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The Hidden Costs of Paying Off Your Mortgage

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One of the most enduring myths promoted by mortgage companies, some financial advisors and the media is the advantages of making extra payments on your mortgage or at least paying it off as soon as possible. This myth is perpetuated by 1) bad math and 2) cultural belief systems.

Let’s start with the math. Mortgage companies encourage us to make extra payments with illustrations of how much we can save in interest over the life of our mortgage. Mandatory disclosure forms illustrate the cost of interest over the time of the loan. The large numbers “horrify” the home buyer.

But the formula for calculating interest is not the same as a mortgage cost/benefit analysis . For example, mortgage interest is tax deductible. So the cost/benefit analysis should include the value of 30 years of tax deductions. That’s just the beginning. A mortgage cost/benefit analysis should include: cost of money(interest) + tax savings + leverage + opportunity costs + inflation protection + diversification + interest arbitrage. Before making extra payments on your mortgage consider these other “hidden” costs which must be balanced against the cost of money (interest).

1. Cost of shrinking tax shield and unfunded tax deferred accounts (opportunity costs). According to economists at the Federal Reserve Bank of Chicago, “about 38% of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts (TDA) are making the wrong choice. For these households, reallocating their savings can yield a mean benefit of 11 to 17 cents per dollar, depending on the choice of investment assets in the TDA. In the aggregate, these misallocated savings are costing U.S. house-holds as much as 1.5 billion dollars per year. (http://www.chicagofed.org/webpages/publications/working_papers/2006/wp_05.cfm).

2. Cost of reduced leverage. A fixed rate mortgage gives individuals with modest income access to the wealth building power of leverage without incurring the risk of a margin account. Compare the leveraging power of a $100,000 home with: A) no mortgage, B) 20% equity and C) 10% equity. Assume the home appreciates at the average annual rate of 4% or $4,000 in the first year.

Scenario A (No Mortgage) Scenario B (20% Equity) Scenario C (10% Equity)
FMV Home $100,000 $100,000 $100,000
4% appreciation $4,000 $4,000 $4,000
Mortgage $0 $80,000 $90,000
Equity in home 100% 20% 10%
Investment in home $100,000 $20,000 $10,000
Return on Investment (ROI) 4,000 / 100,000 = 4% 4,000 / 20,000 = 20% 4,000 / 10,000 = 40%
Leverage 1x 5x 10x

Which return would you rather have on the investment in your home - 4%, 20% or 40%? It’s the leverage provided by a mortgage that has made a home the best investment most Americans make in their lifetime. Your home appreciates at the same rate, no matter how much you have invested in it. Our experience in working with middle income Americans is that any equity greater than 50% is a “loafing asset”.

3. Cost of loafing assets (opportunity cost). Making extra principal payments means you are forfeiting the gains that could be earned by investing the money in something outside your home. The extra principal payment poured into the home could have been invested in a 60/40 conservative portfolio of stock and bond index funds. Over 30 years such a portfolio can be expected to earn about 8%. Economists call this forgone return the “opportunity cost” of the decision to invest your money in the home where it earns no additional return. If I buy the index funds inside my Roth IRA and wait until I’m 59.5 before I withdraw the money, my expected 8% average annual returns are tax free. If I’m in the 25% federal tax bracket and 6% state tax bracket, the true cost of a 6% mortgage is 4.1% (6 x [1 - .31]) because the interest is tax deductible. I can make an extra $100 payment on my mortgage and earn an after-tax rate of 4.1% ($4.10) or I can invest it and earn 8% tax free in my Roth IRA. By making the extra payment on my mortgage I actually paid an “opportunity cost” of 8% or $8 so I could earn $4.10 instead.

4. Cost of interest arbitrage gift to mortgage company. The cost of money (interest) is determined primarily by time horizon, credit risk and inflation risk. The interest rate is what I pay the mortgage company to assume those three risks. That’s why interest is called the “cost of money”. A 30-year mortgage always has a higher interest rate than a 15-year mortgage because of the additional 15 years of repayment and inflation risk. If I make extra payments on my mortgage I voluntarily reduce those risks for the mortgage company. I turn my 30-year mortgage into a 20-year mortgage. If I’m going to shorten my repayment period and reduce the mortgage company’s risk, shouldn’t I also get a lower interest rate? To add insult to injury, most mortgage companies want to charge me a fee to reduce their risk! If you want to pay off your mortgage sooner, don’t make extra payments. Get a shorter mortgage with a lower interest rate.

5. Cost of diversifiable risk. Putting a lot of money into “one egg”, ie. your home may seem safe to some, but to me it seems risky. Who is taking more risk, the (A) investor with the mortgage or the (B) investor who has paid off his mortgage?

Investor Home Mortgage Stocks Bonds
A $100,000 -$80,000 $40,000 $40,000
B $100,000 -0- -0- -0-

6. Cost of inflation risk: During the highest inflationary period in our nation’s history (1974-1982), the stock market tanked. A home with a 30-year fixed rate mortgage provides double inflation protection. A 30-year fixed rate mortgage is the world’s best inflation protection because it protects against both expected and unexpected inflation. During inflationary times, as your home appreciates in value, you are paying it off with “cheaper and cheaper” dollars. Here’s how I see it:

  1. If interest rates go up because of inflation, the owner of a 30-year fixed rate mortgage WINS the bet.
  2. If interest rates go down, the owner of the 30-year mortgage simply refinances and WINS again.
  3. So the “worst” case scenario for the owner of a 30-year fixed rate mortgage is if interest rates stay the same. In this case the mortgage owner WINS again, because he/she had peace of mind and inflation protection for 30 years.
Did you ever wonder why a 30-year fixed rate mortgage with the unlimited right to refinance is not available in most other countries?

Bad math perpetuates the mortgage myth. I believe cultural beliefs also contribute to the problem.

The best way to illustrate the power of cultural or family belief systems is the story of “Grandma and the Christmas Ham”. Mom prepared the Christmas ham, daughter Stephanie asked, “Why do you cut off both sides of the ham before you put it in the oven?” Mom replied, “Because that’s the way Grandma taught me to fix, so you have to ask her,” Stephanie went into the living room and asked Grandma the same question: “Why did you teach Mom to always cut off both ends of the Christmas ham?” Grandma replied, “Because that’s the way Great Grandma, taught me, so you’ll have to ask her.” Since it’s time for our Christmas phone call, let’s ask her.” In a few minutes, Great Grandma was on the phone. “Great Grandma, why did you always cut off both ends of the Christmas ham?” Stephanie asked. “I had no choice,” Great Grandma said. “It was the only way it would fit into our old wood burning stove.”

Paying off the mortgage made sense 90 years ago during the Great Depression. But does it make sense in the economic environment of the 21st century? Consider how the economic environment has changed:

Economic ERA Great Depression Great Recession
Monetary Policy Tightening Expansionary
Greatest economic risk Deflation Inflation
Home prices Decreasing Decreasing/Leveling
Future value of repayment dollars Increasing Decreasing
Top tax bracket 1% 35% (not including the “stealth tax”)
Investment opportunities Bank savings account Bank savings, stocks, bonds, mutual funds, etc.
Qualified Tax Shelters --- 401(k), 403(b), 457, IRA, Roth IRA, etc., etc.
Suitable Mortgage Strategy Accelerate repayment Lock in low rate & prolong repayment

Ever since many of our great-grandparents lost their homes to foreclosure in the Great Depression, families have passed down the wisdom of paying off your mortgage. Mortgage burning celebrations have become a family ritual. The pay off the mortgage myth persists in spite of the overwhelming evidence that home ownership enabled by a mortgage has been the primary means of building wealth for most Americans. Unfortunately, recent economic events may only perpetuate the myth. The real estate bubble was NOT caused by mortgages. It was triggered by the ABUSE of normal lending and leverage rules. We don’t ban pharmaceuticals because people abuse drugs. If high inflation and higher taxes are triggered by an expansionary monetary policy and fiscal stimulus, many people will soon wish they had a 30-year fixed rate mortgage for 50-80% of the FMV of their home During times of high inflation, those wanting to refinance to pull equity out of their home should expect fixed rates of 12-18% based on what we experienced in the late 70’s and early 80’s. Even after they retire, people who itemize deductions should probably have a 30-year fixed rate mortgage both as a tax shield and as a hedge against inflation. And most people should never make extra mortgage payments on a 30-year fixed rate mortgage.

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