Combating Misinformation on Prepaying your Mortgage
There’s nothing that causes me greater irritation (or subsequently gives me greater pleasure) then reading blatantly erroneous financial advice in a major newspaper and then debunking it.
Recently, I read an article in the New York Times entitled “When Not To Pay Down A Mortgage,” in which the author, Ron Lieber, lays out the case for and against early repayment of your mortgage. He concludes that based on current interest rates and economic circumstances, it doesn’t make sense to repay it, because you can probably earn more investing your savings elsewhere. Still, he concedes that there is an emotional benefit to repaying your mortgage early and being debt-free.
Lieber makes some good points about how it’s clearly better to first pay off higher-interest debt, such is that associated with a credit card or home equity loan. Don’t be tempted to make extra mortgage payments in order to lower the duration of your mortgage without first paying down your credit card. He also urges readers that in the current economic climate, it’s very important to make sure that you have an adequate cash cushion in case of hardship, and that emergency funds clearly should not be used to prepay the mortgage regardless of your interest rate.
But here’s where Lieber goes astray. He repeats the classic mortgage fallacy which is that your real interest rate is less than your stated rate because of the mortgage interest tax deduction, which means that your hurdle rate (the rate of return that you would need to earn in order to make not prepaying viable) is much lower than you think. There is only some truth to this, but it depends on the type of investment account and the type of investment. If you use the funds (that you would have otherwise used to prepay your mortgage) to day trade, then you will be taxed on your earnings (or more likely your losses…) at your normal income tax rate, completely offsetting the interest tax deduction. The same is true if you invest using your Roth IRA, since you will necessarily have paid income taxes on all contributions to that account before they can be invested. Really, the only exception is that if you invest in stocks using your traditional IRA, you will be taxed at the long-term capital gains rate (15%), and can reap some benefit from the tax rate differential. Still, this assumes that (at current rates) you will need to average 4-5% a year simply to break even! Maybe you think that you can, but is the added risk really worth it? In this regard, the only way you really “beat the system” is if you contribute more funds to an employer matching 401K. Personally, I would have thought this was obvious, and that anyone with half a brain would have done this before prepaying their mortgage.
Lieber’s other argument is even more questionable: given how much housing prices have fallen, it doesn’t make sense to prepay your mortgage, because if you decide you want to walk away, it becomes even more costly. Of course, this is entirely true, but I have a hard time believing that a significant portion of borrowers obtain mortgages with the intention of breaking them when housing prices decline. I, too, am an advocate of walking away from your mortgage when it makes financial sense, but the idea of financial planning with this possibility in mind strikes me as ludicrous. Even in the current crisis, only a small minority of borrowers (~10%) will default on their mortgages. For those who are underwater, I’m sure that they regret every cent that they paid into their mortgage. But asking them to anticipate the position that they ultimately found themselves in and acting accordingly is unfair.
I think Lieber’s conclusions stand on their own. There is a strong emotional benefit to repaying your mortgage early, as long as you can afford it. While it’s possible that you will come out ahead by paying off your mortgage normally and investing in the interim, there is added risk and no guarantees associated with such a strategy.