Sunday, June 03, 2007

Do NOT Pay Off Your Mortgage Early

The pay-off-a-little-more-each-month-on-your-mortgage fallacy has been around for a long time. The deal is that the numbers are big, so they are really impressive.

Yes. It builds equity faster. (But it's just converting your cash from a flexible form of equity into a less flexible form.)

Yes. You pay less interest over time. (But you lose opportunity to invest).

Yes, you pay off your house sooner. (How many of us will live in our house for 20+ years though?)

There are several ways to look at this prolem though. First, from a strictly financial perspective, the right way to look at this is to consider the alternative uses of the extra money you would be putting into the equity.

For example, a 6% loan has an after tax 4% rate. Instead of putting the money into your house, why not put it into a SP500 index fund? It will get you 8% over time (5.33% after taxes). So by putting $1000 into your house, you lose $13.33 each year. Put it into the IRA that you haven't been funding and it looks even more attractive, because it is tax-deferred (net $40.00/yr/$1000)

If you haven't paid off all those 20% credit cards, and the non-deductible 8% car loan, don't even think about putting extra into your 6% deductible mortgage.

From a risk and contingency standpoint, putting the money into your house is a low-risk way to earn 4% after taxes. At the same time, you effectively lose the use of that money. If you get laid off or need money to pay for medical bills or something, it will be more difficult to get at it. You can do a home equity loan, but now you're paying to get at your own equity.

Alternatively, maybe you take that round-the-world trip that you have always wanted to do, invest in a good personal trainer to enhance your health, or maybe get a good therapist to help you get your emotional act together. You can't put a value on those, but in any case, the pay-off-your-mortgage-faster idea is only for people who do not otherwise have the discipline to save in other ways.

It's kind of like the people who advocate extra withholding from their paycheck so they get more back in April. It makes no sense financially, but if you otherwise lack the discipline, it can be a plus.

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