It’s an age old debate, and sometimes a feisty one in the “personal finance” circle online. The question is this: In this particularly low interest economy that we’re in, does it make sense to pay off your mortgage? I can’t answer that for you. Hell, I can barely answer it for myself. But I figured it would make for a good article to explain my own reasoning for the decision to pay off my low-interest mortgage.
First off, I know most of the money-driven decision makers on here are thinking “BNL – You’re an idiot!” So let me address this financial aspect first.
Before I start, let me just state upfront that I’m going to somewhat simplify the math, particularly around taxes because it starts out simple, but becomes complicated math that would dilute the overall point. Additionally, once I quit, my tax bracket and tax implications change dramatically.
The interest on my loan was at 3.275% and I owed roughly $100K. This means I was paying about $3,275 per year in interest. This interest is tax deductible at a marginal tax rate of ~30%, which means that’s $980 less in taxes I have to pay on my income. Subtract that $980 from $3,275 and you’re left with $2,295, or the equivalent of only paying an interest rate of 2.3% due to the tax break. So now you’re thinking I’m even dumber than you thought, because there are tons of dividend-growth stocks out there that pay over 2.3% dividends (taxed at 15%, for now) and have raised their dividends every year for 10, 20, and even 50 years!
But it’s not that simple. Over the past year, I’ve gotten involved in private money lending (a new article on that will be coming soon), where I lend money to a real estate investor at an interest rate of 12%. On top of that, I get 2 “points” up front, which means I get a payment of 2% of the value of the loan immediately. So if the deal lasts 6 months overall, then that 2% becomes 4% annualized, and the overall return on the loan is roughly 16% annualized. I’ve done two deals with an investor this calendar year, and returned an average of 15% annualized. The 1% drop is due to downtime between the two loans where the money was inactive.
What does this have to do with paying off my mortgage, you might wonder? Considering I just gave up $100K in liquid capital, then at first glance this just makes my decision even crazier, since now I have less money to loan at 12% interest. That’s what I was thinking too, until I discovered the wonderful world of HELOC’s (Home Equity Line of Credit). Now that I paid off my house completely, I can easily get a loan for up to 75% of the value of my house at 4.25% interest rate. What this means: I can borrow money at 4.25% and lend it to someone else with an expected return of about 15%. Better yet, when the money isn’t actively invested with a real estate investor, I can pay down my HELOC and have no interest payments. This is in contrast to keeping the money in cash, where during that same downtime I still have to pay my 3.275% mortgage interest.
There’s also the matter of volatility. If you’re into investing, then you’ve certainly heard the common meme that with risk (volatility) comes reward. And for the most part, I’ve found this to be true. But this can also be turned around: with reduced return comes safety (less volatility). And as someone looking to quit my full time job sometime in the near future, there’s certainly an interest in reducing volatility.
In other words, while I may be able to keep a reasonably predictable income through dividend growth stocks, I still don’t want to see my capital rising and falling with the market. Dividend growth zealots will argue that the capital doesn’t matter as long as the dividends keep coming in (and in fact a bad year such as 2008 can actually work to your advantage since you can buy low), but this argument ignores one very important thing for a proud family man like me – peace of mind. This shouldn’t be discounted, at least not for me. As stoic as I like to consider myself, and as calm as an investor as like to think I am – there’s still no doubt that a year like 2008 will happen again. And I have no desire to watch a $1M nest egg drop to $650K in a single year. Say what you want about dividends not being reduced during that time, that would still be a stressful year. Worse yet, if a few dividends do get reduced and I have to eat into my capital, I’m doing it at a market low point – the worst possible time to tap into invested capital.
The truth is, I didn’t care about my losses in 2008 when it happened, because my job was paying me way more than I spent, and that job was secure. But in the future, when I’m not working and just living off my dividends and other passive income, a few bad months of income could mean having to (a) eat into my capital when the market is down, or (b) having to go find a job. Neither is necessarily catastrophic, but it puts at risk the financial freedom I’ve worked so hard to achieve.
You’ll never hear me talking about “timing the market” or day trading. With that said, there’s a simple fact that I can’t get away from. The P/E ratio, at the time of this writing, is approaching 20 and climbing. This is common. What’s also common is that it will go back down to it’s long-term average of 12-15, potentially at an alarming rate. I prefer to ride the roller coaster up, not down. On some levels, I hate even writing this as I know it’s bad to try to time the market, but simple math will tell you that a P/E ratio of 20 means that it takes 20 years to get your money back before taxes, excluding growth (a speculative play).
Image courtesy of multpl.com.
There are two ways for the ratio to return to 15. Either earnings rise and the prices remain the same (meaning no additional principle growth for me) or the earnings stay flat and the prices drop (meaning loss of principle for me). Of course, it could be some combination of the two scenarios. Either way, neither are attractive to me.
Now, it could be that the P/E will continue to rise to 40 before dropping, in which case if I timed it perfectly I would stand to make a lot more money. But that gets back to speculating. I’d rather stay conservative, and wait for the market to return to normal. This doesn’t mean I’m selling the stocks I have, just that I don’t want to double down on it.
Decoupling Needs From Money
Let’s get away from the financial analysis now.
Ever since I started this site, I set one specific goal – I wanted to become financially independent. There are other aspects to my long term goals of this site, but the fundamental facets to becoming financially independent are:
- Increasing passive income
- Decoupling needs from money (reducing expenses)
My decision to pay off my mortgage negatively impacted #1, and positively impacted #2. You could argue it’s roughly a wash.
However, over the past 3 years that I’ve been (semi) actively writing here, I’ve come to the conclusion that #2 is more important, because #2 is much more in my control. I can buy safe stocks, I can buy a good rental property, and I can find other relatively safe investments. But I can’t control any mismanagement of the companies I own with those stocks, and I can’t control my renters ability to pay rent on time. In other words, I can’t control the reliability of my income. I can reduce risk, but only to a limited extent.
On the other hand, I have much higher control of my expenses. I can control the size of my house and the mortgage required. I can control whether my family needs one car or two. I can control my grocery budget and how often and where we eat out. I can control, to a high degree, my need for money. Up until now, my largest expense by far has been my mortgage. Not that that’s gone, I can focus on the next biggest items (Next up, groceries!)
So that’s it. That’s why I paid off my mortgage. Feel free to leave your thoughts below in the comments. I’d love to hear whether you agree or disagree with my decision (not that I can change it now!)