Should You Keep Your Mortgage or Pay it Off?

A home is the most valuable asset owned by most Americans. A key and confusing financial issue for many is how to manage the home equity. Proper management of the equity can increase net worth and enhance one’s life style.

Managing home equity means determining the trade off between a mortgage and unencumbered home equity. When cash is available, is it better invested in your portfolio? Or should the money be used to pay down the mortgage? If you are purchasing a new home for retirement, is it better to pay cash for the home or to take a mortgage to buy it?

The decisions can become complicated, because there are a number of factors to consider. The tax aspects of both the investment income and mortgage payments are important.

There are many rules-of-thumb people use to make these decisions. For example, subtract your tax bracket from one. Multiply the result by the mortgage interest rate. The result is the after-tax interest rate on the mortgage. In effect, that is the rate of return you earn by paying the mortgage with your cash instead of investing it. If your after-tax investment return exceeds the after-tax mortgage rate, keep the mortgage and invest the cash. If the mortgage rate is higher, pay off the mortgage (or pay cash for the home).

Suppose Max Profits has $300,000 from the sale of his home and is in the 28% tax bracket. He can use the cash to buy his new retirement home. Or he can invest the cash to earn 7% before taxes and take a $300,000 mortgage with an interest rate of 6.4%. Using the formula, Max would multiply 0.72 times 6.4 and see an after-tax mortgage yield of 4.61%. His after-tax investment yield is 5.04%. Using the simple formula, it makes sense to take the mortgage and invest the cash. Using the cash to pay the mortgage makes sense if the pre-tax yield Max can earn is 6.4% or less.

Let’s go beyond the simple rule of thumb and do a more elaborate analysis.

If Max invests the $300,000 to earn 7%, he receives $1,750 the first month in interest and pays income taxes of $700 on it, leaving after-tax income of $1,050. Max then takes a $300,000, 30-year mortgage with an interest rate of 6.4%. He pays $1,896.20 each month. In the first month, $1,625 is deductible interest and $271.20 is principal. The first month tax savings from the mortgage interest is $650.

Because a mortgage payment includes both principal and interest, the monthly mortgage payment is going to be higher than the monthly income from investments even if the mortgage rate is less than the investment yield.

Suppose Max’s intention is that the income from his $300,000 portfolio be used to pay the mortgage, so at the end of 30 years he has $300,000 in cash and a debt-free home that originally was worth $300,000. (At 3% annual appreciation it will be worth over $737,000 after 30 years.)

That plan won’t work because even with the 7% investment yield exceeding the mortgage rate, the monthly income is less than the monthly mortgage payment. After taxes, the shortfall increases. At the end of the second year, Max’s investment account is down to $294,694.45 after all the mortgage payments and tax effects.

Even so, the shortfall is small. After 30 years, Max’s investment fund has a positive balance of over $42,000 and the mortgage is paid off.

It is worth considering that dedicating the investment portfolio to paying the mortgage frees up $1,896.20 of monthly income from other sources that would have been used to pay the mortgage. If that money is invested to earn the same 7% that Max earns on the $300,000, it compounds to a fund of over $2.3 million after 30 years.

It appears that Max is better off taking the mortgage and investing his cash, even if we do not consider that he has other income to invest that could have been used to pay the mortgage.

If Max used the cash to buy the house, he would own the home free and clear but would not have the $42,000 that remained from his investment portfolio under the mortgage scenario. In either case he would have the money that could be accumulated from other income that might have gone to the mortgage payments.

With any projections of this kind, there are assumptions that must be understood. If reality turns out to be worse than the assumptions, the results will be less attractive. There also are factors that cannot be quantified that must be considered.

In this example relatively conservative investment assumptions were used. We assumed that the account would be invested for income to make the mortgage payments. Many people would assume that the portfolio will be invested for higher returns and other income will be used to pay the mortgage. Of course, returns from those investments will fluctuate more, and there are likely to be extended periods when the returns fall below projections.

The earnings from the investment portfolio are not guaranteed for 30 years. They are likely to fluctuate. Someone who took this approach from the early 1980s through 2003 saw interest rates generally decline. It is likely that if investment yields are declining, mortgage rates also are declining. But the mortgage would have to be refinanced to capture those lower rates, and that could incur additional costs. For safety, a sustainable, conservative investment return should be used in projections.

A lower interest rate on the mortgage often can be obtained by taking out an adjustable rate mortgage. But the rate on that mortgage might rise faster than the yield on investments when market rates rise.

The value of the investment account could decline at times. The fluctuations might be less if the account is invested in income-earning investments instead of stocks. Also, the income investments might pay monthly income so principal is less likely to be tapped to make the mortgage payments. Even so, the portfolio’s value will fluctuate with market changes. There will be times when the portfolio declines. The homeowner must be willing and able to stick to the plan during these periods.

The principal fluctuations can be avoided by investing conservatively, but that also will reduce the investment income and make the plan less viable.

Some people are more comfortable with the security of owning a debt-free home. Regardless of how the assumptions look, they want to know that if their investments or other sources of income decline substantially, they will not lose their homes because of delinquent mortgage payments.

When a mortgage is taken, however, the homeowner always has the investment fund available for emergencies and other irregular expenses. If the fund was used to buy the home, a home equity loan must be secured to get cash out of the home. This could take time and incur costs. In addition, it is possible that the retiree will not qualify for a home equity loan.

There is no right answer to whether a mortgage should be maintained even when cash is available to own a home outright. The homeowner has to have a framework that considers all the possible scenarios and decide which assumptions are appropriate and which risks he is comfortable taking.