I’ve talked about not paying off a 30 year mortgage because you are saving for retirement. Or for college savings. I’ve even mentioned that not paying off the mortgage is a hedge against inflation. In 30 years if you are still paying on the mortgage it’ll be substantially cheaper than rent because of inflation. Or investing the difference between a 30 year versus a 15 year fixed payment. All of that makes sense. It also makes sense to pay off your mortgage if you wouldn’t save otherwise.
But there is another reason why I don’t pay off my mortgage. Diversification.
Right now we have too much of our net worth wrapped up in our home. We put down 20% or $115k when we bought our home. After paying it off naturally these past 3 years we’ve gone from $460k to $432k. So we have a total home equity of $142k. But our assets outside of home ownership, after a devestating 2008 are only at $92k. Thus we’re too heavily weighted in home equity versus having it be a smaller portion of our total net worth portfolio.
I know many people believe home ownership/equity is the way to wealth. But I don’t. I believe a home is a nice place to live, and perhaps rentals are investments and should be treated differently. But I believe that it’s important to have a diversified net worth portfolio. And holding more than 50% of our net worth in our home equity is a bad idea.
Thus the idea of paying off our house is foolish. We’d be putting too many eggs in one basket and we’d be betting solely on home appreciation rather than diversifying our net worth. Hence our strategy is to build equity naturally by paying off our mortgage, save what we can in retirement accounts, and build up our taxable accounts to a poitnt where our home equity is one day no more than 10% of our net worth.
This is a very long term strategy and will take a LONG time. But I think that it’s imperative that we try to balance our net worth so we’re not so skewed to home equity. I do realize that our current down payment/home equity is substantial enough that it’s what many people have as a mortgage. Thus our high cost of living is influencing our decision to not pay off our home. But I can see how someone with a mortgage of under $100k would try to pay it off instead of saving for retirement or in a taxable account.
Do you have too much of your net worth tied up in home equity? Do you think it’s a problem or do you believe it’s the safer strategy to pay off the home instead of saving in retirement/taxable accounts?
25 responses so far ↓
1 Kristy // Feb 4, 2009 at 9:33 am
I prefer to invest extra money into taxable accounts, not the home. DH prefers to invest in the home. So we have made a compromise and put a little extra into the home and a little in taxable accounts.
That being said, we have not been investing outside of our retirement accounts since I found out I was pregnant. We have been saving it because the economy is bad and because I do not get a paid maternity leave. Once my maternity leave is over, we will then invest any extra into taxable accounts. Although I doubt if there will be too much extra to invest because of our new addition and daycare payments. We’ll see though.
Some people are more comfortable paying off the mortgage like DH is. He despises any debt. I still have student loan debt because the interest rate is so low. I think after our oldes DD is out of daycare we will pay off my student loan and start putting even more towards our mortgage. I know that DH would like to have it paid off by the time the kids go to college.
2 Meg from FruWiki // Feb 4, 2009 at 9:49 am
Paying off one’s mortgage is often a psychological matter these days, not a financial move — just like Dave Ramsey’s debt snowballs make sense psychologically but not necessarily financially (though hey, whatever finally gets you out of debt is good financially).
Bottom line: If you can get make more money investing your money than you’ll save by not having to pay interest on your mortgage, then it makes sense. Just compare the interest rates.
It used to be an easier decision when mortgage interest rates were higher and you can actually make decent money just by putting money in a savings account. Nowadays, of course, mortgage rates are amazingly low — but then so is the interest on savings accounts. And while the stock market used to be a “sure” way to grow your money, we all know how that’s been going.
Of course, if you have other debts with higher interest rates, pay them off first. And please, please, please save up an emergency fund — preferably 8 months of basic living expenses — before trying to pay off your house.
3 Mary // Feb 4, 2009 at 9:58 am
“Do you have too much of your net worth tied up in home equity?”
Definately not a problem when you don’t have any home equity. I really don’t care either. We’ve been there 2 years; plan on staying 10+. The only obstacle the no home equity presents right now is that we would like to refinance to a lower rate (currently at 6.375%). But if we can’t, no big deal.
“Do you think it’s a problem or do you believe it’s the safer strategy to pay off the home instead of saving in retirement/taxable accounts?”
I’m definately all for putting retirement first. Of course I have to be. My husband is in his mid 40’s with basically no retirement savings. We are working on it, but there is a lot of catch up to be made. But even if he retires in 20 years and we still have a mortgage (especially if it is on this house), it will be manageable on what I earn.
4 LivingAlmostLarge // Feb 4, 2009 at 9:58 am
Definitely. My point is, as you can see I have around $150k in home equity, but around $100k in cash savings. I think this is a very risky proposition to be holding so little cash.
If I had less home equity, maybe I would be more concerned about paying off the home, but right now I want a firm foundation with substantial retirement savings, large EF, and Substantial Savings for things like a Car, Vacations, etc.
I believe that cars should be paid for cash. I am hoping not to have another car loan. And if i put all my extra money to paying off the house, where would I get the cash for the car for?
I don’t believe buying a car is an emergency. It’s a known expense. You know cars don’t last forever, and it’s a large purchase. Or a large home repair because the pipes are leaking (for example).
But would you pull it from the EF? I wouldn’t. But that’s personal preference. The EF is for death and job loss. Everything else I should be saving for. Like 1% of my home value even year for repairs. I know homes don’t fix themselves so I should put the money aside.
I could use that 1% and pay off more of the mortgage, but then what?
5 Miss M @ M is for Money // Feb 4, 2009 at 11:43 am
I don’t have any home equity to worry about right now! I do often think should I be trying to pay down principal or focusing on saving and investing. I’ve taken the latter path, the house already consumes so much of my cash I can’t see putting more towards it. Equity is intagible, cash in the bank I can feel.
6 Fabulously Broke // Feb 4, 2009 at 12:15 pm
I totally agree with what you’re saying. Having some equity in your home, but making sure it’s balanced is smarter.
I do plan on getting a home later, but right now I’m saving up for my next car as well as making sure I have a good cushion of cash to see me through tough times
Fabulously Broke in the City
“Just a girl trying to find a balance between being a Shopaholic and a Saver.“
7 Pearl // Feb 4, 2009 at 12:48 pm
This post and the recent Net Worth post both treat your home equity as the difference between what you paid for your house ($575K) and its current mortgage debt, and then use that value to draw conclusions about your financial condition. Is this wise?
I don’t know about home values in your area, but in mine, a house purchased three years ago is not necessarily worth today what it was then.
For your financial account investments, I assume you are “marking to market,” using current market values on securities rather than what you paid for them. It’s harder to do that with houses because there’s no way to know exactly what they’re worth without trying to sell, but to get a true picture of your net worth and how much is tied up in your house, don’t you think the effort has to be made?
Zillow.com tracks overall changes in home prices by town, zip code, etc. I wouldn’t count on it to accurately reflect my home’s price, but for price change trends it seems really useful.
Another thing that distorts the picture is closing costs. Even if your home price has not changed, the day after you bought it a chunk of your down-payment is effectively lost because, upon sale, you’ll have to pay significant closing costs (commission, fees, title insurance, taxes). These typically run 9-10% of gross selling price.
On the question of diversification, I’m not sure I agree with your analysis. Paying down your mortgage does lock more money up in your house in the sense that you’d have to sell or refinance to free it, but it isn’t really increasing your investment in your area’s real estate market.
By analogy and to explain what I mean, imagine you borrow $10,000 from your broker and use it to buy 100 shares of X Corp, which you use to secure the loan. You owe the loan money and have to repay it no matter whether X Corp. goes up or down. You own the stock. Paying off the loan doesn’t really increase your investment in X Corp. Even when the loan is 100% paid off, you will still only own 100 shares of X Corp., and your exposure to price variations of X Corp. stock hasn’t changed at all.
Unless your loan is non-recourse (i..e., the lender can’t come after you for more than the value of the stock you used as security) and you can imagine circumstances under which you would just walk away from both your debt and your investment, linking the debt and the investment makes sense for some kinds of technical calculations but for deciding whether to pay down mortgage debt early, not so much. There, the relevant issue is whether your money could do better invested elsewhere.
I tend to think of my home mortgage as a kind of reverse CD. When I have some money I want to put in a nice, safe, guaranteed-rate instrument that I won’t need to cash in in the foreseeable future, I compare my after-tax mortgage interest rate to the after-tax rates available on long-term CDs and pick the higher.
8 asgreen // Feb 4, 2009 at 12:50 pm
I completely agree with you. I’m not rushing to pay off my mortgage, instead I’m try to save up a sizable emergency fund and increase my contributions to my 403b.
The only other debt I have are student loans. Now while I would love to pay these off and be done with them, the interest rate is so low that again it doesn’t make sense to forgo savings to pay them off quicker.
9 Amy // Feb 4, 2009 at 4:33 pm
I always wanted the secure feeling of owning, outright, my home so I did the following: bought a tiny (805 sq. ft.) condo in 1997 and put 20% down. That left me with a $34K 15 year mortgage and I paid it off in about 8 1/2 years; that was in 2005. Since then, I have saved money, both in my retirement and non-retirement accounts. If I continue to pay my $220 maintenance fee, property taxes ($300 year) and homeowners insurance, no one can take my house. That’s what I wanted so I made it happen.
10 fengshui // Feb 5, 2009 at 12:12 am
“Right now we have too much of our net worth wrapped up in our home. We put down 20% or $115k when we bought our home. ”
WOW. A $115k down payment?!?!? Where do you come up with that much??? Even if I worked 2 jobs, at $80k a year, and after taxes and bills, it would take me 15 years to save that!!!! And I’m 32, which means that I would be 47 by the time I could make a down payment on a house out there. How depressing….
11 Funny about Money // Feb 6, 2009 at 10:21 pm
Interesting discussion. Too often people think of a house in emotional terms (we’re encouraged to do so by marketing that calls an empty piece of real estate a “home”) and not what it is: an investment.
IMHO, it’s a pretty iffy investment. As Pearl notes, “equity” may not be what it appears to be, for a variety of reasons.
I paid my house off and am glad I did — but a) I’m close to retirement and b) I’m far from your league in terms of earning power. The mortgage represented over half my take-home pay, leaving me with a pretty chintzy lifestyle. Using a small inheritance to pay it off (long before the bubble!) turned my piddling university salary into a living income and, 10 years later, put me in a position to move up to a nicer house and pay for that in cash, too. Now as I look at a probable layoff with two years to go before I can collect full Social Security, I’m mighty glad I don’t have to deal with mortgage payments.
The house, being centrally located in a large city, is still worth more than I paid for it, which is more than I can say for my 403(b).
12 fcmm // Feb 7, 2009 at 12:42 am
Depends on risk tolerance and overall picture. I live in a different tax environment to you (interest on the mortgage is not tax deductable) which is a significant difference. Anyway, I’m two paychecks away from paying off my mortgage and then intend to focus on building my other investments further. I do have a chunk of change in shares but I’d say it’s less than 20% of my net worth (ie my house!). I sat by and watched everyone getting rich (on paper) off the share bubble while I patiently paid down my mortgage. Now that things have turned they’re not doing so well but I’m about to shake off a $2500 a month payment and can live rent free indefinitely (I’m 29). Because interest here is not tax-deductable I would have had to be confident that the after tax return on my investments would be more than the interest on my mortgage for me to want to maintain the mortgage and use the money for investment. Thanks to paying off my house I plan to work my high paying job for hopefully 5 more years to take care of my retirement savings and then I can ‘retire’ to part time work and live comfortably on a relatively low wage. Housing is such a huge chunk of living costs; once it’s taken care of you can live on very little money if you choose.
13 Finance Junkie // Feb 7, 2009 at 2:10 am
I disagree. You significantly increase your monthly free cash flow after paying off your house. I prefer to divert a majority of my extra cash towards house pay-offs while a minority goes towards other investments.
15 Meg // Feb 8, 2009 at 11:07 pm
I also worry/wonder about the large percentage of my net worth I have in real estate. And I agree there is NO reason to plow money into paying down the mortgage until you are at least maxing out retirement accounts and have a year’s worth of expenses in cash.
I’ve read that a good balanced asset allocation is 30% real estate, 30% cash/bonds, and 30% stocks. But the fact is that many people can never achieve that. I think it can make sense for a retiree with limited resources to have a paid off house and a smaller retirement account so that their monthly expenses are minimal.
16 LAL // Feb 9, 2009 at 12:20 pm
Gosh I have so much to catch on responding to! Sorry guys!
Pearl, I have had it looked at by 3 realtors. Gotten comps for the area and $575k is reasonable. There are other personal reasons for listing it at $575k. That is likely the buyout price we will have from a company if we move.
Thus I do realize closing costs on selling and buying homes. I’ve done it before. However, when we bought and sold our last home and this one we paid nothing. This is not a typical circumstance.
Asgreen, good that you are diversifying.
Amy, what happens if you lose your job or become disabled?
Fengshui, I will have to explain in another post.
17 LAL // Feb 9, 2009 at 12:23 pm
arrgh, so far behind. But here goes again.
Funny about money. My equity is pretty secure, as you see my response to Pearl. I think paying off the house is good if it’s 50% of your income! Ouch! For us it was 28%. That is a large difference.
Personally I think 50% of income is way too much to be paying for a home. At least not without major sacrifices.
Fcmm, I agree it is dependent on living in the US. It also depends on which state in the US you live in to boot! It is better to save in 401k/IRA if high tax states like New England, NY, and CA. In places, like TX, FL, WA, where there is no state income tax it might not be.
Finance Junkie, what will happen if you put all your extra let’s say $2k/month for us to our mortgage? When it’s done in 10 years, then where can you shelter it from taxes? You cannot go back in time to a 401k or IRA. So what will you do? Only use taxable accounts?
18 LAL // Feb 9, 2009 at 12:25 pm
Wrapping up, Meg, I believe you have a lot in a stock portfolio. It changes the perspective of your real estate investments. I’ve actually asked you what you would be doing at 25, if you didn’t have your inheritance?
Would you really be investing in RE? Or would you be choosing to save in a 401k/IRA? If you had started out working with no student loans but just a job and no gift money, would you have bought the condo you are in? Or the car? Or just saved?
I agree I think 30% to each sector of stocks, real estate, and bonds would be nice. I think personally I’d weight something more like 50% stocks, 25% bonds/cash, and 25% real estate.
20 karla (threadbndr) // Feb 10, 2009 at 12:18 pm
W and I had a term life insurance policy on the mortgage balance (taken out before he got sick). So I was mortgage free as a young widow. It made the difference between making it on my salary and not (since he had so little other life insurance).
Even before W passed away, we were putting extra towards the principle every month and would have had the mortgage paid off in 20 years on a fixed 30 yr note.
Yes, I’m probably RE heavy (esp since I’ll be inheriting my mom’s house at some point in the next decade or so and then will use my house as a rental). So I don’t put any money into REITs or rental properties now. My allocation is about 50% equities, 35% RE, 15% cash/bonds.
21 LAL // Feb 10, 2009 at 9:01 pm
Karla, would it have been more prudent to have sold the home? Was it necessary to stay put? I am sorry for your loss.
I ask because sometimes sticking with a house is not the most important thing.
24 frugal // Mar 21, 2009 at 6:59 pm
My financial planner told me that I should not pay off my house but rather invest this money in the stock market instead. After what has happened to my investments lately I am glad I did not listen to him.
25 LivingAlmostLarge // Mar 22, 2009 at 10:28 am
Frugal, are you close to retirement? I think that would be a great time to pay off the home. That and after you have substantial cash savings.
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