Should You Pay Off Your Mortgage?
Who wouldn’t want to retire debt-free, especially with the peace of mind of owing nothing on one’s own home? The mortgage-burning party was such a feature of home ownership 50 years ago that there’s even an All in the Family episode from 1975 in which Archie and Edith gather neighbors and friends to proudly celebrate owning their house outright. But it’s hard to imagine a similar scenario in a Modern Family episode today, unless it somehow involved the sitcom father dadsplaining the ancient rite and accidentally torching the lawn.
The disappearing custom owes in part to the rise in refinancing, as lower interest rates have made it less expensive to carry more debt for longer. When rates are relatively lower—as has happened dramatically at various points since the 1980s—mortgage borrowers who lock in a new lower rate also tend to restart the clock of a 15-year or 30-year mortgage when they pay off the older mortgage. (You don’t always have to restart the clock. Some lenders offer a “rate modification” or “float down” that saves on refinancing fees and merely amends the existing mortgage with a lower rate rather than writing a whole new mortgage; always find out if that’s an option.)
If a family is already tight for funds and needs the savings to make it through the month, then refinancing is a blessing because it reduces monthly costs even as it extends the life of a loan (see chart, page 28). Finance people would say you are using your balance sheet to increase your cash flow. In our example, the refinancing puts off for an additional 10 years the day when your monthly mortgage payment is zero, but in the meantime it saves you $300 a month.
Many personal financial advisors will look at that $300 a month in savings and say the mortgage is the right way to go, especially if a family can manage the monthly payments on its regular income and use the savings to make the most of an employer’s retirement savings match or contribute to a tax-advantaged retirement savings account where it’s invested. It’s a stretch for most people to max out the tax benefits of retirement savings; the 2018 limit for IRA contributions, for instance, is $5,500 ($6,500 for those 50 or older, and double for married couples), and there are many more tax benefits if you have extra savings to stash away in other kinds of tax-advantaged plans—up to $24,500 for those age 50 and older in a traditional 401(k).
Discuss your own situation with an expert, including your expectations about other costs, such as health care and property taxes, if you’re nearing retirement. At the very least, you should check with a tax accountant to see if it even makes sense for you to deduct the interest in 2018, following the federal tax changes put in place last December. The Tax Policy Center estimates that the number of U.S. taxpayers who will claim a mortgage interest deduction on their 2018 tax returns will drop from roughly 40 million in 2017 to 16 million, largely because of the tax law’s increase in the “standard deduction” to $12,000 for individuals ($24,000 for married couples who file jointly). If a couple’s charitable contributions, mortgage interest, and local taxes, for instance, are $20,000, they are better off just taking the standard deduction of $24,000, and there’s no longer any tax advantage to paying mortgage interest.
A good financial advisor can also help you figure out how important it is to you personally to be debt-free. Yes, your mortgage will be running longer if you don’t make extra payments to pay it off early, but that may be smart if you are comfortable with the risk of investing to be wealthier, as the retirement savings and investments would ideally outpace the cost of the mortgage over the long term. It may sound like a bad sitcom scheme, but the big idea is that you are borrowing against your home to invest in stocks and bonds, or at least to save more by making the most of an employer’s retirement match at work. It’s what people are doing when they save for retirement rather than retiring the mortgage, and it’s a positive explanation for the disappearing mortgage-burning party: Archie and Edith would still have to make a mortgage payment each month, but they’d have a nice IRA statement, too.
The 28/36 Rule
What’s a manageable mortgage payment? A rule of thumb among mortgage lenders is the “28/36” measure of how much of your total pretax income goes to paying back loans: no more than 28 percent for monthly housing expenses (property taxes, homeowners insurance, homeowner’s dues, and mortgage), and no more than 36 percent for all debt (car, home, student loans). This “debt-to-income” guideline roughly translates, for instance, into a 30-year mortgage of $180,000 at 4.5 percent (monthly mortgage payments of $912; mtgprofessor.com/calculators.htm), on a household income of $52,000 a year. The math works if you double it—so a $360,000 mortgage for a household income of $104,000 a year.
Banks also take into account the “loan-to-value” measure of how much of your own money you’re putting down, on the assumption that people will be more likely to keep up payments on a home that’s worth more than the mortgage—this is the classic 20 percent down payment that is a cushion for the bank against a slump in property values. Neither rule is ironclad as a maximum or minimum, but the general idea is that people will not fall behind on house payments if the payments fit into their budgets.
Doing the Math
Figuring out what a refinance will cost (click at top right to enlarge chart)