect sense in the context that you could pay your mortgage and chose to or chose not to.

When you pay down a mortgage in part, without the funds to pay in full, the situation is different. You reduce the cost, but you have actually increased your risk, both because more assets are at stake in a foreclosure and because you have reduced your liquidity (this assumes you didn't recast). That liquidity could have been used to meet future mortgage payments and forestall foreclosure should events go other than as hoped. You're not living debt-free, nor are you able to do so, so the values discussion is somewhat moot.

As an alternative to a partial prepayment, you could reduce the (net) cost and reduce the risk, even without enough cash to pay off the mortgage entirely, by offsetting the mortgage with a bond position. Put the extra amount you would pay towards your mortgage into a bond fund, and when you have enough, pay off the mortgage in a lump sum. The cost of the mortgage is effectively reduced by earnings on the bond fund, and your risk is reduced because you're increasing your liquidity.
You pointed out that prepaying a mortgage can be risky due to reduced liquidity. Well, this is why nobody would recommend prepaying a mortgage without having a suitable emergency fund.

IMO you should also call keeping the mortgage a risk, and not reserve the word risk for the liquidity question. Prepaying a mortgage reduces the overall leverage in an investor's finances. This makes the overall financial picture less risky, similar to increasing an allocation to bonds. A larger mortgage is more risky in the same way that a lower allocation to bonds is more risky. And since the tax-adjusted interest rate on the mortgage is typically higher than the rate on safe bonds, prepaying the mortgage is usually the better choice over a higher allocation to bonds.

Deciding whether to prepay or not is a balancing act between these two risks.
leonard
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Re: Why pay off your house?

Post by leonard »

Rufus608 wrote:Isn't housing a life-long cost? IF you factor it as a constant cost into retirement, do you need to rush to pay it off now?

If yes, what about the loss of a tax deduction?

Don't you want your money more liquid than dependent on the real estate market?

Confused.....
No more concern about payments, posting of payments, writing checks, initiating online payments, etc. etc. Paying it off eliminates a big piece of administrative mind share in life.
Leonard | | Market Timing: Do you seriously think you can predict the future? What else do the voices tell you? | | If employees weren't taking jobs with bad 401k's, bad 401k's wouldn't exist.
avalpert
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Re: Why pay off your house?

Post by avalpert »

leonard wrote:
Rufus608 wrote:Isn't housing a life-long cost? IF you factor it as a constant cost into retirement, do you need to rush to pay it off now?

If yes, what about the loss of a tax deduction?

Don't you want your money more liquid than dependent on the real estate market?

Confused.....
No more concern about payments, posting of payments, writing checks, initiating online payments, etc. etc. Paying it off eliminates a big piece of administrative mind share in life.
Really, setting up an automatic withdrawal once is a measurable piece of administrative mind share? That's as bad a reason for making this decision as losing a tax deduction would be - it is trivial in this day and age to put mortgage payments on autopilot.
leonard
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Re: Why pay off your house?

Post by leonard »

avalpert wrote:
leonard wrote:
Rufus608 wrote:Isn't housing a life-long cost? IF you factor it as a constant cost into retirement, do you need to rush to pay it off now?

If yes, what about the loss of a tax deduction?

Don't you want your money more liquid than dependent on the real estate market?

Confused.....
No more concern about payments, posting of payments, writing checks, initiating online payments, etc. etc. Paying it off eliminates a big piece of administrative mind share in life.
Really, setting up an automatic withdrawal once is a measurable piece of administrative mind share? That's as bad a reason for making this decision as losing a tax deduction would be - it is trivial in this day and age to put mortgage payments on autopilot.
I disagree. As simple a transaction as it is - it needs to be monitored. Mortgage amortization schedules are complex - the application of payment to interest and principle need to be monitored for accuracy. Payments are misapplied. I work in finance and accounting - believe me mistakes happen all the time. So, "autopilot" doesn't work.

I am much happier without the headache and wouldn't accept the tax deduction benefit back ever.
Leonard | | Market Timing: Do you seriously think you can predict the future? What else do the voices tell you? | | If employees weren't taking jobs with bad 401k's, bad 401k's wouldn't exist.
placeholder
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Re: Why pay off your house?

Post by placeholder »

That is quite the stretch.
leonard
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Re: Why pay off your house?

Post by leonard »

placeholder wrote:That is quite the stretch.
"That"?
Leonard | | Market Timing: Do you seriously think you can predict the future? What else do the voices tell you? | | If employees weren't taking jobs with bad 401k's, bad 401k's wouldn't exist.
EnjoyIt
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Re: Why pay off your house?

Post by EnjoyIt »

So here is the answer I think.

If you have enough cash in an emergency fund, and the value of your home is not a huge percentage of your wealth, then paying off that low interest rate mortgage may be a good idea even financially as you don't need to take on unecessary risk.

If you don't have much of a nest egg, then taking on the risk of arbitraging your low interest rate mortgage for a few extra dollars in the market is probably a risk worth taking. Not to mention you don't want all your wealth stuck in a house.
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fourwedge
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Re: Why pay off your house?

Post by fourwedge »

My wife and I max out our tax advantaged retirement space 28,500 and triple our house payment. ... And our interest rate is only 2.875%. The peace of mind that comes with a paid for house is irreplaceable. Our 10 year mortgage is due to be paid off in 2 years instead. We have a TIGHT budget and live on nothing, throwing every extra dollar at the mortgage.

Freedom is just about 7-9 months away!
Max out your tax sheltered retirement accounts with inexpensive, well diversified, index funds and you will beat 90% of all investors.
Curlyq
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Post by Curlyq »

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fourwedge
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Re: Why pay off your house?

Post by fourwedge »

Another question no one has addressed....


Where is this big tax deduction everyone is talking about with a mortgages???

Specifically... How much money are you saving on your taxes? And how much interest are you paying?



No one that talks tax deduction ever answers this question when I pose it.
Max out your tax sheltered retirement accounts with inexpensive, well diversified, index funds and you will beat 90% of all investors.
avalpert
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Re: Why pay off your house?

Post by avalpert »

fourwedge wrote:Another question no one has addressed....


Where is this big tax deduction everyone is talking about with a mortgages???

Specifically... How much money are you saving on your taxes? And how much interest are you paying?



No one that talks tax deduction ever answers this question when I pose it.
Really, no one ever answers that question - how many times have you posed it without a response? Any examples.

I paid $5,245 in mortgage interest last year - which was then worth ~1,469 in lower federal taxes and ~$288 in state taxes. So my net interest expense was $3,488.

For comparison, my net portfolio returns on the value of my mortgage last year was about $19,000 (that's a low end approximation)

Any other questions no one has addressed for you?
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Ketawa
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Re: Why pay off your house?

Post by Ketawa »

fourwedge wrote:Another question no one has addressed....

Where is this big tax deduction everyone is talking about with a mortgages???

Specifically... How much money are you saving on your taxes? And how much interest are you paying?

No one that talks tax deduction ever answers this question when I pose it.
Is this a rhetorical question meant as a barb towards people who tout the tax benefits of a mortgage, or was it asked sincerely? People answer it frequently. There are two things to look at.

1. Overall effective interest rate of the mortgage. You exclude mortgage interest from your tax return and determine how much tax you would owe without a mortgage. Then determine how much tax you would owe with mortgage interest on your deductions. Reduce the mortgage interest by the change in tax liability and you have the overall effective interest that the mortgage is costing you. This way, you can account for a scenario where some of the mortgage interest is not helping your tax return since you are still below the standard deduction, and the rest of the interest is putting you over the top.

2. Marginal benefit of extra payments towards mortgage principal. This is more simple. If you itemize, multiply the mortgage interest rate by (1 - marginal tax rate). If you take the standard deduction, it's just the mortgage rate.
avalpert wrote:Really, no one ever answers that question - how many times have you posed it without a response? Any examples.

I paid $5,245 in mortgage interest last year - which was then worth ~1,469 in lower federal taxes and ~$288 in state taxes. So my net interest expense was $3,488.

For comparison, my net portfolio returns on the value of my mortgage last year was about $19,000 (that's a low end approximation)

Any other questions no one has addressed for you?
This is an incomplete story since we don't know what your portfolio holds. If you have bonds in your portfolio and barring barriers like large embedded capital gains, or funds being in tax-advantaged accounts, you might be borrowing at a rate that's higher than the bonds you hold, and you could have done even better by selling bonds to pay the mortgage and holding the same amount in equities.

Just trying to give fourwedge more food for thought. :sharebeer

I would still recommend that the first priority be maxing tax-advantaged accounts every year before paying low interest mortgage debt ahead of schedule.
freddie
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Re: Why pay off your house?

Post by freddie »

Bonds pay out more than what a mortgage is these days. Mortgage: 3.5% *(1-.43)= 1.995%. Muni funds in my state are yielding ~2.7%. I guess that's the win of being in the high tax brackets:) Yeah I know munis are not remotely risk free. I am a big gambler and am willing to bet I can make 2% over the next 30 years. I like to live dangerously:)


Ketawa wrote:
fourwedge wrote:Another question no one has addressed....

Where is this big tax deduction everyone is talking about with a mortgages???

Specifically... How much money are you saving on your taxes? And how much interest are you paying?

No one that talks tax deduction ever answers this question when I pose it.
Is this a rhetorical question meant as a barb towards people who tout the tax benefits of a mortgage, or was it asked sincerely? People answer it frequently. There are two things to look at.

1. Overall effective interest rate of the mortgage. You exclude mortgage interest from your tax return and determine how much tax you would owe without a mortgage. Then determine how much tax you would owe with mortgage interest on your deductions. Reduce the mortgage interest by the change in tax liability and you have the overall effective interest that the mortgage is costing you. This way, you can account for a scenario where some of the mortgage interest is not helping your tax return since you are still below the standard deduction, and the rest of the interest is putting you over the top.

2. Marginal benefit of extra payments towards mortgage principal. This is more simple. If you itemize, multiply the mortgage interest rate by (1 - marginal tax rate). If you take the standard deduction, it's just the mortgage rate.
avalpert wrote:Really, no one ever answers that question - how many times have you posed it without a response? Any examples.

I paid $5,245 in mortgage interest last year - which was then worth ~1,469 in lower federal taxes and ~$288 in state taxes. So my net interest expense was $3,488.

For comparison, my net portfolio returns on the value of my mortgage last year was about $19,000 (that's a low end approximation)

Any other questions no one has addressed for you?
This is an incomplete story since we don't know what your portfolio holds. If you have bonds in your portfolio and barring barriers like large embedded capital gains, or funds being in tax-advantaged accounts, you might be borrowing at a rate that's higher than the bonds you hold, and you could have done even better by selling bonds to pay the mortgage and holding the same amount in equities.

Just trying to give fourwedge more food for thought. :sharebeer

I would still recommend that the first priority be maxing tax-advantaged accounts every year before paying low interest mortgage debt ahead of schedule.
Last edited by freddie on Tue Apr 08, 2014 10:48 pm, edited 1 time in total.
avalpert
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Re: Why pay off your house?

Post by avalpert »

Ketawa wrote:
avalpert wrote:Really, no one ever answers that question - how many times have you posed it without a response? Any examples.

I paid $5,245 in mortgage interest last year - which was then worth ~1,469 in lower federal taxes and ~$288 in state taxes. So my net interest expense was $3,488.

For comparison, my net portfolio returns on the value of my mortgage last year was about $19,000 (that's a low end approximation)

Any other questions no one has addressed for you?
This is an incomplete story since we don't know what your portfolio holds. If you have bonds in your portfolio and barring barriers like large embedded capital gains, or funds being in tax-advantaged accounts, you might be borrowing at a rate that's higher than the bonds you hold, and you could have done even better by selling bonds to pay the mortgage and holding the same amount in equities.
Well, we've discussed this question enough time here for people to see all sides of the issue but I don't adjust my portfolio allocation because of my mortgage - so I think it is fairer to compare it to my portfolios weighted average return since the money would come out of the investments that way. I wasn't claiming to compare risk-adjusted returns because as you know, I can't buy anything with risk adjusted returns.

But if someone wants to see the comparison, my fixed income returns last year were ~4.25% and my mortgage interest rate is 2.625%. If you wanted to tax adjust that, I get 28% tax deduction off my mortgage interest and my fixed income is all in tax-advantaged accounts that I expect to average at 0 to 15% when withdrawn.
JFC
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Re: Why pay off your house?

Post by JFC »

In our case we paid the first house in 48 months but we did buy below our means. Then, when I changed career and went from internship to short term entry level jobs with unemployment in between for 3 years, we were happy to save these 10 000 dollars every year. We were able to sell and move.

Somebody earlier mentioned that a mortgage is a fixed cost eroded by inflation. It is worth to mention that this fixed obligation must be met, for most retired people, with a variable income, with the risks that implies. Also remember that the dollars taken from a retirement account to pay a mortgage will be taxed at the top rate versus somebody who paid off his mortgage: to get 10 000 spendable dollars, you will need to draw 12 000 (15% state+federal), 12500 (20%), 15000 (30%) which, if you apply the 4% rule will require 300k, 325k, 375k, etc... In savings.
freddie
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Re: Why pay off your house?

Post by freddie »

And that money that went into the house and not the retirement account was also taxed at the top rate. Sure you need to have 300k more if you have a mortgage. But guess what you have that because you didn't pay down the mortgage:)

JFC wrote:In our case we paid the first house in 48 months but we did buy below our means. Then, when I changed career and went from internship to short term entry level jobs with unemployment in between for 3 years, we were happy to save these 10 000 dollars every year. We were able to sell and move.

Somebody earlier mentioned that a mortgage is a fixed cost eroded by inflation. It is worth to mention that this fixed obligation must be met, for most retired people, with a variable income, with the risks that implies. Also remember that the dollars taken from a retirement account to pay a mortgage will be taxed at the top rate versus somebody who paid off his mortgage: to get 10 000 spendable dollars, you will need to draw 12 000 (15% state+federal), 12500 (20%), 15000 (30%) which, if you apply the 4% rule will require 300k, 325k, 375k, etc... In savings.
JFC
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Re: Why pay off your house?

Post by JFC »

To keep the risk at the same level as a mortgage you would have to accumulate 30 years us treasuries. We never had enough interest to itemize and any interest/qualified dividend would have been taxed at what? 15%?
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