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Financial Planning > College Planning > Student Loan Debt

Pay Off That Mortgage, or Not?

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Aptly called the American Dream, home ownership is being enjoyed in ever-increasing numbers. A combination of low interest rates and a long boom in real estate prices has made purchasing a home a great investment, in addition to the psychic benefits. But does it makes sense to pay off a mortgage in the event of an inheritance, bonus, or other liquidity event?

Conventional wisdom suggests that investing a lump sum in the market is a more prudent course of action than paying off one’s home. After all, a mortgage is for most folks the cheapest type of loan available. When you consider the tax deduction of mortgage interest, it may seem foolhardy to pay off a mortgage early, or even at all.

Such rules of thumb can be useful, but provide an incomplete view of an issue with ramifications for consumer spending, risk tolerance, and one’s outlook on the market. I think going without a mortgage can be a prudently responsible move for many clients.

Let’s take the simple example of a professional who receives a $250,000 after-tax inheritance and holds a fixed-rate mortgage of the same amount. The client tells you that he is willing to pay off the mortgage or invest the total proceeds in a diversified portfolio of stocks and bonds.

This scenario represents a series of tradeoffs. In paying off the mortgage, the client is swapping the possibility of earning a higher market return for a dramatic reduction in monthly expenses. If the client invests the lump sum, he is betting the markets will out-earn the after-tax cost of the mortgage loan.

The breakeven graph at right represents the client’s options. If a 6% mortgage is paid off and the proceeds invested, the pretax portfolio return would have to be about 8.4% for the two choices to have equal value in 30 years. The lower the mortgage interest rate, the more compelling the case for investing the sum.

Clients considering eliminating a mortgage should be aware of the constructive ownership laws: Once a mortgage is paid off, the IRS will only allow an interest tax deduction on the first $110,000 of a home equity loan. Even so, an equity line of credit on a paid-off house is a good way to access cash in emergencies.

Paying off a mortgage is more than just a mathematical exercise. Many clients feel debt is an evil they’d be better off without. Owning one’s home free and clear will certainly reduce the urge for consumer spending, especially if other types of debt are avoided and the funds earmarked for the monthly payment are dedicated to a systematic investing plan. Clients who most attempt to keep up with the Joneses might be best served with no mortgage. After all, in a country where more than 50% of the population spends more than it makes, anything that lessens the desire for material possessions can be a good thing.

Deciding whether to pay off a mortgage depends on many non-mathematical considerations. Advisors should think about the riskiness of the client’s job situation, for example, and his philosophical views on debt before making a recommendation.

The Puzzler, CIO of Memphis-based Sovereign Wealth Management, can be reached at [email protected].


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