25 Apr 2014 Should You Pre-pay Your Mortgage?
The question of whether you should pay off your mortgage is a complex one and everyone has an opinion. Some radio talk show hosts say all debts should be eliminated as fast as possible, including your mortgage. Debt presumes on the future they say. Your ability to pay might be impacted by health, job, or other unforeseen factors.
Some financial advisors might suggest that pulling funds from investments growing at 7-11% to pay debt that costs (interest) only 3-5% doesn’t make financial sense. Left in your investment program, your money would grow by a net of 4-6%. CPAs would add that the tax deduction reduces the effective cost of the mortgage by your tax savings.
But the reasons presented so far are logical in nature. Debt carries substantial emotional weight. For some (perhaps many) the idea of being debt-free, owing no one is liberating, both emotionally and spiritually. For some, freedom from debt is worth most any price. But, the measures above don’t provide much information to enable an informed decision.
Whether you approach this question from an emotional/security perspective or from a financial/investment perspective, today’s Brief is for you. We have the tools to answer the questions from both the logical and the emotional perspectives.
To examine the question as objectively as possible we consider mortgage elimination for three distinct age groups: 30, 40, and 65. The scenarios are tailored to address the broadest number of our readers, while keeping as many of the variables as uniform as possible to simplify the comparisons.
30 Year-old Couple
Let’s start with a 30-year old couple, Jack and Donna Adams. They each make $40,000 and save the maximums into their 401Ks of $17,500 apiece with combined balances of $200,000. The couple has a new $300,000 mortgage at 4.5%. Soon after closing on their mortgage, Donna received a raise that afforded the couple the possibility of increasing their mortgage payment by $775 a month or and adding an after-tax amount of $620 to their investment portfolio. The Adams asked us what they should do.
Their current plan has them invested in a 70% stock and 30% bond portfolio until they turn 65. Using our Monte Carlo model to compare the two scenarios we find that if the couple invests the after-tax amount ($620 – increasing as the tax benefit wanes) they have an 81% chance of meeting their ideal spending level of $138,000 throughout their retirement years until age 95 (increasing annually for 3% inflation) and leaving more than $1.5 million to their children.
When we consider the alternative of pre-paying their mortgage in 15 years instead of 30 by adding $775 monthly, we find that the couple’s spending level drops by $5,000 to $133,000 at the 81st percentile. There are two ways to examine the difference. Emotionally the couple might say that a $5,000 drop in annual spending is a reasonable price to pay for the security of being debt free in 15 years.
On the other hand, their logical side might enjoy knowing that saving the extra money, rather than pre-paying their mortgage would earn them an extra $5,000 annually, increasing at 3% annually for the rest of their lives. The present value of that $5,000 per year stream for 30 years is $84,500 at 3%. Now the couple has some information to make an informed decision from either perspective, emotional or logical.
40 Year-old Couple
Our 40-year old couple are Bill and Dianne Baker. Their combined income is $250,000. Like the Adams’ they save the maximums into their 401Ks of $17,500 with balances totaling $600,000 combined with a brokerage account worth $150,000. The Bakers have a 30-year mortgage with an outstanding balance of $400,000 at 4.5%. They took out the mortgage 10 years ago at $500,000.
The couple asks us for advice on whether they should pay off their mortgage in 10 years by increasing their mortgage payment by $1,667 per month or send us the same amount net of tax ($1,100) increasing to $1,667 as the tax benefit wanes. Bill would rather save the money for greater liquidity down the road and Dianne prefers to pay off the mortgage for the security of knowing her house is secure from creditors.
The Baker’s plan indicates that they have an 81% chance of spending $165,000 after-tax during their retirement years from age 65 to 95 (increasing with inflation of 3%) and leaving more than $1,500,000 for their children. They are invested in a portfolio of 60% stocks and 40% bonds.
If the Bakers choose to pre-pay their mortgage, their spending amount at the 81st percentile drops by $10,000 to $155,000. Now Bill and Diane have more information to weigh as they discuss security vs. liquidity.
65 Year-old Couple
George and Carol Cook are ready to retire. They have IRA’s worth $1.5 million and brokerage accounts totaling $2 million. Their remaining mortgage balance is $150,000 and ask if they should pay it off.
The couple’s plan indicates they can spend $138,000 (adjusted for inflation) for the next 30 years and leave more than $1 million for their children at the 81st percentile. If they pull $150,000 from their brokerage account and pay off their mortgage, their income at the same level of confidence will drop by $5,000 annually.
In each of the cases above, we opted to compare what happens to spending levels in retirement given the pre-payment vs. savings scenarios. Another option might be to reduce estate values. In the case of our 40-year old couple, we would need to reduce their estate by $500,000 in order to maintain spending of $165,000 at a confidence of 81%.
Without a tool like Wealthcare, people really have no way of evaluating the full impact on their lifestyle of eliminating their mortgages. They understand the feeling of debt-free, but knowing the cost in retirement spending or future estates for their kids might cause many to adjust their plans by compromising or doing nothing.