Conventional wisdom is that getting out of debt is always the smart move. Intuitively, my brain tries to apply this "wisdom" to our mortgage and I want to think that we should absolutely pay our mortgages off as early as possible. However, given our historically low interest rate of 3.5%, only slightly higher than historical inflation of 3%, paying our mortgage off early makes little financial sense. In fact, I would argue that if we were being 100% rational, we should do a cash-out refinance at a 30-year mortgage (rates about 3.8% at the time of writing) and leverage the cheap money to invest for retirement or other long-term goals. The battle between my rational side that understands the time value of money and the side of me that hates debt has flip-flopped on this issue for the last couple of years. I am such a nerd that I write our personal financial report every year for fun and I looked back at the last three years' worth of reports. Before we bought a house, we planned on paying off our mortgage in 12 years, mainly for emotional reasons (i.e. we don't like debt). When we actually bought our house, we decided to compromise and took out a 15-year mortgage as opposed to a 30-year one, but decided to not make any extra payments. Within that report, I stated "our current interest rate on the house is below our investment return and it does not make sense to pay off the house early." However, in the 2015 report, we again changed our mind and now plan to pay off the house in only 5 years. So much for having a plan and sticking to it. ;)
To be honest, this is one of those rare cases where I have done my homework, know the best financial options, and have decided to take the illogical route.
Reasons Why We Should Not Pay Our House Off Early
If we were making this decision based only on maximizing our long term net worth, then paying off the house early makes no sense. Almost every article written,, in recent history (with today's interest rates in mind) concludes it a bad idea and a horrible investment. Paying off our house is bad for us because...
- It is a bad investment: Long term market returns are always much better than the 3% after-tax return paying our mortgage would yield us. Even the most pessimistic outlooks estimate a 5% return on the market and even low risk investments like municipal bond funds pay out around 3%. I ran a simple model and, if we ignore the time value of money, paying the house off in 5 years "saves" us $60,000 in interest compared to a traditional 30-year mortgage. However, if you account for the time value of money and the fact that long-term market returns are between 5% - 10%, paying off our mortgage early is really going to cost us between $12,000 - $35,000. If you are interested, you can pick apart my model, I have it in a Google Spreadsheet.
- It is risky. Tying up your liquidity in your house is generally thought of as a bad idea. Once you put your liquid cash into your mortgage, it is practically impossible to make it liquid again. In our situation, we don't plan to sell for at least another 5 to 10 years and, if we had an emergency or other need for that money before we were in a situation to sell, we would be up a creek without a paddle. Putting extra money towards the mortgage also makes our investments less diverse, since we have so much cash tied up in a single real estate investment.
- Lost tax savings. If you are able to itemize your taxes, then you can deduct your mortgage interest. To maximize our tax savings, we donate two years' worth of donations every other year, allowing us to take more advantage of itemizing to reach a lower tax bracket those years. This means that our after-tax mortgage rate is closer to 3%. If we choose to invest our extra money in a tax-deferred retirement account, we would also see an additional 31% (25% federal and 6% state) return on our investment.
Why We Are Paying Our House Off Early Anyway
We have a strong financial foundation and are comfortable with our current savings rate and our current emergency fund. Thanks in large part o compound interest, our current retirement savings are such that if we stopped saving for retirement today, we could retire on about $25,000/yr (in 2016 dollars), though we obviously still plan to make additional retirement savings a priority. We also have enough in liquid assets that, in an emergency, we could afford not to have an income for more than 12 months. Because of our current strong financial situation, our choice for where to put our extra money boils down to either paying the mortgage or investing. We are choosing to pay off our house early because...
- I hate debt. My wife and I were very fortunate to graduate from college without any student loans and the only debt we had was a $9,000 loan for the used car I bought to commute to my new job. I hated that loan so much! I tracked every penny I spent and did not buy anything but necessities until it was gone in less than nine months. When I was deciding if I should pay off the house early, I read an article that really resonated with my dislike of debt. The article asked "Would you be willing to refinance the equity out of your mortgage (thus increasing your debt) to add to your investment accounts?" For me, the answer was a resounding no. In our situation, it feels like not paying our house off would be leveraging our home to invest.
- Flexibility and security. When we decided to start paying the house off early, we were not sure whether my wife would want to take a few years off work to stay at home with children. We reasoned that removing the house payment would increase our monthly cash flow and make living on one income a real possibility without straining our finances too much. However, my wife enjoys her job and finds it very rewarding. She has decided she would like to stay in the workforce and we are instead planning on using the extra cash flow from her salary to pay for Catholic school for our children (read about our plan). Having our house paid for will also act as additional insurance if one of us loses our job.
- Forced savings. Having an ambitious goal tends to help keep us motivated about saving and keeps lifestyle inflation in check. We also have a lot of personal pride and excitement in being able to own our house outright and doing it in only 5 years.
- It saves some money. We bought our current house with the plan to live in it for at least 7 - 10 years. But if we have more than three kids, we plan to buy a larger house once our family outgrows our current one. With that in mind, we could save about $2,500 in loan origination fees by buying in "cash". We have also talked about using our current house as a rental property. But neither one of us are sold on the idea yet.
- Lack of investment opportunities. We have essentially maxed out our risk free (FDIC insured) investment options (high interest checking and high interest prepaid cards). Any new money makes us less than 2.25% after taxes. We could invest in stocks or bonds, but since we are talking about leveraging our home to invest we are not comfortable with that level of risk. A risk free return of 3% is not great, but it is also hard to find anything better in today's market.
- It makes my wife happy. She also hates debt and is looking forward to the extra flexibility that comes with not having a mortgage or any other form of debt. And happy wife = happy life.
Our mortgage pay-off plan is pretty basic. We used an online calculator to figure out how much extra we would have to pay each month to pay off the house before our 5-year anniversary in our home. For extra motivation, we printed out a diagram of our basic house layout and fill in with a yellow high-lighter how much we have paid off each month. Currently, we own our bedrooms, bathrooms, the living room, and all the closets right now.
Given today's interest rates, paying our home off early is not the best financial decision we will ever make. But we are very happy with our decision anyway and it is a heck of a lot better idea than spending the extra money on less important things.