Everybody who has a mortgage dreams of the day when he can pay it off. Although I cannot personally attest to owning a home outright, I certainly can imagine what it will feel like to send that last payment to the mortgage company. I am looking forward to the day; however, I am in no hurry to accelerate that process. Why? Let’s look at some reasons.
1. Loss of Financial Flexibility
When I use precious cash flow to make extra payments toward the principle of the mortgage, I’m reducing my financial flexibility. If I were to need the cash later, the only way to access it would be to take out a home equity line of credit. Why pay interest on equity in a house when I can own more liquid assets? Although I don’t plan on needing a large amount of cash and already have a fund for emergencies, I still think it is important to own assets that are relatively liquid.
Here’s something else to consider. Let’s say I start saving the amount that I would have paid in extra payments. In five years I decide that strategy was a bad idea. If I still have the cash, I can pay off the mortgage! Quite simply, locking up assets in extra mortgage payments reduces financial flexibility.
2. Missed Opportunities
It’s no secret that interest rates are still near historic lows, and I have to look at the opportunity cost of making extra payments toward the principle of my mortgage. In 68 20-year rolling time periods ending in 2012, the S&P 500 has never had a negative annualized return and has only had three years (1947, 1948, 1949) where the annualized return has been less than 6% (4.71%, 3.11%, 4.46% respectively). Based on this information, there is a good chance that my money will serve me better invested in the market than in my real property. As the time frame of the rolling period gets shorter (i.e 15 years, 10 years, etc.), the volatility of returns increases. Knowing this, I will consider making additional payments on the mortgage as my amortization nears final payments.
3. Lost Tax Benefits
If I itemize my deductions, I can use the interest as a deduction on my income tax return. Although I will likely pay taxes on any dividends, interest, and capital gains on any investments (my alternative to extra mortgage payments), qualified dividends and long-term capital gains are tax-advantaged compared to ordinary income. The deduction on my income tax return for mortgage interest is more likely to offset income taxed at a higher rate than the taxes paid on qualified dividends and long-term capital gains each year.
Ultimately, the idea is to maintain relative liquidity, provide assets an opportunity to grow, and still have the ability to pay off a mortgage early if desired. Is there risk involved? You bet. Will this work for everyone? Absolutely not, but in the current interest rate environment, it may be an appealing option.
Ryan Edwards is a financial planner in Shreveport, LA, who enjoys working with young professionals desiring to plan for their futures. He holds the CERTIFIED FINANCIAL PLANNERTM (CFP®) designation and can be found online at http://www.cornerstoneshreveport.com/team/ryan-edwards.