Clients often ask this straightforward question, but the answer depends on several factors.
Many people think the answer is purely a tax issue because a mortgage can provide a significant tax deduction. So, by eliminating a mortgage, they assume their taxes will be much higher. Others have learned that using leverage to buy a home or second residence is a good way to enhance their overall net worth. Based on these two notions, they would probably conclude that it does not make sense to pay off their mortgage.
But is that really the case?
- What are the alternate uses for the money? By obtaining or keeping a mortgage, you are freeing up funds for other purposes. Those could be consumption, paying for college or investing.
- What are the potential earnings? Once you know your alternatives for the money, the next step is to estimate the potential return for these funds. Ideally, this estimate would be made in annual terms for the same period as you are contemplating keeping the mortgage. You might assume that the annual return on consumption is zero (or even negative), whereas the return on a college education might be quite high, given the salary earning potential of some degrees.
- What is the estimated after-tax rate of return of the funds in their alternate use versus the after-tax mortgage rate? At the simplest level, if the mortgage rate is more than the alternate use return, it might be time to consider paying it off.
Life is rarely simple, however, and other factors should also be considered.
- Liquidity. Your mortgage rate might indeed be higher than the return on your other investments, but if paying off the mortgage means having to sell a significant portion of your investments, limiting both your future returns and means to raise cash for lifestyle expenses, keeping the mortgage could makes sense.
- Cash flow in retirement. For most people, retirement is a period of reduced income. Even if a retiree’s assets provide ample support for continuing mortgage payments, they may prefer to keep cash inflows and outflows more balanced by eliminating their mortgage. This could provide a more predictable budget for planning purposes and could help avoid the need to make unscheduled investment sales to meet monthly expenses.
- Risk preference. Many people simply prefer to be free of debt and feel more financially confident if they own their home outright. This subjective preference may not make complete analytic sense, but it is never the case that numbers are completely right and attitudes are completely wrong.
There is no “one size fits all” answer to the question of whether it makes sense to pay off a mortgage, but there are smart answers — those that consider the full picture of your assets, your goals and your opportunities. A Creative Planning wealth manager can help you determine what is the smart decision for you.
