Should you pay off a mortgage?

One of the questions people frequently ask me is if they should pay off their mortgage and become debt-free. The question is a bit complex and depends on a lot of variables that we will explore.

Inflation

Inflation is a powerful force. Central bankers across the globe are constantly increasing the supply of money that exists. This causes currencies such as the US dollar to lose significant purchasing power over time. Let us review some history regarding inflation.

Since the Federal Reserve was created in 1913 the US dollar has lost 96% of its purchasing power. Another way to think of that is that it would take $25 dollars to have the same purchasing power as $1 in 1913.

Many things have happened since then, particularly the US went off a gold standard in 1971 and became a Fiat currency. The US dollar used to be redeemable for gold. If you bought something with US dollars in 1970, you were indirectly paying with gold. After 1971, anything purchased with US dollars was backed by nothing. Prices effectively doubled over the 1970s to compensate.

These times were amazing for homeowners with a mortgage. Inflation is a transfer of wealth from creditors to debtors. Money is redistributed from savers holding cash to those holding debt. Many people during the 1970s saw their mortgage payment become eroded by inflation while the value of their house may have tripled.

Houses in Brooklyn only cost $55 a month in 1911

Thus owning a home with a fixed-rate mortgage is a great hedge against inflation. If there is inflation, your cost of living will rise but you will be protected because the future cost of your mortgage is reduced.

Even if heavy inflation never materializes, these forces work in your favor. At 2% inflation per year, a mortgage would lose 21.8% of its value over 10 years compounding. A $1,000 a month mortgage payment magically turns into $817 a month in today’s dollars. If inflation picks up then you basically won at the slot machine.

The key to note here is that you want a mortgage for an inflationary situation so that the debt gets wiped out. A paid-off house does not offer as much protection.

Tax deductions

Mortgage interest is tax-deductible. Recent changes to the tax code have made this less favorable due to increases in the standard deduction. If you have enough itemized tax deductions and your mortgage interest is high enough then you can effectively take a huge tax break. Depending on how low of a rate your mortgage is, after inflation and tax deductions, your “interest expense” may actually be free.

Forced savings vehicle

One reason that housing helps families build wealth is that it is a forced savings vehicle. It is not a terribly great investment. Let’s be honest, most households have very little self control financially. They spend every penny they earn. The portion of the mortgage payment that is applied towards principle effectively forces them to save assuming that they are not constantly withdrawing equity.

When one is deciding to make extra mortgage payments or not they should seriously consider what they would do with the money as an alternative. If you don’t make extra payments are you going to invest the money wisely? Or will it be squandered on vacations, new cars, and consumer goods? If it is the latter, then paying off the mortgage is probably a smart decision.

Investment opportunities

A key in deciding to pay off a mortgage depends on what investments you have as an alternative. If you can invest in an asset that yields a higher rate than your mortgage it will never make sense to pay off a mortgage. For instance, if your mortgage rate is 4% but you can gain a 5% return in the stock market after taxes, it won’t make sense to pay it off. You’d end up wealthier investing the proceeds.

Emotional considerations

There are secondary benefits to being debt-free and having a mortgage paid off. People who are debt-free have less stress and feel more secure emotionally. They don’t have the weight of debt hanging over them. They don’t feel like an indentured servant that must work to pay their debtors. From a happiness perspective, it can be beneficial to pay off your mortgage.

Historically American families would hold “mortgage burning parties” to celebrate their newfound financial freedom with friends and family. These days those rarely happen because families constantly stretch their finances to the maximum. As soon as their house starts to build up equity, they sell it and buy an even more outlandish house relentlessly. This cycle typically repeats until people realize they are working into their golden years.

Conclusion

To me, if you have a fixed-rate low-interest rate (less than 4.5%) it doesn’t make sense financially to pay off the mortgage. It is a great inflation hedge. It is often best to pay off a mortgage as slow as possible in order to save or invest the extra money. I am personally paying my mortgage on the minimum payment using a 30-year fixed-rate loan. I have no plans to accelerate payments even though I could pay off the mortgage balance.

If you would not invest any extra mortgage payments and there is a chance the money would be spent then paying off your mortgage makes sense.

In cases where you do not have a fixed-rate mortgage, you don’t really have a lot of inflation hedging. If inflation rises then presumably the interest rate on your mortgage will also rise. Although it is usually capped this presents a liability that makes paying off your mortgage worthwhile.

Although it is suboptimal from a financial perspective, many people like to be debt-free as it provides comfort psychologically. That is a respectable position. You likely won’t end up as wealthy but at the end of the day happiness and security are important.

The decision to pay off a mortgage is complex and involves many variables. I don’t think there is a one size fits all “Suze Orman” solution.

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