Thoughts on Paying Off My Mortgage

Thoughrs on Paying Off My Mortgage

Hello everyone! Hope all is well. Here I am on a Sunday typing up some thoughts that have been running in my head lately on paying off my mortgage or investing in the stock market. In the backdrop of these thoughts is my recent “liquidity situation” now that I’ve invested most of what was in my taxable brokerage account into my small business.

The Background

First, let’s start with a little background. Just a few months ago the US Government gave us a holiday present with their tax reform act. Most everyone will now be paying less in taxes. But how the reform affects me the most right now is the increased standard deduction. I will no longer be itemizing and if I do, there will be marginal benefit over the standard deduction.

So now, having a mortgage on my house doesn’t really have any tax benefit for me. I’ve talked before about how buying a home has been a positive for my net worth, and the tax savings from mortgage interest deductions has been a primary reason.

The Question

Now that it makes no difference on my taxes if I pay down my mortgage or not, perhaps I start paying it down faster?

Granted, my mortgage interest rate is close to historic lows. We bought our home in mid 2012 and secured a 30-year rate below 4%. As I pay down the mortgage, there will be no getting back a super low rate like that.

The Value

The mortgage tax effective rate is no longer sub-3% since I can’t deduct the interest. What I mean here is that if the mortgage interest expense is tax deductible and for simplicity sake say my normal rate is 4% and my tax rate is 30%, then the tax effective rate is 2.8% (1-.3 X 4% = 2.8%).

The benefit of paying off the mortgage faster now is saving the full ~4% interest expense rather than the tax effective rate of 2.8% before the tax reform. Effectively, putting more money toward my mortgage is locking in a 4% return (interest savings) and my net worth will go up because of the money put toward my mortgage will pay down the loan balance.

The other value driver is paying it off entirely. If I were to divert all the money we make (after continuing to max our 401K and IRAs), it would take me about three years to pay off the mortgage entirely. At that point, our annual expense / cost of living would drop $15K or so as we would no longer have a monthly mortgage payment.

At that point going forward, we’ll have more and more cash flow available to invest in the stock market. That timeframe would also coincide with when both our boys will be out of daycare. That would be another ~$20K of less expense each year to invest.

By paying off the mortgage in the next three years we’ll be investing a lot less in the market now, but still have plenty of opportunity to invest heavily once it’s gone for good.

The Opportunity Cost

While paying off my mortgage is locking in a 4% return on that money, I’d be missing out on investing more into the stock market which I’ve always been a huge proponent of. Right now, I’m 100% in the stock market via various index funds. No doubt the market has been pretty hot in the last 18 months or so, and even if tax reform puts a little more wind in the economic sails, I have a feeling that we’re closer to the peak of the market than the trough.

8% returns has always been my long term expectation for the stock market, so paying a ~4% mortgage may not be a keen decision…

The Catch

The thought in the back of my mind goes back to the current stock market likely be closer to the next peak than the prior trough. Who knows for sure, but that would be my inclination. I can divert cash flow from the stock market toward my mortgage in the near term, then as soon as the stock market has a ~20% correction, I could do a cash out refinance on my home and throw the money in the market at that point and try to ride it back up. Of course, who knows what kind of market gains I would potentially miss out in the near term.

I know trying to time the market is a tough conquest, but the only sacrifice I’d be making is a the potential upside in the market while paying off my 4% mortgage early. That may not be a huge loss. Meanwhile the rest of my funds and investments will continue to be 100% in the stock market. It isn’t like I will be pulling all my investments to the sidelines.

I’d be trying to time the market and risking it continuing to drop for a while, but those funds would have otherwise already been in the market in the first place had I not chosen to pay off the mortgage early.

Ultimately, it would be a winning proposition if the market gains less than 4% per year between the time I decide to put all my extra cash flow toward the mortgage to the point when I decide to do a cash out refinance to put that money back into the market. If the market simply stagnates for a while (not even a full 20%+ correction), it could be a win because in the meantime I’d be saving that 4% interest. In essence, the decision would be a 4% win if the market is flat.

Thoughts?

Something to ponder as we move into 2018 and the new tax environment. The proposition for saving 4% is surely greater than 2.8% when the tax environment allowed me to deduct the interest expense. What do you think? Have you considered a similar plan? Is it silly to change my investment philosophy that has worked for me so well? Let me know in the comments below.

Thanks for taking a look!

The Green Swan

 

Disclaimer: Refer to my disclosure page. This post is simply for discussion purposes and something I’m currently contemplating. Do not construe this as investment advice. Talk to a professional if you need help with investment considerations.

Facebooktwittergoogle_pluspinterestmail
share on:

24 Comments

  1. Even thought the tax benefits of the mortgage go away with the new law, I’m keeping my modest mortgage. I’m at a 3.33% rate and I still think the market will do better. Maybe not every year, but the odds are still in that favor. And since none of us can do any better than “going with the norm”, the norm says keeping the mortgage is the right move by the numbers.

    1. Nice disciplined approach! Can’t go wrong with having that level of discipline in your investing strategy. Don’t fix it if it isn’t broken!

  2. I’d still dollar cost average into the market with less money, and throw the extras at the mortgage. Kinda the best of both worlds. Maybe it takes slightly longer to pay down the note, BUT you’d still be mortgage free at some point much faster than the 30 yr pay down time frame.

    1. Good thought, Dave. I certainly see the appeal of dabbling with a little of both. Sort of hedging my bet. Thanks for sharing!

  3. I’m a bigger fan of paying off the mortgage or doing a balance of increasing the payment you make while still investing in the market.

    If you are maxing out your 401(k) and IRA, then you are still putting a big chunk of money into the market each yet your paying off the mortgage.

    At the end of the day dollar cost averaging instead of timing the market seems like a less risky choice, while paying extra on your mortgage makes sense with the tax law change.

    1. It wouldn’t hurt putting more toward the mortgage considering how much is and will continue going into the market via 401k and IRA, as you mentioned. The mortgage does have the certainty of return. Lots to stew on! Thanks for the thoughts.

  4. In these situations, I’ll point out an important thought — diversification.

    Just as you would diversify your investments (index funds over individual stocks), you ALSO can diversify your approach here — put some percentage toward index fund investing, and some towards faster pay down of the mortgage. Sure, you won’t pay off your house in 3 years like you would if you put EVERYTHING towards mortgage pay down, but maybe you accelerate the process a little while still increasing the stock holdings.

    I don’t know, maybe it’s just me, but I tend to always err towards “a little bit of both” when someone presents one of these scenarios.

    1. Great points and I appreciate your considerations. A balanced approach makes sense. “Everything in moderation…”!

  5. I agree with chad and Dave. I call it digging a tunnel from both ends. I pay a few hundred dollars extra towards the mortgage and invest a little bit more than that into VTI with Vanguard each month. When my mortgage balance equals my stock investments I’m essentially mortgage free. Then I can decide to kill the mortgage or keep it.

  6. I came to the same conclusion when I looked at the tax reform details. I’ve started to pay it down for just the fact it’s no longer tax deductible. A real 4% return plus the peace of mind in what many consider an inflated stock market makes sense to me. Also once you don’t have a mortgage it obviously would make your monthly expenses that much lower. As I read more and more articles about RMD’s for pre-tax IRA’s I think this is my plan for the next few years. Also, if you think you need after tax money to pay off your mortgage, do you think taxes will be lower with the new tax plan in 2018, or will be lower in the future ? Not getting political here, just saying in my situation they will be lower % in 2018, and I don’t think they will get lower in the future, I see them going the other way.

    1. We have a very similar thought process, Chris! And I hear you on your point about tax rates too, especially if you still have a ways in your career before retirement. Hard to see them going any lower. But once in retirement your tax rate could go down as a function of moving down in the bracket with lower reportable income. Lots to think about!

      Thanks for sharing your considerations!

  7. I always have conflicting thoughts on this. On the one hand I want to pay off the mortgage like yesterday, but that is because I like not owing anyone. At the same time at 2.875% interest rate I know that I will most likely get a better return in the market. I already max out my 403b, but I can also add a 457b if I wanted. I sometimes play with the idea of switching over, maxing that account out and when the account reaches the point of my mortgage then taking that money and just plunking it down on the house. I only have 9 years left on my mortgage anyway, but I would like it gone tomorrow if I could. I wonder if I had the money in the bank if I would truly pay it off? Oohhh…that is a good blog post. See GS you inspire me as I am writing comments.

    1. That’s a good thought exercise! I don’t think you can go wrong one way or the other, but it certainly is hard wrestling with the decision.

  8. We have been working towards paying our mortgage off over a seven year period. We have successfully completed four out of seven years. However, we designed the original plan to continue invest in both the market (by maxing out pre-tax accounts) and diversifying across other assets.

    However, there have been two variables that have us considering paying it off even faster than the remaining three years:

    (1) Our income has grown much faster that projected.
    (2) The tax reform that makes takes away the ability to deduct the interest expense.

    We are now seriously considering trying to pay it off over the next 18 months. Like you, this would free up about $15,000 per year in living expenses.

    My concern for the past four years has been around maintaining a diversified approach and managing the concentration of our homes equity as a percentage of the total net worth pie. One thing we have done to address this was to attach a HELOC to the house. This at least gives us access to a portion of the tied up equity.

    I will be interested to see what you choose.

    Cheers,

    Dom

    1. Sounds like you’ve thought it out thoroughly. Similarly I don’t necessarily want my home equity to be a large part of my net worth either. It’s just not the most efficient asset in my mind. Ideally I’d keep it under 10%. Since right now it’s less than 7% it isn’t much of a concern for me. Thanks for sharing, Dom!

  9. Hi JW,
    It’s an interesting one for sure – and also on country. Over here we no longer get tax breaks on the mortgage interest, so for me I aim to fill up the tax free shelters we have, then overpay the mortgage.
    Cheers,
    FiL

    1. Nice plan, FiL. We’re thinking along the same lines. I’ll have to put some final thought to it before I decide. Thanks for sharing.

      1. Hi JW,
        As always so much is down to personal circumstances, and the size of the mortgage. Get the mortgage down to manageable (if it isn’t already), fill up tax shelters, or the combination!
        Good luck – I look forward to seeing what you choose!
        FiL

        1. The mortgage is definitely manageable and I am not necessarily itching to get rid of it simply for the sake of being debt free. One other part of the puzzle for me is the fact I have somewhat lower amount of “liquid” assets held outside of tax sheltered accounts since much of it has been used to buy the small business. To manage early retirement I need to keep building those up over the next five years (and carry some level of a mortgage into retirement as result).

  10. You haven’t quantified risk. The opportunity cost of sitting out a bull market is real, but in a bear market you’ll still need a place to live. It’d be a shame to sell equities at a discount to make a mortgage payment. With the mortgage paid off, you can reinvest mortgage-payment sized amounts into the biz where you should see your greatest return (and have maximum control and knowledge).

    1. I hear ya, Steve, especially on sitting out the still rising bull market. I don’t plan on selling equities to pay off the mortgage though. I’ll continue to pay the mortgage and any contemplated accelerated payments will be with cash flow from W2 income.

      1. I’m pulling for you, man.

        Currently reading Anti-Fragile by Nassim Nicholas Taleb and his dumbbell strategy. Have you written on this topic?

        1. No I haven’t written about it. I remember reading that book and finding the dumbbell strategy as an interesting concept, but I’d have to go back and reread it again. Basically just taking a position in low probability high impact situations, right?

Leave a Reply