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When is Paying Down Your Mortgage a Bad Idea?
| September 10, 2010 | Posted by Roshawn Watson under Uncategorized |
By: Roshawn Watson
I hate debt almost more than anyone I know. I am a HUGE fan of paying off your mortgage quickly, if you decide to have one at all. However, my spirited but friendly debate with Kevin from Invest It Wisely inspired me to clarify my position on when paying down your mortgage is a bad idea.
Sophisticated Calculations
When you tell a “financial person” to slow down on the repayment on their mortgage in order to maintain an emergency fund, what is her response? Her answer will typically come from two main perspectives: risks or rewards. In other words, “what is the risk of not maintaining an emergency fund” or “what is the benefit in paying off my home early?” You can arrive at two entirely different answers based on which question you ask yourself. Are you risk adverse or risk insensitive? If you are only risk insensitive, you will just run the numbers, and you may decide that it is pointless to keep several thousand in the bank while having mortgage debt. It makes more sense to forgo having an emergency fund and pay the home off sooner. If you are only risk adverse, you may think nothing can compare to the security of maintaining adequate liquidity (cash reserves). You will pay the mortgage off with your cash flow (income) but not at the risk of your liquidity.
Both sides have valid points, which is why I believe it’s best to incorporate both perspectives in your decision.
To do this, revise your initial question to “what is the risk reward ratio of paying down my mortgage without an emergency fund?”
The Reward: If your mortgage is at 6% APR, and you pay it down early, then you are effectively getting a 6% rate of return on your money. That sounds reasonable, right? Some people argue that 6% is a lot better than the 3% they receive from their bank, so it only makes sense to put the money towards the mortgage. Additionally, if you pay it off, you have a debt-free home, which is pretty awesome.
The Risk: However, if you stop here, you are only seeing part of the story. Consider things like “how stable is your job?” Keep in mind that the average person changes jobs every 18 months or so. I have said it before: no amount of skill or experience can insure that you won’t be unemployed tomorrow. Also, when will you need to replace your car, your roof, your furniture, or your HVAC? How long will it take you to pay off the mortgage? Even frugal people with decent incomes often take at least 7 years to pay off their mortgages. Many take longer. Numerous data show that most people fail to systematically prepay their mortgages. Things such as prom dresses, car alternators, job losses, and child births always seem to “get in the way.” Statistically, we know that medical expenses, credit card expenses, and job losses are the major contributors to financial ruin.
If we mathematically factored risk into the calculation, we would see that the spread is no longer 3% (6% mortgage saving versus 3% interest in emergency fund). Because there are so many variables (financial risks) that could occur during the payoff of a mortgage, one must conclude that the actual rate of return is less than 6%. In the investment world, this is referred to as a risk-adjusted rate of return. According to Investopedia, the risk-adjusted rate of return “refines an investment’s return by measuring how much risk is involved in producing that return.” This correction is necessary because the initial rates of return are exaggerated. Thus, if your calculations don’t factor in the risk of encountering an emergency, they have limited validity in the real world.
Dare I say, that even if you are abnormal and do manage to pay off the home in 7 years, you may still end up behind financially if you decide to forgo the emergency fund. Again, there is a lot that could happen during the pay off, and the last thing that you need during a major life event is to be house poor and broke. Thus, the damage done by encountering an emergency without adequate cash reserves may exceed the interests savings from paying off the mortgage early.
What about borrowing on a HELOC or Credit Cards in an Emergency?
Some people think that their Home Equity Lines of Credit (HELOCs) or credit cards will be there during a pinch. Financial institutions have tightened lending criteria, so I wouldn’t necessarily count on easy credit to get out of a bind nor would I want to put my financial destiny in the hands of bankers (does anyone remember what the credit act changes in the 1980s did to entrepreneurs?). HELOCs and credit cards have a nasty tendency to be slashed just when you need them the most. They can cut you off almost at will and often do so, especially when you don’t appear to be able to pay the bills (hence an emergency). The financial reform act did not solve this problem for you. Additionally, the last thing one needs during an emergency is to be leveraged up to their eyeballs anyway. Remember, debt is NOT your tool, and getting into more debt is definitely a poor option, particularly when it’s preventable by maintaining an emergency fund (adequate liquidity).
What about using my investments as an emergency fund?
Another common rebuttal is “I have investments, so I really don’t need to maintain an emergency fund.” If you are talking about 401K or Roth IRA investments, it is best to treat them like they are not there except to avoid foreclosure or bankruptcy. For example, if you want to take money out of a 401K, you get taxed at ordinary income tax (your current income tax rate) plus a 10% penalty. For most people that’s like borrowing money at 40% interest: not smart especially when it could be prevented with better liquidity. The 401K loan is not a great idea either because it is due in full whenever you leave the job. With the average job lasting just 18 months, changing jobs is not just a possibility for many people, it is a reality. However, what if you have non-retirement account investments? Well, for all practical purposes this is an emergency fund. As long as you are willing to cash out the investments in an emergency, regardless of whether the investment is up or down, then you have reduced your financial risks with adequate liquidity.
So When is Paying Down Your Mortgage a Bad Idea, Again?
Okay, there are the rewards, the risks, and “the bad alternative solutions” (borrowing on credit cards, HELOC, retirement accounts or cashing them out). My hypothesis is that it is unnecessary to be house poor for a marginal return when you can pay down your mortgage AND maintain an emergency fund. In retrospect though, we didn’t really answer the question directly. When is paying down your mortgage a bad idea? Well, it is really quite simple…at the expense of your long-term financial solvency.
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We have flip-flopped on this issue a few times. Having finally built up an emergency fund that could cover 3-4 months' expenses, we started to feel silly holding it in a bank account at 2% interest when our mortgage is costing us 5.49%. We almost took some of the emergency fund money out and put it on the mortgage, but decided against it in the end. The "sleep at night" factor just outweighed the interest savings, especially in today's uncertain climate. Great discussion!
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Great post! I loved the conversation on Kevin's site as well. I think that factoring the risk of being broke or at least illiquid during an emergency would outweigh wanting to pay off a small portion of a mortgage. Of course, I do think that for higher interest debt, the reward of paying it off restricts me to about 1 month of living expenses in my EF.
So, while I have credit card debt I hope to keep 1 month and then build it up to about 3-6 months, then pay off my student loans. After that I may go up to 1 year – but not all in a high-yield account.
I had a feeling this was related to our discussion when I saw the post title in the reader 🙂
I agree with you that it is not "either-or". It is about finding the balance that is right for you. I believe that the adequate way to protect oneself is to carry *some* cash, carry insurance, and maintain a spread of liquid investments.
In my own personal case, I usually have 2-3 months of expenses in cash and somewhat more than that in highly liquid investments that can be withdrawn without much of a tax consideration. Beyond this, I will pay down the mortgage or invest. I know some people go for 6 – 12 months of cash, but to me, this is wasting an opportunity to shave a couple years off of the mortgage.
I also agree with the point that as we get older and have more assets, what seems "huge" is no longer huge. For me, $10,000 is an emergency fund seems sub-optimal because it represents a large portion of total assets. However, for someone with $250,000 behind them, $10,000 in an emergency fund isn't all that much.
I would argue that a healthy gap between expenses and income is more important than an emergency fund. I am strongly against being "house poor", which is why I would never purchase a home that required me to spend most of my income to live there. Life is much more flexible when you have a lot of headway between what you need to live and what you earn!
I just want to point out that there are a few differences between Canada and the US that affect this discussion. In Canada, mortgage loans generally renew every 5 years and are also "recourse" loans. Interest is also not tax-deductible. As we are currently in a low interest rate regime, all 3 of these factors swing the pendulum toward the mortgage.
Good discussions, Roshawn.
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P.S. Thanks for mentioning my article 🙂
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Khaleef,
I also varied my EF based on the kind of debt I was repaying. In order to finish paying off my student loans, I liquidated most of my EF but kept a small cushion (not much though). However, before I could apply that same type of intensity that I used to pay off all my other debts to my mortgage, I fully funded my EF plus some.
Having a year's worth of EF is definitely a sweet deal, but where to put it? At 1-2.25%, these high interest accounts are dismal. Some bond fund action gives you a more reasonable return, but what about the much-discussed bubble. I hate the penalty on a c.d. Even a diversified portfolio can give you pause in today's economic climate 🙁
I certainly welcome your thoughts.
Anyway, thanks so much for the comment, the Tipd, and the #followfriday
My recent post When is Paying Down Your Mortgage a Bad Idea
Kevin, thanks for the comment, you seem to be inspiring a lot of posts lately my friend.
I definitely agree that you personal finance has to be adaptive to your unique situation; otherwise, it cease to be relevant. With 2-3 months, that is at least twice the average savings in America (I know you are from Canada). Plus, you have additional liquid investments and can tighten your budget in an emergency . Thus, you would be able to weather an economic storm. People in your predicament would not be in as much of a bind as the typical household.
Those differences in the laws are relevant. I have to keep remembering that laws in America do significantly differ from other countries.
You are welcome!
My recent post When is Paying Down Your Mortgage a Bad Idea
I went the route of paying off my mortgage early, and it has been great! Now I have an extra $1,500 per month to do whatever with!
That said, with interest rates soooo low today, I don't know if I would pay it off early in these days (especially if I went with a fixed loan)…
@Money Reasons
Oh my, you are so awesome! I love hearing stories like this. This is what I desire for everyone: to own their homes outright, be completely debt-free, and have tons of unrestricted cash flow!
Since I became debt-free (excluding the mortgage), I could not imagine going back into debt, low rates or not. I don't like the constraints debt puts on my cash flow, which is why I wouldn't keep a mortgage around either.
Thanks for your comment. People need to hear your story!
Hi Watson,
I would have to disagree with you from a Canadian perspective. In Canada interest is not tax deductible so there's a first point out of the way.
your rate of return is 6% + the taxes you paid on this 6%. Here's why, If i am taxed at 40% and i manage to save 100k in interest after paying down my mortgage I can theoretically invest this money and recover the taxes by contributing to a registered retirement plan.
My second point would be about the emergency fund, sure I like to keep an operational fund of about 5k but not more because I can borrow the money from my HELOC (my heloc is setup and accessible) and it would be equivalent to having lent the money to the house with interest and gotten it back.
I enjoyed reading your post,
Cheers!
Hello Mate,
I completely get that an "operational" emergency fund will catch the bulk of the emergencies.Surely, an emergency fund doesn't need to be 7-10 months worth of expenses before you aggresively pay down your mortgage.I think we all agree that the actual number depends on one's lifestyle and risk tolerance. I think the part that I am most uncomfortable with is leaving my financial destiny in the had of a banker, who at his bosses whim can cut my credit with the stroke of a pen. Additionally, I wouldn't want to be in bondage to a banker, especially in an emergency. That said, my bias is that I am risk adverse. I own that and get that others feel this is much ado about nothing 🙂
I am sorry that Canadians can't deduct the interest from taxes (although I like the it does encourage those mortgages to get paid off).
Kind Regards!
My recent post When is Paying Down Your Mortgage a Bad Idea
Hi Watson,
I agree with you that lifestyle and risk tolerance will dictate how you chart your mortgage vs emergency fund strategy.
I used to feel sorry for us Canadians when it came to deducting interest rates from taxes. Nowadays, i find it to be the right thing because this measure appears to be an indirect subsidy from the government to the housing market. Had this not have been in place, it could have been introduced as a tool to help the housing market recover when it needs it the most.
I am sure the housing market would've done just as fine without this subsidy while billions of unducted dollars would have contributed to reduce outstanding debt all along.
Regards,
I'm not the least bit sorry I paid off my mortgage, and have sufficient savings that I don't have to worry about HELCOs and credit cards for emergency funds. The tax deduction was way overrated compared to not having to write that check every month.
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Hello Mich,
Indirect gov't subsidy sums it up quite nicely. Additionally, its byproduct is an indirect encouragement for people to stay in debt. The only reason I feel bad for Canadians though is that I read that your housing is already more expensive in many cases, so not getting a tax break does impact your finances.
Secondly, people always need a place to reside, and there is no place like your own home. Subsidy or not, people are going to buy homes.
Kind regards my friend,
Shawn
My recent post When is Paying Down Your Mortgage a Bad Idea
"The tax deduction was way overrated compared to not having to write that check every month."
Absolutely, people will knowingly spend $6,000 in interest every year to keep from paying the government $1500 in taxes citing tax detections. Overrated is certainly a legitimate characterization (as is ridiculous).
Congrats on paying off your mortgage! That's just so weird, but in a very good way! 🙂
Cheers to you!
Shawn
My recent post When is Paying Down Your Mortgage a Bad Idea
I am very happy with my decision to accellerate my mortgage. Just by paying a couple extra hundred dollars per month, I will shave 9 or 10 years off the loan. Then, I will have a lot of options of what I want to do with my life and no mortgage payment to hold me back.
I definitely agree the emergency fund comes first. But, then get rid of the mortgage. The tax deduction is a joke, unless you have a very big mortgage with a lot of interest. The personal deduction is over $10K now, so you only get a break on interest above that.
Hey Bret,
We are definitely in agreement on the priority of funding an emergency fund and paying down a mortgage.
One interesting thing about the tax deduction for paying mortgage interest is that it can count towards an itemized deduction if you give a significant portion of money to a charitable organization. In our case, the personal exemption never exceed the itemized deductions for this very reason.
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