MONEY TALKS - Back in the mid 70’s and early 80’s mortgage burning parties were once an iconic theme in American culture. In fact, a few of you may remember the 1982 Settling Debts episode of M*A*S*H where Hawkeye and friends threw a mortgage burning party for Colonel Potter. Customarily, when a family paid off their mortgage it was considered a rite of passage. Family and friends would gather round the fire while the mortgage documents were engulfed in flames followed by a spirited party. Although a lot has changed since 1982, such as the average 30-year fixed mortgage rate dropping from 16.4% to 4.25% in 2014, the American mentality that paying off your mortgage is a celebratory event has not. In fact, this concept is so deeply engrained that many have developed a fear of mortgages, mortgage aversion as I call it, to the point where they are putting every extra dollar they can scrub from their paychecks towards paying off their mortgage early. While paying off your mortgage may give you a sense of security, it can actually impede your financial progress.
Good Debt - First, I want to begin by dispelling the notion that all debt is bad debt. When the item being financed lasts longer than the loan, e.g. your home, that is good debt. Likewise, if the debt provides a long term future benefit, such as a college loan allowing you to get a higher paying job, that is also good debt. Consumer debt from dinning out, shopping, and traveling is bad debt because the debt last much longer than the product itself.
Financial Dysfunction - Understanding that a home mortgage is good debt is a step in the right direction. Now let’s examine the ways a mortgage can actually help you and why paying off a mortgage can lead to financial dysfunction. As you may know, mortgage interest is tax deductible. You need to take that into account when calculating the real after-tax rate of return. For example, if you are in the 25% tax bracket, a 6% mortgage actually costs you 4.5% after taxes. Meanwhile, over the past 30 years the stock market has averaged close to 10% annually. If you took $500 a month and invested it in the stock market for 30 years with a 10% return, you would have over $1.1 million. Even after capital gains taxes you would have over $960,000. By comparison, over that same time period, if you took that same $500/month and applied that towards your $400,000 mortgage with a 6% interest rate, you would save less than $183,000 in interest. Thus, by not paying off your mortgage and investing your money, you would save over $777,000; not to mention the money you would have saved in taxes by deducting the additional interest you would have paid. We have all heard the old adage, “don’t put all your eggs in one basket,” – well owning your home outright without adequate cash reserves and investment savings is doing exactly that. In this case, paying off debt early leads to a more volatile and risky portfolio. This lack of diversification can be particularly devastating if the value of real estate drops significantly, like in 2008.
Functional Asset Allocation - Developing a functional asset allocation strategy that includes your home as well as your investments is an important tool that can help you to reach you goals in life. For most people their home is their biggest asset; yet, many of us don’t properly leverage it to help achieve a more balanced and safer investment portfolio. For more information on functional asset allocation strategies please contact your local financial advisor.