Many Americans dream of holding their home’s title in their hand, but owning your home outright or having a lot of equity in your home may not be the fastest way to grow your wealth, and it could even put you in a precarious financial position. I’ve been involved in many situations where people find themselves in financial trouble and all their net worth is tied up in their home. If you’re in financial trouble, no lender will lend you money, or if they do, the terms will be painful. In these cases, years of hard work can be wiped out and much of your home equity squandered in either a hasty sale or a disadvantageous home refinance.
Many people work hard to pay off their home only to do a reverse mortgage in their retirement years. I used to look at these loans in a fairly good light until my parents were considering doing one. I did not find the costs and terms to be very palatable.
All too often, I’m approached by someone who wants to know whether they should pay off their home or invest their extra money. Still more people have bragged to me that they’re making double or triple payments on their home mortgage. Both of these groups of people get introduced to my contrarian view on this subject.
Today, the average interest on a 30-year mortgage sits below 3 percent per year. At these low interest rates, this debate is all but settled. If your home mortgage is near 3 percent, then I have to tell you, that’s as close to free money as you’re ever going to get. This is especially true if you’re still able to write off your mortgage interest. If you can write off your mortgage interest expense on your taxes, that makes the effective cost of a 3 percent interest loan less than 2 1/2 percent for most people.
Don’t pay off your home just for bragging rights or just because you can. Pay off your home only if it makes the most financial sense.
If you’re considering making extra payments to your mortgage or paying it off outright, ensure you do these things first:
- Pay off all your credit cards and lines of credits.
- Pay off your vehicles and then pay into a vehicle fund so you don’t have to tap credit cards for future repairs and so you can pay cash for your next car. That will keep you out of car debt. Even if you get a low rate on a car, it is a depreciating asset. That means its value decreases, and typically it decreases quickly.
- Build up a savings equal to six months of living expenses in a cash or near-cash reserve or emergency fund. I like to have three months in an easily accessible money market account and three months in a stock account that could easily be cashed out if needed.
- Get your retirement savings on track so you’re not forced to tap into your home equity.
If you do meet all these criteria, then congratulations, you’re doing a great job. But that still doesn’t mean you should automatically pay off your home just so you can hold the title in your hand. Rather than paying off your loan, consider other investments. If you can identify an investment that will pay you an average of just 4 percent interest per year and your mortgage is at 3 percent, then you’re going to grow your wealth faster by investing your cash and making minimum payments to your mortgage.
Let’s look at a quick example. Let’s say you have a home with a $300,000 principal balance and you refinance on a 15-year mortgage at 3 percent interest. After 15 years of making the minimum payment, you will have paid about $72,914 in interest on that loan. If you have $300,000 in cash at the same time of that refinance and you put it into an investment that’s paying you just 4 percent interest per year, then after 15 years, you will have made $240,283 in earned interest. That’s a net gain of $167,369 in your net worth. That doesn’t even account for any tax benefits you get if you’re able to write off your mortgage interest.
I’m not saying don’t pay off your mortgage. I’m just hoping that this article makes you stop and think. There may be better financial options that you should consider. If you proceed with paying off your home, I hope you do it because it makes the best financial sense and not because you’re simply following your programing.
Interest rates will go back up. There’s a chance rates will never be this low again in your lifetime. If you rush to pay down your loan now, then you might find yourself in a situation where you have to access that equity at a much higher rate later. It would be a shame to pay off a 3 percent loan only to have to refinance your home at an 8 percent rate to access your equity when you’re in or closer to retirement.
These are just some things to think about. I’m just a dumb Marine and not a financial professional. Your specific situation will involve a lot of different variables, and you should consider speaking with a financial professional to determine the best financial strategy for you and your family.
Justin Pierce is a real estate investor and real estate agent who regularly writes about his experiences buying, renovating and selling houses in the Washington area.
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