If you ever find yourself in the enviable position of being able to pay off your mortgage from savings, you’ll be faced with a choice: Pay it off and have little left over, or lose a fat bank account while gaining peace of mind. That’s the question faced by this reader:
I will start by saying how much I enjoy your newsletter. I look forward to reading it every day. In saying that I have a question that I would love to have your take on.
I have a 30-year mortgage of $140,000 at 5.5 percent. At the time I took the loan I was making about that (interest rate) on my savings. Needless to say I’m now making about 1.5 percent on my savings.
I have enough in savings to pay off my loan but am concerned about the huge reduction in liquid monies for emergencies. I’m thinking I’d like to get the “monkey” off my back and pay the loan off. I can then start putting the money I’m paying toward the loan payment back into my savings and start building the nest egg back.
There’s not a lot of places to have money work for you anymore. We’re buying Roth IRAs every year and have some stocks, CDs etc. I’m 50 and my husband is 58. We have two children, one 15 and one 13.
I’m really interested in your opinion and look forward to hearing back from you.
Here’s your answer, Dania!
As it happens, I’m in a similar position — no debt other than a mortgage, and money enough in savings to pay it off. I’m paying a little less interest on my mortgage — 4.75 percent — and I’m close to your husband’s age. I’m 57.
So rather than tell you what I would do, I can tell you what I’m actually doing. I pay a little extra on my mortgage every month, but have not paid it off.
At first blush, this seems wrong. After all, the math is simple. If you’re paying 5.5 percent and earning 1.5 percent, your debt is making you poorer by 4 percent annually. So as long as you have adequate emergency savings and a secure job, the math demands you retire the debt. In fact, mistake No. 1 in 10 Money Mistakes Everybody Makes is: “Paying much, earning little.”
Then why do I still have a mortgage?
1. I’m earning more than I’m paying
By definition, I can’t be earning more on bank savings than I’m paying on my mortgage. Like Dania, I’m earning almost nothing. But unlike Dania, I have plans for the money.
Last summer my neighbor’s house went up for sale and I went in with a friend and bought it for cash. We had it remodeled from the ground up and are now using it as a vacation rental.
The rent alone is providing me a 5 percent return on my investment, and I hope to make much more when we eventually sell the property. As I said in Housing Has Bottomed — It’s Time to Buy, I think housing prices will rise as the economy recovers.
I also own stocks that earn more than my mortgage costs. For example, look at my personal portfolio and you’ll see I own 343 shares of ConocoPhillips. I paid about $31 a share and the dividend is $2.64, which means I’m earning more than 8 percent.
Of course, it’s not all wine and roses. Real estate takes a lot more of my time than bank accounts do, and stocks are a lot riskier. (You’ll note that I also have losers in my stock portfolio.) So I’m not going to sink every available dollar in houses or stocks. If I come to the conclusion that I have enough in these two asset classes, I’ll use savings beyond what I need for emergencies to pay off the mortgage.
But I haven’t gotten there yet. In short, I’m keeping cash because I might want to invest elsewhere.
2. The interest on my debt is tax-deductible
Tax-deductible interest lowers the effective rate I’m paying. For example, my mortgage interest rate is 4.75 percent, and I’m in the 28 percent tax bracket. This effectively reduces my after-tax interest by 28 percent, so rather than paying 4.75 percent, I’m actually paying 3.42 percent. While that’s still a lot more than I’m earning on my money market account, it lowers the bar.
3. It feels good
This gets to the heart of Dania’s question. When you live a frugal life for decades and finally wake up one day to find yourself sitting on a fat bank account, it’s a very, very nice feeling. Sure, the math commands that you drain the bank account and satisfy those remaining debts, but you don’t care.
It’s like having tons of food in the freezer, or having your files organized, or your laundry done, or your house clean. Feeling safe, secure and flexible is good.
What should Dania do?
I started this post by saying that Dania and I are in similar situations. While we are in some ways, we aren’t in others.
I may be more willing to take risk in both stocks and real estate than Dania. That doesn’t make me smarter, just different. Dania may have her eye on retirement in a few years. Retirement for me isn’t around the corner; I plan to die at my desk. So I’m more willing to invest in riskier assets. Dania might be justifiably hesitant about taking too much risk. I may have more experience and stronger convictions about investing.
Here’s the point: When it comes to money, we like to pretend the answers are all objective. But let’s be real. The answers to many questions about money involve more than math. Keeping money in a low-return savings account while paying higher interest on a debt comes at a cost. But it also gives you flexibility and peace of mind. And that’s something you can’t plug into a formula.
So what should Dania do? If she doesn’t want to assume the risk required to earn more than she’s paying, she should probably pay off the mortgage. But if she likes the feeling and flexibility of a big bank balance, rather than all or nothing, she could choose to use some of her savings to retire part of the mortgage while refinancing to a lower rate.
If she’s paying 5.5 percent, she could lock in 2.7 percent on a 15-year loan (see our mortgage search), which would save a ton of interest. So she could take $70,000 of her savings and refinance into a new $70,000, 15-year, 2.7 percent mortgage. Then she’ll have a smaller mortgage and still have plenty in savings.
Whether that makes sense depends on how much it costs to refinance and how long she’s going to stay in her house. (See Should I Refinance My Home?)
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