[Editor's Note: Here is a great exchange from our Living Below Your Means discussion board. It involves one person asking a question and the rest of the community helping him out. Do you have questions that you need help on? Have you joined the Fool Community and taken our 30-Day Free Trial yet?]
Crescentng's question: My partner and I just bought a home together. The sale of our separate homes is almost complete, and they sold for far more than we expected. As a consequence, we find that we could pay off the mortgage. To do so would leave me with a cash reserve of less than $10K.
Our options, as I see it, are to 1) pay off the mortgage; 2) refinance and keep a mortgage of say $40-$50K; 3) pay off the mortgage and open a home equity line. With the third option, we could draw on the line right away to put some cash in reserve.
I am leaning toward paying off the mortgage, and opening the home equity line, but not drawing on it unless we need it. A line of credit seems as good cash to me. If we drew on it, or take out a small mortgage, the money would be my reserve and not something that I could invest aggressively.
I like the idea of owning our home free and clear. I like the idea of no monthly payment. But are there other factors we should consider?
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Polarg responds: I have several thoughts.
1) Lines of credit are never as good as cash. If you use them, you owe them. Cash is spent and gone, but never owed at an interest rate (no matter how small).
2) I recommend that you and your partner speak with a CPA or tax lawyer regarding the tax implications of:
a) selling the previous properties at a profit and what that might mean for capital gains. (In some states, if you do not reinvest the cash into additional property within the state, you get hit with a very large capital gains tax.)
b) The interest loss on prepaying the mortgage. Depending your tax brackets and whether you itemize, this could hurt you (or not hurt you) enough to help make the decision.
Personally, what *I* would do in your position is: Put aside 6 months of joint living costs in an interest-bearing, but safe account with high liquidity (a money market, etc.) and leave it alone. I would put all "extra" money toward prepaying the mortgage. That way, I would have a generous cushion in case of disaster, plus I would have additional equity built up in the house immediately.
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AngryPuppy qualifies Ploarg's comment: Unless your profit is over $500,000, you will not incur any capital gains tax (at least at the federal level). I'd pay it off right now. Since you won't have a mortgage anymore, you'll be able to quickly build up your emergency fund.
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SykeMOL offers: I think option two is the wisest, for several reasons:
1) Cash is king. If you have cash in your investment account and a crisis/opportunity/emergency arises, you can cheaply and easily access the money. If the money is in your house, it will be expensive and time-consuming to access it. Home equity lines of credit (HELOCs) are great, except that if you read the fine print it says the bank can freeze your HELOC at any time -- for example if you're having a financial crisis. So you can't really count on it as a true source of emergency cash. You could take it out immediately as you suggested, but then you're paying a higher interest rate than your mortgage would have been. From a financial standpoint that doesn't make sense.
2) Opportunity. Houses usually appreciate at the rate of inflation, give or take. There are probably better long-term investments you can find (30-years, the life of a typical home mortgage is definitely long term). At the end of 30 years, you'll probably find that you're a lot wealthier if you invested in places other than your own home. Also, 20 years from now your mortgage payment will be laughably small. Because of inflation, you're essentially taking full value dollars now to pay off smaller, future dollars.
3) Risk. It's financially risky to have most or all of your assets tied up in one thing, your house in this case. Sometimes neighborhoods go bad, the local economy sours, the house next door to you gets converted to a frat house and your house isn't worth what you thought it would be.
4) Peace of mind. If you have cash in your investment account, you can probably handle whatever storms are on the horizon. You could even make the mortgage payments out of it, indefinitely if you had to.
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Bringing it full circle, Crescnetng writes: It is interesting. Regarding risk and peace of mind, I have the opposite reactions, though perhaps with different objectives. I feel safer with my home paid off, because it is less likely that a turn of events could leave me homeless. This is what increases my peace of mind.
For the same reasons, I favor a line of credit over a mortgage, though I wasn't aware that the bank could freeze the line as you say. I've had a line before and one thing I liked about it was that, if things got tough, I only had to pay the interest on the loan. With a conventional mortgage, I have to pay principle and interest, and, for many years, the interest is a tiny part of the total payment.
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