Paying Down Your Mortgage: Factors to Consider

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Ask Carrie: Carrie Schwab Pomerantz - The Personal Side of Money

Paying Down Your Mortgage: Factors to Consider
by Carrie Schwab-Pomerantz, CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc.
February 13, 2008

Dear Carrie,

Is it wise to pay off your house loan before you retire? I realize that there are certain tax advantages in keeping a house loan, but if you are nearing retirement doesn't it also make sense to look toward paying off your mortgage rather than investing in the market? Assuming you are paying 7% and your mortgage is sizable and credit cards are paid off, wouldn't not having to pay a mortgage be like steady, no risk income every month since you can live on less?

—A Reader

Dear Reader,

I’m really glad you pose this question because I think it’s a pretty common dilemma. I also like this question because the answer depends not just on the numbers, but also on the psychological value of owning your own home outright.

But let’s start by looking at the financial side. The first thing to note is that because of its tax deductibility and relatively low rates, mortgage debt is not necessarily a bad thing. In fact, an affordable mortgage can be a valuable part of one’s financial plan. So before you rush to pay it off, think about the following:

Have you saved enough for retirement – and taken advantage of any available employer match within your company retirement plan? Because retirement is such a big challenge, I encourage you to do everything you can to build your retirement nest egg. At the very least, you should contribute enough to take advantage of any available employer matching contribution. Failing to do so is like leaving free money on the table.

Have you paid off your "expensive" debt? You mention that you don't have credit card debt, so this probably won't apply to you, but in general, when considering paying down debt, you'll want to start with the most expensive (i.e., highest non-deductible interest) debt first. For most folks, that means credit card debt and possibly an auto loan. (It's obvious but still worth pointing out: If you do have credit card debt, start by paying down the card with the highest rate first.)

Do you have an adequate emergency fund? Your next priority should be to build an adequate emergency fund for that proverbial rainy day. Again, you may have this covered already, but everyone should have at least three months of non-discretionary living expenses stashed in a very safe, very liquid investment vehicle. If something happens—an unexpected illness, say, or unemployment—your emergency fund can help you avoid taking on more debt or derailing your long-term investment plan.

Have you maxed out your retirement savings contribution? Assuming you’ve already taken advantage of any available employer match and have an adequate emergency fund, your next step should be to fund your retirement accounts to the max (based on either what the law allows, or what you can afford, whichever is greater). If you're over 50, take advantage of the "catch-up provision" and add extra money to your 401(k) or IRA (up to $5,000 per year for 401(k) plans; up to $1,000 for IRAs and Roth IRAs).

Have you saved for your child's education? Again, this may not apply to you if you're nearing retirement, but setting aside money for your children's education—through tax-advantaged vehicles like 529 plans—could be higher on the priority list than paying down your mortgage.

Do you have a home equity line? If you have a home equity line, of course, you should pay it down before paying down your mortgage (since it's probably at a higher rate than your underlying mortgage).

If you've checked off all of the above, the financial part of your decision comes down to two more things:

Your "after-tax opportunity cost": Figure out what your mortgage loan "really" costs you (after factoring in the fact that the interest portion is tax deductible) and compare that with your potential investment return. For example, if you are in a 40% (combined federal and state) tax bracket, your 7% mortgage loan effectively costs you 4.2%. Could you earn more than 4.2%, after taxes, by investing in the financial markets? The answer is probably "yes" if you're a long-term investor, but you'd be taking on a certain level of risk. As you point out in your question, paying off your mortgage is a risk-free proposition.
Prepayment penalty: Typically, traditional mortgages don't have prepayment penalties, but you should certainly confirm that before you move ahead.

And finally, you might also consider refinancing your current mortgage if you can obtain a lower rate. If you qualify, you should be able to do better than 7% in the current rate environment. Be sure to factor in any costs associated with refinancing. Divide your out-of-pocket costs by your monthly savings to calculate your break-even time horizon. As long as you plan on staying put at least that long, then why not reduce your interest expense?

That concludes the financial discussion. But for many people there is an equally valuable psychological part of the picture. If paying off your mortgage would give you a great deal of peace of mind, it might be worth it even if you're giving up some return in terms of what you could earn in the markets with that capital.

One final note: You might want to consider a halfway solution. You can accelerate your payments or you could pay off half your mortgage (again, assuming there's no prepayment penalty). You'd still have funds for investment and/or liquidity, but you'd greatly reduce your monthly expenses.

Good luck!

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction and investment strategy for his or her own particular situation. Data contained here is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

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