The Veridian Blog

In these trying economic times, should you pay down your mortgage balance instead of falling victim to the equity markets?

More than ever, “cash is king”.  We have always advocated the strategy to keep your cash and NOT pay down your mortgage for three reasons:

1.      Rate of return*– Mortgages are still the cheapest source of financing in the world – why not take advantage of this and allocate elsewhere the cash that would have otherwise been used to purchase the home?  The subject home will appreciate over time whether or not there is a mortgage lien on the property.  Paying down a 7% mortgage means you need a rate of return around the same to break even, right?  Not at all – with long-term investments, you have the advantage of the power of compounding, whereas your debt does not (making it more “attractive” debt).  For example, a 5% return on $100 over 10 years yields $162, not $150 – all the while your debt payment stays the same.  So to break even on the debt interest, the rate of return would actually only be less than 7% paid on a mortgage.  But wait… there’s more good news…

2.      Taxes – “Good” mortgage debt is an itemized deduction for taxpayers at their highest federal tax bracket, ranging upwards to 38% of ordinary income while long-term federal capital gains tax is as little as 15%.  Why not maximize tax-advantageous debt and tax-friendly gains?  This further emphasizes allocating money elsewhere – even some long-term CD’s today will beat out what you have to pay on after-tax mortgage debt!  

3.      Liquidity – It’s certainly easy to put cash into a home, or pay down a mortgage.  But what if you need it back?  Selling a house during a housing downturn or applying for a cash-out loan are both unfortunate situations borne out of poor financial planning.  Ironically, many people rationalize that they need a lower mortgage payment just in case they lose their jobs.  But, what happens if they do lose their jobs or the house depreciates and they need cash?  This is a situation that in recent years would have been laughed off but has now become a sad reality for many.  They can’t get a decent loan!!!  Real estate is an illiquid asset and that fact should be a huge consideration when deciding how much to borrow.

*This article was written initially 3 years ago and while liquidity is clearly a compelling reason to refrain from putting cash into your home, we also steadfastly stand by the Rate of Return reason despite the recent collapse in equities.  When considering this analysis, the comparison of strategies is over a long-term period to allow for fluctuations in the market.  Understandably, things wouldn’t sit well for a homeowner who invested in the S&P 500 instead of paying down their mortgage.  However, remember that investing is a periodic, long-term, disciplined approach.  While that homeowner has lost half his capital since October, the strategy is to continue investing during the valleys as well as the peaks.  Over time, we strongly advocate that this strategy prevails. 

For more details or further discussion, please email us!

Richard