Should You Pay Off Your House?

It is commonly thought that paying off your house as soon as possible makes good financial sense. However, this is often not the case. Here is an illustration of why it is usually best to mortgage 80% of the cost of the house and not to pre-pay on the loan.

Mr. Payment, Mr. Pre-pay, and Mr. Cash are each buying a house for $100,000. Each has $100,000 in cash and each has $1,000 per month to spend on mortgage payments and/or to save.

Mr. Payment uses $20,000 as a down payment and invests the remaining $80,000. He takes on a 30-year fixed rate mortgage payable at 7% for $80,000. His monthly payments are $532. Recall that each buyer has $1,000 per month to spend or save, therefore, Mr. Payment has an additional $468 to save each month for 30 years. In addition, he can invest the tax savings from mortgage interest tax deductions.

Mr. Payment’s Initial Situation

Mr. Pre-pay takes on the same mortgage for $80,000. He also puts down $20,000 and invests the remaining $80,000 he has in savings. He too has a monthly mortgage payment of $532 and an additional $468 per month remaining after making mortgage payments. However, instead of saving, he pre-pays on the mortgage each month. After nine years, the house will be paid for and Mr. Pre-pay will then be able to save $1,000 a month for the next 21 years. He also saves income tax deductions to his investment portfolio for the nine years he is paying some mortgage interest.

Mr. Pre-pay’s Initial Situation

Lastly, Mr. Cash pays for his house using his $100,000 in savings. Since he has no mortgage payments, he is able to save $1,000 per month for 30 years. He receives no income tax deductions.

Mr. Cash’s Initial Situation

Let us look at the advantages and disadvantages of each situation. Mr. Cash’s house is paid for. He has no monthly mortgage payments to worry about and he is not paying interest. This is generally what most people consider the “sleep better at night” scenario. However, what happens if Mr. Cash has an emergency and suddenly needs $20,000? All of his money is tied up into the house. Selling the house is not a viable option. Besides borrowing from friends or family, his only other apparent option is to take an equity line of credit.

Mr. Pre-pay has what most consider the best of both worlds. Mortgage payments and pre-paying will end in nine years and his home will be paid for at that time. He also has an investment portfolio that has been growing the entire time and after the mortgage is paid, he can begin saving $1,000 monthly. Unlike Mr. Cash, Mr. Pre-pay has easily accessible emergency reserves. He can either sell a portion of his investment portfolio or margin (borrow against) the account, often at a rate lower than an equity line of credit.

Similar to Mr. Pre-pay, Mr. Payment also has easy to access emergency reserves. However, Mr. Payment will not own his home completely for 30 years and in that time he will have to make monthly mortgage payments. His biggest benefit comes down to the end result. In 30 years, all three will have a paid-for home, but Mr. Payment will have the largest of the three investment portfolios.

Investment Portfolios 30 Years From Now

*Assuming 11% annual rate of return on initial investment, monthly savings, and annual income tax deduction savings and 34% tax bracket.

Mr. Cash and Mr. Pre-pay gained nothing financially from paying off their homes early. In addition to the actual cost of the home, it cost Mr. Pre-pay $521,858 (difference between Mr. Payment’s portfolio and Mr. Pre-pay’s) to have his home paid for in nine years. Mr. Cash has an even greater difference. The cost to “sleep better at night” was $994,377. For many, that is a high price to pay for good sleep.

Is it worth it? Each homeowner will have to decide what is best for him or herself, but from a purely financial standpoint, it usually makes the most sense not to pay off your mortgage early. In times of higher interest rates, borrowing becomes less advantageous, but in times such as today when interest rates are lower, borrowing is more advantageous.

Disclosures

This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.