March 5th, 2017

Me 2012

Home Ownership, Mortgages and Investment

I am about a hundred entries back on LJ, because it's annoying to read on my phone these days, but I still look at it on the weekends. So I'm reading Kristine Rusch's business blog post from a week and a half ago now, and the advice in it made me laugh. She advised that if you have a financial windfall as a writer -- a big advance or good sales or whatever -- you should pay off your mortgage.

I didn't laugh because it's bad advice -- it's reasonably good advice for many people -- but because it's exactly what I did with the money I made from A Rational Arrangement in the first few months (when it was a large enough sum to make a difference in my bank account). But I did not pay down my mortgage because it is the highest and best use of my money.

Rusch goes on to write:

[Standard financial advice says] you should never ever pay off your mortgage, because—at least in America—you can use the mortgage tax deduction and it’ll be better for you than…oh, shit. This is where it breaks down for me. Because I have no clue how a tax deduction is better for a person than owning something outright. Especially something like your home. Shelter. The place you live.

I am pretty sure I have written about this before, but I feel like writing about it again, so I will. I don't expect to teach Rusch about finances, but I imagine it's a point unclear to many other people, too.

Let's say that you either acquired or refinanced your mortgage back in 2012, when mortgage rates hit their low. Your interest rate on a 30-year loan is 3.5%. We'll say your mortgage is $100,000 to make the math easy. You're paying $3,500 in interest* per year. Let's assume you can take advantage of the tax break (this is a big assumption) and your top marginal tax rate is 25%. So you get back in taxes 25% of your $3,500. That makes the cost of the mortgage interest $2,625 per year.

* OK, you're not, because your principal will go down slightly over the course of the year, but in the first 15-20 years of a mortgage, you are not paying much principal, so we'll just pretend it's zero.

So, let's say you get a $100,000 windfall and you decide to pay off your mortgage. You are now richer by $2,625 a year! You also don't have to pay the escrow for taxes or insurance or repay the principal, but you still have to pay taxes and insurance and you already paid for the principal (that's why your $100,000 windfall is now gone) so that is not money saved. Only the interest, net of your tax deduction, is saved.

There are many other things you could do with your windfall! You could spend it on a world cruise. You could buy a new and bigger house. You could commission oil paintings of every major and minor character in your book. You could buy a thousand pairs of expensive shoes. Etc. These are all options that leave you poorer than paying off your mortgage: you are still spending $2625 per year on the mortgage instead of $0. Paying off your mortgage is by no means a bad idea!

But let's say you don't want to pay off your mortgage but you don't want to fritter the money away either. You could put it in a CD at your local bank and make like 1.25% interest. That makes you $1,250, but you are still spending $2625 on mortgage, so your net spending is $1375. From a financial standpoint, this is not necessarily a mistake. You can't get 3.5% on a new mortage made in in 2017. So if you think you will need to spend $100,000 on something in the next year or two, you'd want it accessible: you don't want to pay off your mortgage only to get a new mortgage in a year. But if you don't need that money for a near-term expense, a savings account of CD is not as good as paying off a mortgage.

Real estate, including your house, is an investment. Let's say that instead of investing further in real estate (yes paying off your mortgage is an investment in real estate),, you want to invest in something else. Howabout stocks? Let's not make a bet on a specific stock: we'll put your money in the Vanguard Total Stock Market Index Fund, which is designed to mimic the performance of the entire US market. If US stocks go up, VTSMX goes up. If they go down, VTSMX goes down. The US Stock market as a whole has done very well for the past 15 years, and VTSMX's average rate over that period is 7.75%. (Over any shorter recent period, it's actually higher, so even granting that 2002 was one of the market troughs this isn't ridiculous.) So let's say that investing in VTSMX returns 7.75% for the next year and let's also say that you take that net return out of stocks after a year. You will have made $7,750, and have to pay 25% of that in taxes*, for $5,812. You'd still spend a net $2,650 on mortgage interest, so your net profit is $3,162.

* This is wrong because capital gains taxes are different from income tax and you'd probably pay 15 to 20% but let's just keep faking it.

So you've gone from spending $2,650 a year if you fritter away the windfall, to spending $0 by paying off the mortgage, to making $3,162 a year by keeping the mortgage and investing the windfall in a stock index fund.

And that is why it can be a better idea to keep your mortgage and invest in something else than to pay off the mortgage. The relevant phrase here is "opportunity cost": when you pay off your mortgage, you lose the opportunity to do other things with the money, like put it into stocks. Sometimes that cost is substantial.

Stocks are risky, Now in particular is not a great time to buy stocks: they are at an all time high. There is no guarantee that you would make this money in the next year. But over the long term, historically stocks have returned more than mortgage interest rate cost. So you are very likely to make more money long term -- over 15+ years -- by investing in stocks than you would pay in mortgage interest. Keeping your mortgage and investing in stocks is a good idea. It gets even better if you use a tax-advantaged account, like a Health Savings Account (if you are saving for medical expenses or retirement) or an IRA or a 401(k) (if you are saving for retirement), because you can lower your tax expense that way.

So: if I know that my money is better invested in the stock market than in paying off my mortgage, why did I decide to pay down my own mortgage?

Because I hate owing money.

Not every financial decision you make has to be the highest-and-best-use. You also have to take into account your own psychological limitation and quirks. One of the most common weaknesses among would-be investors is obsessing over their current returns. If you're the sort of person to panic and sell your stocks when you see their value drop 20% over the course of a day, then investing in the stock market is not a great idea for you. It turns out I have plenty of risk tolerance in that respect: I weathered the big drops from 2000-2002 and from 2006-2009 with nary a change in my investing behavior.

But I do hate fussing with my money. I don't want to refinance my mortgage to get the best interest rate, or figure out whether or not the fee cost is justified, or cash out my stocks if I have a financial emergency and need it to pay my mortgage payment, or any of that nonsense. My hatred for it doesn't necessarily justify the opportunity cost of paying off my mortgage rather than investing in stock, but I do lots of things with my money that don't necessarily justify the opportunity cost. I am okay with this. It is my particular investing weakness.

All of this is to say: it is always good to know what the best strategy is. But you don't always need to follow it, if for whatever reason it doesn't work for you. Sometimes there are really good reasons why it wouldn't work for you, like the above one about "I will need this money for something else very soon." Sometimes they are kind of iffy reasons and you may want to reconsider. Or you may find that, like me, you make all the calculations and think about the differences and then go "screw the probabilities, I want the mortgage paid off already." That's all right too.