If you read much in the area of personal finance you will frequently come across heated debates about the merits of living in a paid-for house as compared to having a mortgage. Some folks will argue that mortgage money is cheap and that taking into account the tax benefits, it makes more sense to keep the mortgage and use the extra cash to invest. I get that. Other folks point to the emotional benefits of being debt-free and actually owning your home free and clear of any mortgage obligations. I get that too.
Reconsidering Mortgage Payoff Issues
Guaranteed Rate of Return on Investment
Our mortage interest rates are in the 6% range. Every extra dollar we pay toward the mortgage balance gives us a guaranteed rate of return of 6%, tax free. Compare that to what we have experienced in the markets recently. Moreover, I have no confidence that market returns will be anything but flat for the foreseeable future. So I’m going with a sure thing.
Tax Free Shelter Services
Our house is our home but in the economic world it is more than that. It is a source of what economists call “shelter services.” Shelter services are a necessity, not an option. You can get them from a house you own, a rental apartment, friends or family, or even a homeless shelter. If you rent or have a mortgage, you need to pay for those services. You need income to make those payments. Generally you will pay income taxes on that income.
Now if you own your home with no mortgage payment, you still receive the shelter services. But now those services are “free” in the sense that you do not need any cash flow to pay for them. (I am excluding from this analysis property taxes, insurance and maintenance costs, which are typically much lower than mortgage payments.) Since I don’t need income to pay for our shelter services, I won’t be paying any tax for receiving those services. That will really come in handy when we are retired and trying to keep our investment withdrawal income down so that we can maximize our Social Security benefits. I expect marginal tax rates to increase. I also expect that Social Security benefits will eventually be “means tested”, i.e., the benefit levels may be adjusted depending on your other income. If I don’t need as much “other income” because I have no mortgage payment to make, I can reduce the impact of means testing on our Social Security retirement benefits.
Reduced Financial Risk
As we get older, the odds of a health-related problem increase. At the same time, my earning capacity will decrease. I want to minimize the risk that a money catastrophe will force us into doing something drastic or cause us to lose our home because we can’t make the payments. Also, we want to be in a position where we can ride out an extended downturn in the market and not have to sell investments to meet everyday living expenses. Having a paid-off mortgage reduces both of those risks.
Peace of Mind
There is a certain level of peace, contentment and satisfaction that I expect will come when we have paid off our mortgages. I have often heard others talk about it. This is an intangible benefit but it may be one of the most important. If you think about it, part of the peace of mind factor is tangible. If as Mrs. GoTo and I get older we need additional income due to financial emergency, we can look into a reverse mortgage. That is always easier to do if your home is paid-for.
Countering the Counter-Arguments
I’ve already addressed the biggest argument against paying off your mortgage, i.e., using the free cash to invest. As I said, we have opted for the guaranteed 6% tax free return that we get from paying it off.
The mortgage proponents also argue the tax benefits from deductibility of the mortgage interest. That benefit is usually overstated. Their analysis of the tax benefit does not consider that only the portion of the annual mortgage interest paid that exceeds the standard deduction is really providing a benefit. This makes it a much smaller benefit than most people think. As one example, a married couple filing a joint tax return in 2008 is entitled to a $10,900 standard deduction. If that couple pays $11,000 in mortgage interest and has another $1500 in deductions, the couple can deduct $12,500 instead of taking the standard deduction. But if you think about it, they are receiving an actual tax benefit only on $1600, which is the difference between the total of that couple’s deductions ($12,500) and their standard deduction ($10,900). If that married couple has an effective tax rate of 30%, the mortgage interest is providing an actual tax benefit of only $480. The couple is paying $11,000 in interest to save $480 in taxes. That is not enough for me to keep a mortgage payment hanging around my neck.
Hopefully I will be able to soon announce that we have begun our mortgage-free life.