Should you deleverage your home?
Deleveraging is a financial term that basically means paying down one’s debt. This can apply to individuals, companies and governments. When governments deleverage, it is called “austerity.” When individuals deleverage, it’s typically called “good common sense.”
When deleveraging, one should always first pay off debt with the highest (after tax) interest rate. This is typically credit card debt, with annual interest rates often exceeding 20 percent. A simple financial rule is “whenever the after tax interest rate on debt exceeds the maximum expected investment return, use any available funds to pay off this debt.”
In today’s investment environment, any debt with annual (after tax) interest rates above 6 percent should be “deleveraged” if possible. But does it ever make sense to pay off a 4 percent or 5 percent interest rate mortgage?
Mortgage interest payments are typically tax deductable. Thus, for someone in the 28 percent federal bracket, with a 5 percent state income tax, one-third of all mortgage interest payments are “government subsidized.” For this taxpayer, a 4 percent mortgage rate provides an after tax interest rate of only 2.67 percent, while the after tax interest rate of a 5 percent mortgage is only 3.33 percent. A low risk investment approach should outperform these low rates. Let’s examine where that might not be the case.
If you have a diversified stock and bond portfolio, consider using some of the bond portfolio assets to pay off your mortgage. Since high quality corporate bonds are currently yielding 3 percent, their after tax return to the taxpayer shown above is only 2.00 percent.
Paying off a 4 percent mortgage provides a 0.67 percent positive return over buying a 3 percent corporate bond and 1.33 percent return over a 5 percent mortgage rate. Paying off your mortgage will likely provide a higher investment return than will any lower risk bond investments.
Since the 2008 stock market crash, many investors have maintained a significant amount of their investments in credit union savings accounts, CDs or other low risk, low yielding investments. For these investors, paying off all or part of their remaining mortgage debt provides a much higher investment return than these low yielding investments.
In addition to the greater rate of investment return of mortgage payoff over low risk investments, there are two other areas where retiring a mortgage is beneficial, especially to anyone age 60 or over.
When a mortgage is retired, one less monthly payment is required and there is one less area of concern. While this benefit may seem trivial, it can be priceless to anyone who has ever worried about losing their home.
2. Long-term Care Insurance
Many couples are concerned about the cost of long-term care. Once a home is mortgage free, the full value of the house can provide a form of “long-term care insurance.” An older couple may decide to sell their home and move into a continuing care community. If so, the proceeds from their home sale may be more than sufficient to pay for the long-term care that the couple will require.
If a couple decides to remain in their house when one or both require long-term care assistance, a reverse mortgage can provide one-half the home's value to help pay for in- home care. With a reverse mortgage, a couple can likely pay for the long-term care required, while remaining in their home throughout their lifetimes.
Most financial advisors agree with the deleveraging rule that “whenever the after tax interest rate on a debt exceeds the maximum expected investment return, use any available funds to pay off this debt.” Many advisors will argue that a diversified investment portfolio’s total investment return should easily exceed the investment return one receives from paying off their mortgage. However, if the diversified investor uses only the fixed income and cash portion of their portfolio to pay off their mortgage, their after tax return will likely exceed these low return investments.
Paying down one’s mortgage is not appropriate for everyone. However, especially for those aged 60 and older, if the investment portfolio is adequate, using some of it to pay down a mortgage will likely be a very good investment.