Emotions vs. Numbers
July 16, 2010One of the questions that I have fielded more often than other questions in my career as a financial planner is about paying off a mortgage vs. keeping it for those who have the ability to write a check & pay it off all at once. I have had a lot of discussions with my friends about this topic. (Yeah, I just might need to get a hobby.) These friends are CPA’s, MBA’s, CFP’s, math geeks, as well as friends who have no financial background but who have always shown an ability to use common sense. After years of debate and discussion (So….my friends need hobbies too!), we have found that there is no true consensus around this topic. But, we have come up with what we believe to be the most important points to consider.
- In favor of keeping the mortgage: If the mortgage rate is 6% and it’s tax deductible, the tax-adjusted cost of the loan is around 4%. If you can do better than 4% on your investments, keep paying the mortgage.
- In favor of paying it off: For every dollar you pay in interest, you get a tax break of maybe $.25 to $.40. For every dollar you’re willing to give me, I’ll gladly give you a few dimes back! The total interest cost can be 2-3x the amount borrowed over the life of the loan. You still lose over half of each dollar paid in interest with the tax impact factored in.
- And, in down markets you not only lose money in your investment accounts (think about the -37% S&P 500 returns in 2008), but the interest on your mortgage is lost opportunity cost. Paying off the mortgage in Jan ’08 would have yielded a 4% return with the assumptions above. Keeping it would have cost 41%, the 4% paid in interest along with the 37% lost if your returns were similar to the overall US stock market. A mortgage can be viewed as a means of leverage, and as we’ve seen with the financial markets – leverage isn’t always a great thing.
I have seen literally hundreds of “keep vs. pay off” mortgage calculators. The inputs on the calculators usually include the interest rate of the mortgage, the investment account’s assumed rate of return, income and/or tax rate of the homeowner, along with other more specific data items. The 1 thing that is NEVER seen in these calculators is “How are you wired? How would you sleep best at night? Do you like having a mortgage or do you really despise owing money to anyone?” The most sophisticated calculators, accurate out to 16 decimal places & including the last 5 years of specific tax data, miss the single most important factor in this decision. Which option feels best to you?
In my experience, the option that feels best is the option that individuals will choose. There is a lot of analysis, discussion, calculations, changing of assumptions, and an enormous amount of time can be devoted to this decision. In the end, what matters is the emotional viewpoint of each individual. Almost always, emotions trump numbers in this kind of analysis.