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Should You Pay Down Your Mortgage?

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When stocks start jumping hundreds of points in either direction on a regular basis, you might feel like you'd be more comfortable with a guaranteed return. That's the primary motivation behind an increasing trend among ordinary investors: paying down your mortgage earlier than you have to.

Mad as hell and not gonna take it anymore
The increasing popularity of paying down mortgage debt shows just how far the housing market has come in the past 10 years. Before the housing market bubble burst, many borrowers scrambled to take out as much debt as they possibly could. When their home prices rose, they often returned to their banks to refinance and take cash out. As long as their homes continued to gain value, homeowners did all they could to live up to their new-found means.

Now, though, behavior among homeowners has taken a 180-degree turn. For many, the threat of losing their homes due to excessive debt looms large, even with the "robo-signing" scandal forcing Bank of America (NYSE: BAC  ) and JPMorgan Chase (NYSE: JPM  ) to halt foreclosures last month. Despite record-low mortgage rates that in the past would have encouraged homeowners even further, the lack of home equity and increasingly tough standards to get mortgages have many people nervous about financing their homes.

Given all these prospective hassles, along with ridiculous moves that Wells Fargo (NYSE: WFC  ) and Deutsche Bank (NYSE: DB  ) have taken with mortgages, many homeowners have clearly had it with mortgage debt. That makes paying down your mortgage balance look more attractive than ever.

Best of a bad lot
In addition, homeowners don't have a lot of great alternatives for their money right now. Having a substantial amount of cash in a savings account earning 1% or less doesn't make much sense if you can effectively earn 4% or more by paying down your mortgage debt. Even long-term bonds are paying less than many outstanding mortgages right now, especially if you haven't refinanced your home loan in some time.

That's not to say there aren't any alternatives. Better yields are available from the stock market. Dozens of stocks have dividend yields that beat current mortgage rates. And while mortgage REITs Annaly Capital (NYSE: NLY  ) and Hatteras Financial (NYSE: HTS  ) may leave you more exposed to potentially rising interest rates than you'd like, you'll find that even blue-chip Merck (NYSE: MRK  ) , with its 100-plus year history of doing business, pays a yield above 4%.

The benefit that paying down your mortgage has that stocks don't have is certainty. You know that you'll save whatever rate you're paying on your home loan by paying it down early. In contrast, stocks might go up, down, or sideways, and even though those dividend payments will help cushion any drop, you could effectively be putting your home at risk by speculating with unnecessary mortgage debt.

But one downside to paying your home loan early is that it can be tricky to get access back to the money you use to make extra payments. So even if you can afford to pay down your mortgage now, tapping that extra equity in the event of a future emergency may require some additional steps, such as opening a home equity line of credit.

Making the right decision
From a long-term view, paying down mortgage debt when rates are around 4% doesn't seem like the optimal move. If you believe that stocks will revert to their long-term average return of around 9% to 10%, then accepting less than half that return has a huge opportunity cost.

What you get in exchange, however, is the peace of mind that at least when it comes to the roof over your head, you're in control of your own financial destiny. What value that has depends on your own particular views, but for many, it's priceless.

So in deciding whether to pay down your mortgage, weigh all the factors together. Financial considerations like adequate emergency savings and your investment temperament are important to include, but don't underemphasize the psychological factors involved. Even if a decision may not give you the best return on paper, it still might be the best thing for you to do.

Are you paying off your mortgage early? Chime in by leaving a comment below!

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

Fool contributor Dan Caplinger is aiming to be debt-free. He doesn't own shares of the companies mentioned in this article. The Fool owns shares of Annaly Capital Management, Bank of America, and JPMorgan Chase. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy helps you put a roof over your head.


Read/Post Comments (18) | Recommend This Article (15)

Comments from our Foolish Readers

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  • Report this Comment On November 17, 2010, at 1:17 PM, Melaschasm wrote:

    Another important consideration is when you will retire. It is rather difficult for most people to retire when they have a house payment.

    If you want to retire in 5 to 10 years, and you have 15 to 20 years on your mortgage, an aggressive early payment plan may be the difference between retiring on time and having to work a few more years..

  • Report this Comment On November 17, 2010, at 1:48 PM, AnthemFool wrote:

    Well - retired we are - and with a mortgage. So - pay or not to pay? Presently the answer is: not to pay.

    The stock market with its income from option trading and dividends certainly looks more attractive than the 4+% return on paying back the mortgage, even though it is a guaranteed return.

    Thank you Fools for helping us manage the funds we have while paying a mortgage and enjoying life! Must admit: one of the best decisions we have made has been to join the Fooldom!

    BTW - we became a "one-car-household": sold two cars and bought one we both like. The proceeds of the two cars sold are invested, which is covering the 2.9% car loan payments very nicely (and then some) as we are dancing to the bank.... :-)

    Fool on!

    AnthemFoolOne

  • Report this Comment On November 17, 2010, at 2:03 PM, dschechter wrote:

    I am paying down my 5.2% ARM mortgage now. I would have prefered to refinance to a fixed rate mortgage in the 4% range, and keep the money to invest but my bank is refuses to refinance my loan.

    We're in a high foreclosure area near Detroit and I was laid off in August, although my wife is still gainfully employed.

  • Report this Comment On November 17, 2010, at 2:40 PM, mahkagari wrote:

    I am making extra payments on my mortgage, but as part of my conservative investments. I'm not giving up stock investment in favor of extra payments, I'm giving up low returns on bond funds, etc. I still allocate the majority of my investment capital to stocks.

  • Report this Comment On November 17, 2010, at 2:47 PM, outoffocus wrote:

    If you have the money pay it off. You have to remember the house isnt really yours until you pay it off. Yes you may have extra cash but in the end you are still a slave to the bank with extra cash. Also you cannot take your health for granted in retirement. Last thing you need is for someone to get extremely sick and all your money that you have in the market needs to come out to pay medical expenses. Not only that you face the very real possibility of foreclosure in retirement. Its not a risk retirees should take.

  • Report this Comment On November 17, 2010, at 2:59 PM, Drkj4u2 wrote:

    I paid off my mortgage 11 years ago.the rate at that time was 6.5 percent..this has allowed me to retire this year and never have to worry about paying a mortgage..I sleep very well at night..

  • Report this Comment On November 17, 2010, at 4:58 PM, r1976smith wrote:

    I think one thing you will need to also look at is can you average a return on the investments that is higher than the interest on the loan?

    I do not mind paying the mortgage, I personally picked a house that was within my means. I would rather use the funds for investment purposes.

  • Report this Comment On November 17, 2010, at 5:27 PM, zenawarrior wrote:

    An additional consideration is if you have a college bound child. The amount of equity you possess affects the scholarship eligibility for your child. This becomes significant (I would think) if, the equity is frozen and does not generate the requisite cash flow.

  • Report this Comment On November 17, 2010, at 5:33 PM, boogaloog wrote:

    Don't forget that paying extra on your mortgage buys you nothing if you need some money down the road. Maybe you've paid an extra $50k on your mortgage, but now you lose your job or have a major medical expense. Think the bank's gonna give you that $50k back? Think they'll allow you to take out a home equity loan for $50k now that you're unemployed or unable to work? Guess again. If you start missing your monthly payments, they'll take your home regardless of how much ahead you are on payments.

    I'm not saying it's wrong to pay extra on your mortgage, but it's not as simple as saying you're "earning" a 4% equivalent.

  • Report this Comment On November 17, 2010, at 6:55 PM, KwizatzHaderach wrote:

    The "don't pay your mortgage down because you might need the money in an emergency" argument rings hollow to me. Even the Fool says to have 3-6 months of living expenses (or is it income?) as an emergency fund BEFORE investing in stocks. Also, there is 0 guarantee that your stocks won't dive in value just as you need the money for an emergency. Also, if you get laid off and can't make house payments, the bank will sue you for your stocks after foreclosing on your home. And lastly, having lots of stocks also affects your kids financial aid applications.

    Your stocks don't just have to beat your mortgage rate. They have to beat your mortgage rate AND taxes (and a tithe, if you do that sort of thing). Saving on your mortgage is a rate of return free and clear of all of that.

    No mortgage means a lot less worry. The benefits of that range from the vague "higher quality of life" to the more concrete higher job performance. For me it also would mean I could spend more time building my small business than worrying about shuffling papers and buying and selling shares.

    For most of us our greatest wealth-building tool is our income. When you don't have debt, you free up your income. Imagine how much you could invest if you didn't have a house payment.

  • Report this Comment On November 17, 2010, at 10:26 PM, aleax wrote:

    Let's start by assuming you're talking about a fixed-rate mortgage with decent equity and a decent rate: per http://basicstory.com/tag/current-30-and-15-year-mortgage-ra... , with a good credit score, you should get a 3.5% 15-year mortgage today (if you're paying substantially more, or a variable rate, refinancing to terms like these should be your top prudential priority, not paying towards the mortgage you have -- in the context of refinancing, ensuring that you have a comfortable, but not excessive, equity cushion is key... as a very prudent guy, the kind who NEVER would do 66 in a 65-mph area, I find 50% equity is way plenty for myself, for example).

    Once you're in the less-than-4% area, and with plenty of equity to cushion you, I can't believe even the most prudent, risk-averse person could not find a better allocation for their investments (doubly so if said person is paying substantial income taxes -- as long as mortgage interest is deductible -- and there is the possibility to contribute to a tax-protected account such as some form of IRA or 401k... but, even without that twist).

    Consider for example VWELX (the "Vanguard Wellington" no-load, low-cost mutual fund), started just BEFORE the Great Depression. In over 80 years since inception, it has returned, annualized, over 8% per year -- that's through the Great Depression itself, every boom and bust since, every war, terrorist atrocity, bonehead policy mistake by sundry government and Fed agencies, oil cartel maneuver, what-have-you. Over 8%: over twice what you should be paying as interest on your mortgage. Even in the last 10 terrible years, through TWO major bear markets within one decade, and with bonds yields currently below the basement to boot, it has returned, annualized, 6.27%.

    Does anybody seriously think that the next ten years will be TWICE AS BAD as the terrible last ten (for both bonds and stocks), to halve that annualized return to A LITTLE below the interest rate on your mortgage? If I were THAT pessimistic, the only investments I would consider would be ammunition, canned goods, and the like -- who cares if your mortgage is paid down (or how much physical gold bullion you have in your strongest safe, for that matter), once Mad-Max-like post-apocalyptic hordes are roaming the land? Thus, even for the most pessimistic investor, pouring those funds into mortgage repayment (rather than, in their case, extra ammunition and canned goods) would be utter, wanton waste of good cash.

    If you're not quite THAT pessimistic, and think that Western civilization will endure through the coming disasters much as it has over the last 81 years (through Dust Bowls, mad dictators, nuclear confrontation, world wars, terrorists, dollar printing presses, etc, etc;-), then (once your home equity is secure and your interest rate below 4%) it really makes no sense to use any extra funds to repay your mortgage, rather than (at the safest) in conservative, low-cost, long-lived funds such as VWELX or VWINX (I'm sure there are plenty other good ones, but Vanguard's where I personally choose to keep my tax-deferred savings and other "ballast" counterparts to my riskier, better-prospect stock-centered investments).

  • Report this Comment On November 17, 2010, at 10:51 PM, allwayssummer wrote:

    How about this plan of attack. I put half of my savings in the stock market and half in cash. I saved enough cash to pay off my house when my itemized deduction was the same as the standard deduction. Then I paid off my house. Got money in the bank and a paid off house.Debt always equals slavery!

  • Report this Comment On November 18, 2010, at 2:52 PM, VoiceintheCrowd wrote:

    Count me among those who would always counsel investors, especially younger investors, to stick with the stock market rather than paying off their mortgages early. Dan says that the one benefit that paying a mortgage down ahead of schedule offers is certainty, but it doesn't even really offer that, because while it offers a certain interest rate, it also does NOT offer certainty against any other surprises life might throw at you. Indeed, the omnipresence of uncertainty is one of the strongest arguments in favor of preserving liquidity; this is a widely cited reason why many corporations who don't really need to sit on large piles of cash are doing so anyway.

    Over time, you'll not only get a better rate of return in the stock market, but you will have the ability to more readily access your money when you need it.

  • Report this Comment On November 18, 2010, at 3:25 PM, boogaloog wrote:

    KwizatzHaderach,

    I don't recall saying anything about putting money in stocks. I didn't suggest where to put your money at all. I also didn't say "don't pay down your mortgage". All I did say was that one factor in any decision you make is to consider liquidity. If you run into bad times, will you have access to money in order to prevent foreclosure? That may be money under your mattress for all I care.

    Your statement "if you get laid off and can't make house payments, the bank will sue you for your stocks after foreclosing on your home" is exactly why I suggested considering having liquid assets to prevent the "can't make house payments" part of your sentence.

    You state: "When you don't have debt, you free up your income. Imagine how much you could invest if you didn't have a house payment." True ... partly. If you use all of your income to pay off debt, then you may not have any money freed up to invest, which is why so many successful companies (and small businesses) prefer to carry some debt. I am NOT saying you should carry debt -- I'm just saying it's yet another financial consideration which may or may not be right for an individual.

  • Report this Comment On November 20, 2010, at 10:46 AM, RonChapmanJr wrote:

    Took money out of the market and paid off my house at 29. Don't have to worry about what the market will do and have no worries about losing a job because the house is mine. If you have enough money to pay for your house completely, do it. If you just have enough money to make a couple of extra payments, run the math and see if it makes financial sense.

  • Report this Comment On November 21, 2010, at 10:07 AM, Stickerstev wrote:

    Great article and comments. Paid off my house a year ago. 20 year morgage with a 10.5 ARM. My how times have changed. What I will say, paying off your morgage is freedom. If you have the means and right statagy, do it. Remember, use the same conviction with your investments as you do with your morgage.

  • Report this Comment On November 21, 2010, at 8:48 PM, kitt9827 wrote:

    Technically if I pay an extra $95 now, I avoid an entire payment of $541 on my mortgage.

    That's like getting a quintuple return instantly.

  • Report this Comment On November 22, 2010, at 1:29 AM, ETFsRule wrote:

    One last thing to consider is whether or not you pay private mortgage insurance (PMI). Most people have to make this payment each month if the remaining principal on their loan is greater than 80% of the value of the house.

    If you can pay down the principal below this level, you will save more than just the interest rate of your loan: you will also save the PMI payment each month. I actually made a spreadsheet to calculate the total return on my investment by paying down my mortgage to the magical 80% mark, and I was impressed with the outcome.

    After that, I don't think it's worth it to pay your mortage off early just to earn 4-5% on your money... especially not when you consider that the interest payments are tax-deductible.

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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