Paying off mortgage not risk-free

Don Taylorq_v2.gifDear Dr. Don,
I am thinking of paying off my mortgage. I have an interest rate of 6.5 percent and about $80,000 left on the mortgage. I have enough liquid assets to pay it off completely. What are the pros and cons of doing this?
-- Sue Savings

a_v2.gifDear Sue,
A form of your question is a perennial favorite of Bankrate readers, but I'm not usually asked to delineate the pros and cons of the decision to pay off the note. Here are my thoughts.

The pros of paying off your mortgage:

  • Increased discretionary income. Once your mortgage is paid off, you can rebuild your savings and investments by socking away what you would have paid on the mortgage.
  • Possibility of higher financial returns. If the after-tax (effective) rate on your mortgage is higher than the after-tax returns on your savings/investments, you'll get a better return from paying down the loan than you're getting on your investments. This is especially likely for very conservative investors.
  • Extra retirement income option. Owning the home free and clear gives you financial options in retirement for a reverse equity mortgage that can act as a financial safety net if needed.

The cons of paying off your mortgage:

  • Money diverted from more expensive debt. Mortgage financing is typically the cheapest source of money for homeowners. It may not make sense to pay off the mortgage while keeping a balance on your credit card or making a car payment.
  • Loss of mortgage interest deduction on income taxes. This is a mixed bag. The deduction reduces the effective rate on your mortgage, but you're still paying the interest expense.
  • Loss of financial flexibility. If you're dipping into the emergency fund, raiding the retirement accounts or just not contributing toward retirement goals, paying off the mortgage may reduce your financial flexibility by too much.
  • Remortgage issues. You can't find a willing lender if you need to remortgage the property.
  • Other expenses remain. A paid-off mortgage won't free you from a host of other contractual payments on the house, such as taxes, insurance and maintenance.
  • Prepayment penalties. Paying off the mortgage is not an option if there's a prepayment penalty still in effect on the loan.

There's a psychic satisfaction that comes from owning your home free and clear. Conservative investors look at the tumult in the stock market and use that as a justification for staying out of the financial markets and investing in things that have very little risk to principal. With low current returns on safe investments such as CDs and savings accounts, it's attractive to just empty those accounts to pay down or pay off the mortgage.

All that can make sense. But by deleveraging your investment in real estate, you've concentrated your investments in real estate. There's risk to principal there as well, as many homeowners can tell you from recent experience.

What I'm saying is that it's not just a choice between money invested in savings and deleveraging your real estate investment. You need to look at how all of your wealth is invested, your sources of income and what your goals are over time.

Take a big-picture approach to what you want out of life and how you can use your income and wealth to achieve those goals. That could mean you should be as worried about loss of purchasing power through inflation as you are about risk to principal.

I'm not trying to talk you out of paying off the loan. I'm just trying to get you out of this either/or scenario so you'll take a more holistic view of your life and financial goals. By doing that, you should reach a better decision.

You may need to work with a financial planning professional to help you reach that decision. Bankrate provides a directory of financial planning professionals.

Read more Dr. Don columns for additional personal finance advice.

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