I frequently hear people debating whether to pay off a home mortgage, which usually has a relatively low interest rate, or invest the money. Often the misguided answers to this question stem from only looking at the interest rate for the decision, as if it were the only valid variable. The following are the mistaken answers I repeatedly hear:
Never pay off a 3% debt.
Leverage low interest loans all you can.
Investing it for higher interest is a no brainer.
There isn’t a scenario where it makes good mathematical sense to pay off your mortgage.
Do the math: 6% vs. 3%. Enough said.
There is bad debt and good debt, and your mortgage is good debt.
If everyone followed these recommendations, they would frequently make the wrong decision. Interest rate is not the only variable to consider. There are other factors that are often ignored by those who only read about being debt free, but have never actually gone through the process of becoming debt free like I have. There is a big difference between book sense and experience.
I learned about the shortfalls of book sense when I entered my first live poker tournament in Las Vegas. I had played poker online with imaginary money for months, learned the odds of winning each hand and thought I was a great poker player because I was consistently winning the imaginary poker games. About halfway through the tournament, during a break, I spoke with an old guy who seemed to have played in many poker tournaments. I mentioned this was my first tournament. He surprised me when he said, “Yeah, I know.”
How could he know I was a rookie? Because I was making a lot of rookie mistakes which the experienced players had learned to avoid. The same way all experienced people can spot rookies. Doctors who have been in practice for years can easily spot a doctor who just finished residency. They stand out for their lack of real-world experience. I asked the experienced poker player what I was doing wrong. He commenced to tell me about all the things I had done in the last two hours that gave it away. None of the advice he gave me was in any of the books I read about poker.
That’s the way it is in life. You can’t get all the information you need about a subject by reading it in a book or doing the math. There are additional things you need to put into the equation that you don’t realize until after you have lived through it. This is when the other important variables that aren’t in the books are revealed.
The following are some additional variables to keep in mind in order to see the whole picture before answering the question about paying off a 3% home mortgage. I have lived both with a home mortgage and without one and picked up a few things along the way.
The following is a typical question I encounter almost daily, and is asked frequently by my coaching clients.
I, Toni, received a big chunk of money from a relative. It is just enough to pay off our home mortgage. We are getting close to financial independence. We already have our emergency fund fully funded, we are maxing out our retirement plans, and I would like to go to half-time as soon as possible. With our mortgage, which is our only debt, the half-time budget will be tight. I’m torn between investing vs paying off the debt. Our original loan was for $600,000 at 3% over 30 years with a monthly principal and interest payment of $2,529.62. We still owe $400,000. I want to pay off the house, but my husband keeps saying it’s a bad idea to pay off a 3% loan, we need the tax write off, and using leverage is smart. What should we do?
Is there a right answer? I think there is.
Those whose tunnel vision is focused on the interest rate lose sight of cash flow. I learned the importance of cash flow when I began investing in real estate. It has the same considerations here.
Toni would like to work half-time but their current cash flow will not allow it. The house payment costs $2,529.62 every month. She is likely paying at least 33% of her income to taxes. Thus, she needs to earn $3,794.43 a month to have enough cash flow to make the house payment.
Paying off the house is equivalent to an immediate $3,794.43 a month raise ($45,533/yr). If she earns $227,000 a year, paying off the house creates the ability to take one day off each week without any financial ramifications.
If she invested her $400,000 in certificates of deposit paying 5% interest, it would bring in $1,667 per month on average, but she likely couldn’t collect the interest monthly. She would pay the 33% tax and be left with $1,116.67 a month cash flow. Far short of what paying off the house generates.
In fact, Toni would need to find an investment that would return a guaranteed 11.38% before tax to get the same monthly cash flow as she gets by paying off her house. It will be extremely difficult for Toni to find an investment that will beat the guaranteed cash flow she will get by paying off her house.
There is actually no tax write-off for her mortgage interest
Many people believe their home mortgage payment is a great tax write-off. In fact, Toni, just like 90% of the rest of America gets no tax write-off at all for her mortgage interest. We have been led to believe in a tax write-off that doesn’t actually exist for most Americans!
Toni and her husband, being a married couple filing jointly, will get a $27,700 standard deduction on their 2023 taxes. The interest on their remaining $400,000 mortgage balance at 3% will be about $12,000 this year. They will also likely get the maximum $10,000 SALT tax deduction (State And Local Tax deduction limitation). Their $12,000 mortgage interest deduction and the $10,000 SALT deduction come to $22,000. Since their $27,700 standard deduction is greater than their itemized deduction, they will take the standard deduction instead of itemizing their deductions. In doing so, they will not get any tax write off for their mortgage interest.
It is estimated that in the 2022 tax year 90% of taxpayers used the standard deduction. That means they were not able to write off any mortgage interest. Since about 63% of Americans have a home mortgage, but 90% of all taxpayers cannot take a mortgage interest deduction because they will use the standard deduction, there are a lot of people mistakenly thinking they get a write-off for their home mortgage interest.
We need to stop perpetuating the misbelief that people get a tax benefit from keeping their home mortgage, since most do not. Couples who do get a write-off, don’t get as much as they suspect since the first $27,700 written off on their Schedule A doesn’t count.
The risk of bankruptcy is zero if you have no debt. Bankruptcy is the action that happens when a person has no way to pay their debt. No debt = no chance of bankruptcy. It doesn’t matter if you acquired the debt from borrowing to buy a house or undergoing a medical emergency generating a large medical expense you can’t pay. Bankruptcy is about debt you can’t pay.
This is left out of the equation from those who talk about keeping the mortgage and investing the money elsewhere, possibly even in something super safe.
We have recently seen some banks fail. It happens from time to time. Banks can get over extended just like people do. When you are over extended and can’t cover your bills, bankruptcy happens. What happens when your super safe investment was in a bank that declared bankruptcy?
Your savings is FDIC insured up to a point. But that money will likely be accessible after a waiting period as the insurance payments get sorted out.
Investing the money is not guaranteed
Many people will tell Toni she should put the money somewhere to earn more interest than she is currently paying on her loan. If she leaves it there for the life of the home mortgage, she will be slightly better off mathematically than if she used the money to pay off her home mortgage.
Unfortunately, this is not how the scenario usually plays out. If Toni pays off her mortgage, she gets guaranteed results for many years. But the money that gets invested at a higher interest may not have such a good outcome. If something comes along and we see that big chunk of money just sitting there, we may decide to use it for something more “productive” than earning interest. So, we buy a boat, a new car, a vacation home, pay for a wedding or take a fantastic trip.
Now the side of the equation that is collecting “higher” interest isn’t collecting any interest at all. This is the problem when both sides of the equation are not real. Paying off the mortgage locks in a return that investing the money does not.
The power of now
If I ask which is better to have $10,000 now or $10,000 later, almost everyone will say having the money now is better. Now has a lot more value than later. Using the $400,000 to pay off the house has an immediate effect on Toni’s pocketbook. She gets the immediate effect of having a $3,794.43 a month raise, by no longer needing to earn the money to pay the mortgage payment and the income taxes. That is a raise of $45,533.16 a year. Many people would uproot their family and move for a $45,000 a year raise.
Taking the option to keep the mortgage and put the money in an investment paying higher interest is based on letting all of the money ride until the mortgage is paid.
This assumes you will continue to pay the house payment at the lower interest rate and keep the investment at a higher interest rate so that many years from now you will have a slight difference in net worth. By then your net worth will be so large that the difference between the two options will not likely matter.
We must find a balance between having financial effects now vs later. We can’t stop going on vacations simply because saving that money instead of spending it on a vacation will increase our future net worth, allowing us to be able to retire sooner and go on more vacations later in life. Vacations can’t all be saved up until we retire simply because it creates a mathematically higher net worth. With the logic usually used for paying mortgages early, there is no mathematically logical reason to ever take a vacation.
Making the assumption that the right answer is always the one with the highest net worth at retirement is missing the point of living life. Some money needs to be used now for enjoyment and some of the money needs to be saved for the future when we can no longer earn a living.
Using this money to allow Toni to switch to working half-time and enjoy her life and family more by working less will create a huge deposit into her happiness factor with minimal change to her future net worth. The bigger hit to her net worth will come from earning less income by working half-time, which Toni has already determined is an acceptable outcome. If she is willing to take that big financial hit, then the small one between investing vs paying off the house is irrelevant.
Both options, paying off the house or investing the money, have the exact same immediate effect on Toni’s net worth: It increases by $400,000. Paying off the house will then increase her happiness for the next 20 years. Investing the money will likely create a minimal increase in her net worth at retirement.
Since Toni has already almost reached FI and is ready to decrease her workload, the best overall use of this money is to help her achieve the lifestyle she has been working toward. This is the final move to push her over the threshold to realizing her goal.
That “good debt” is killing you
I think the most important argument is not about the amount of money gained, but about the power you gain from this opportunity. Toni says she wants to cut back to part time, but the household budget is currently too tight to allow her to take this step. If she paid off the house, she could comfortably switch to working part time immediately. That is power! She can’t switch to part time if she invests the money anyplace other than paying off the house.
She has the chance to make a big change in her life right now if she pays off the house, but she will have to continue to work and earn more money if she chooses to keep the house payment. Many people don’t catch hold of this concept. They are burning out at work because someone convinced them to keep their “good debt.”
That “good debt” may be all that is standing between having a long life as a part time doctor or burning out, which may lead to quitting and losing all their future income potential. That will be a far greater loss of money than you could ever gain from investing the $400,000.
I feel strongly that there is no such thing a good debt. All debt is a burden. Sometimes it is a burden we can live with, like the mortgages on my apartment buildings, and other times it comes with a very high price tag. In this case, keeping the “good debt” will keep Toni from switching to half-time and living her dream. Don’t let “good debt” get in the way of living a great life now.
I once coached a doctor who planned on keeping his home mortgage and retiring in five years. But if he used the cash he already had in the bank to pay off his house, he could retire immediately. He only needed to work the extra five years so his retirement accounts could grow enough to make the house payment with a 4% annual withdrawal. When he realized what paying off the house with the cash he had saved would allow him, he retired a month later.
If you are struggling with the issue of paying off your house vs investing, then get a copy of The Doctors Guide to Eliminating Debt and look at more than just interest rate arbitrage. When you include how you want to live your life in the decision-making process, you can make an informed decision. If you only look at the interest rate, you may make a mistake and miss out on a great opportunity that could have changed your life. Eliminate interest rate tunnel vision so you can see the whole picture.