Paying off the Mortgage: A Bad Idea?

Thursday, November 17, 2005
Here is a myth that many Americans believe in that isn't necessarily true. Paying off the Mortgage early is a good idea. It just isn't true. I'm almost sure this is a myth perpetuated by the Banking industry themselves.

Why on earth do I, the ultimate saver, say this? Isn't it safer to pay off your house just in case? In fact, it may be one of the more risky things you do. Why?

Think About It. In times of crisis, the most important thing is to have liquidity. That is, you need to have an easy and fast way to get cash out of whatever investments you own. By paying off your mortgage early, all you are doing is locking your money into the house. I know what you are thinking; can't I just take out a home equity loan against the equity in my house? No, not necessarily.

Let's say you lose your job. Almost no bank will loan you money if you don't have a job, even with your house as collateral. Banks don't want your house, they want to be paid back. If you don't have a job, they can't be paid back. But it gets worse. You still have to pay back your mortgage, even if you have been paying it off early. Banks expect their check every month, and if you start to fall behind banks get nervous. If they foreclose, you are very likely to lose everything, including all that built up equity.

What makes this problem even more insidious is that the bank is more likely to foreclose on you if you have paid off more of your mortgage. Huh? Let's just say the market tanks and interest rates rise so that the bank has a number of foreclosures on its hands. What house are they going to foreclose on first? The house with the smallest amount of debt. Why? Because in all likelihood they will not receive full market value for the house. They will only get up to the value of the mortgage, and all other funds will be directed to other lien holders and then the former owner. They can only recoup the money left on the mortgage and in a depressed market that will only happen to houses with a small debt ratio. In fact, if you have a high ratio they will most likely work with you to delay payments and allow you to live in the house until you can resume payments. Kind of ironic isn't it?

I am not advocating just going out and spending the money you would otherwise use to pay off your mortgage early. Quite the contrary. I highly suggest that people put the money aside in a liquid account and allow the money to earn interest. Given a mortgage rate of about 5.7% and a tax bracket of 25% that means the money cost about 4%. There are plenty of investments that make 4% that are relatively safe. If the time ever comes you can't make a payment you can use the funds built up on your liquid account to make the monthly payment. At worse, if you have to walk away from the house, you still have the money that would have otherwise evaporated when the bank sold your house. When the amount in this side account equals the payoff amount of your mortgage, that is when you should pay it off.

Of course, the above course takes tremendous discipline. Most people don't have the will to be able to put money aside and not touch it. I'm also not saying it is never a good idea to pay off the mortgage early, it just isn't the no-brainer people make it out to be.