By any measure, the math says that paying off your home is not a smart move financially. Then why is it that so many people see paying off their home as a great goal?

There are three reasons really. One is out of date thinking, the other is a financial myopia, the last one is No Discipline Syndrome.

Out of Date

Out of date thinking, or as I like to call it “Old Timey Wisdom” (like in Oh Brother Where Are’t Thou – Old Timey Music). Old Timey Wisdom is wisdom that was once true in different times but may not hold up today.

Just one generation ago, paying off your house meant financial security. Often, this was a major deal to this generation, because one generation before a lot of people lost their homes at various times, but most notably during the Great Depression. The wisdom became that as long as your house was paid off, you never had to worry about a huge part of your financial security.

So what is different today than just a few decades ago? Well, then, it was likely that the first house you bought could be the one you lived in your whole life. Of course, there was the concept of a “starter home” which was a cheaper house that you bought first with the idea that you would trade up to your “real” house later after on in life. Even then, it was very likely that you would pay off your house not by doing anything clever, but by simply living there for 30 years until the mortgage ran out.

How likely does that sound today? Between transfers and promotions, layoffs, new opportunities, moving for better schools and so on, the average person will own something like five to seven homes. Do the math. If live in 7 different houses each for just 3 years, that means you will live in six non-permanent houses and it will take you 18 years to do that. If you buy your first house at age 21 then you won’t buy your final house until you are 39 years old. Pay off a 30 year mortgage and you’re 69 years old. That’s great, but it isn’t quite the same as your parents or grandparents might have done.

The other HUGE difference is pensions. Just a generation ago, it was common to work for the same employer for thirty years. At the end of that career you got a pension. Why is that important? Well, a house isn’t free even if you own it without a mortgage. There are property taxes, maintenance, insurance, and heating and cooling. With a pension, you had a way to take care of some of these expenses. Without a pension, you have to have some other money to take care of these ongoing expenses. Don’t forget you have to live on that money too. As a professional financial planner I see a lot of people who didn’t count on that fact and now they are coming to me because they don’t know what to do.

Financial Myopia

With financial myopia you can see something great, but you have a hard time seeing other things. In this case, you can see very well that ever month your biggest expense is your mortgage payment. You think that if only you didn’t have that mortgage payment, then things would be different. If I had a nickel for every time I heard this line of thought, I’d have my house paid off!

While paying off your house isn’t a bad thing, it is important to look around and see the whole financial picture before you make any moves in this area.

Savings First

First, do you have sufficient savings. Once you send the money into your mortgage company it is gone. You can’t get it back. No matter how much you owe or don’t owe on your house, First National Mortgage isn’t going to mail you a check for $10,000 when your water heater blows out and leaks all over your basement the same week your car starts making a funny sound. That money is what we call “dead equity.” Yes, it is your money, and yes, it helps your net worth, but it can’t be moved to take care of other needs. It is dead to you. I know what you are thinking. You can get a home equity loan.

The home equity loan rescue plan has trapped more people than I can count. For starters keep in mind that no matter how much equity you have in your house a home equity loan or a HELOC are still loans. That means you are going to have to qualify for the loan. That means you are going to have to have a job (or other income) that pays the right amount for the payment. Too many people lose their jobs, eat up their savings, and then go into the bank looking for a home equity loan. Sorry. They don’t give loans to people that don’t have a way to pay them back. It takes a lot of work to foreclose on your house and sell it to get their money back. They want to make sure that it isn’t likely they’ll have to do it.

Do yourself a favor and make sure you have built up a sufficient cash reserve BEFORE you start sending extra money to your mortgage.

Retirement?

Remember the whole no-pension thing? Without a pension you have to count on yourself for your retirement income. Here is what I see every day that people have forgot to think about.

If you have a $400,000 mortgage and $400,000 in the bank, you can continue to make your mortgage payments. You can also eat, pay the light bill, and occasionally buy something for yourself.

If you have a $0 mortgage (house completely paid off) and $0 in the bank, you don’t have to make a mortgage payment. Good thing because you don’t have any money. Oh, you also can’t eat, pay the light bill, or buy anything for yourself. Even worse, at least once a year you are going to owe some property taxes. I guess you’ll be selling off your furnishings in order to stay in your house. Again, if you are thinking home equity line here, you are busted. Unless you get it before you retire, no one is going to set one up for you. Even if you do get one are you really getting anywhere? Is it any different to owe $400,000 on a equity loan than to owe $400,000 on the mortgage.

Reverse Mortgage Mythology

The first thing out of many people’s mouth when they come to see me with a ton of equity and no retirement savings is “reverse mortgage.” In the next decade you’ll see a major government campaign to clear up the misconceptions around reverse mortgages as more and more baby boomers find themselves unable to support themselves because they were counting on a reverse mortgage.

For a sobering reality check visit the AARP Reverse Mortgage Calculator (Stay off of other reverse mortgage web sites. This is an area full of scams and con-artists. Searching for “reverse mortgage” is a recipe for disaster.) The guys in our example above can get between $150,000 and $200,000 in a reverse mortgage if the owners are 75. Want one at 65? As low as $65,000. Keep in mind that once you take a reverse mortgage, you are no longer the owner of the home for borrowing purposes, so you CANNOT get a home equity loan of any kind after you get a reverse mortgage. How long do you think $65,000 will last in retirement?

What To Do?

Obviously since this is an article on the psychology of money, I am well aware that you might want to pay off your mortgage anyway. If so, here is the smart way to go about it.

1. Cash Reserve – If you don’t have 6 months worth of expenses in a non-retirement account (not a 401(k) or IRA) then save money into a money market account first. Only after you have six months worth of savings should you consider paying off your mortgage.
2. Worse Loans – If you have ANY OTHER kind of loan you are better off paying it off first. Most importantly is to pay off all credit card debt. That’s right, all. Every cent. If you have any credit card debt you are an idiot for sending extra money to your mortgage. I can’t be any plainer than that. Also, pay off student loans and car loans first. Don’t bother paying off a car lease. With most leases you pay all the interest whether you pay it off early or not, so don’t bother.
3. Retirement – If you are not saving at least 10% of your salary into your 401(k), then do not send extra money to your mortgage. Instead, increase your contribution to your 401(k). You will need an account built up of many years worth of 10% savings in order to retire comfortably and PAY FOR YOUR HOUSE’s non-mortgage expenses. If you get a lump sum of money, then put it in a money market account, increase your 401(k) contribution and use withdrawals from the money market account to make up the shortfall in your paycheck. By the way, if you are over 50 and your 401(k) balance isn’t north of $300,000 then go 15% ASAP and don’t bother with the mortgage.
4. Major Expenses – Don’t be near sighted. Scan the horizon for major up-coming expenses. Want to know where to look? Try a glance at your kids first. How many years until college? Are you where you want to be for helping them out? If Annie is 16 years old and you have an extra $20,000 do you think the smart move is to pay $20,000 on your mortgage today and then get a $20,000 home equity loan in 2 years? (The answer is no.)
5. Does Another Option Sound Safe Too? – Many people who pay off their mortgage do so because it sounds “safe”. Ask yourself if anything else would make you feel just as safe. For example, if you had a $200,000 mortgage and $100,000 in U.S. Savings Bonds would that make you feel safe? (Savings Bonds are garbage by the way, it was just an example.)
6. Feel O.K. About Paying in Chunks? – Most people pay off their mortgage early by sending extra money in with their payments. I myself round up to the next $100 just because it makes me feel good and it doesn’t have any overall impact. But, if you are sending an extra $500 or $1,000 a month consider the “Big Extra Payment” strategy. Instead of sending an extra $1,000 to the mortgage company, put it in a money market account. Wait 15 or 20 months. Now, if you still want to pay early on your mortgage you can send in $15,000 or $20,000 all at once. The interest you pay in the meantime will be equalized by the amount you earned on the savings. This way, if something happens, say in month 13, you’ll have $13,000 that you can replace the roof with (or whatever) instead of scrambling to come up with the dough.

Discipline Anyone?

Tons of people proudly tell me how they claim less withholdings on their W-4 than they have to because then they get a big refund when they do their taxes. You’ve heard all about how this is a dumb strategy because it’s the same thing as giving the government and interest free loan. They do it anyway. Why?

For most people an extra $200 in their paycheck is something they just spend without ever noticing. But, $2,400 all at once is something that they would do something smart with. For these people, the “forced savings” plan of low-balling your W-4 withholdings is the only way they’ll ever save money. I suppose it is better than nothing.

A similar kind of person likes the idea of paying off their mortgage early for the same reason. The theory is that if they saved $500 a month, then eventually they would notice $5,000 in the bank and they would blow it on a vacation or a car. Instead, if they send $500 a month to the mortgage company then they won’t have that extra money so they won’t spend it.

You know yourself better than anyone else and if this describes you then by all means, do what works for you. I’m the first one to say that financial planning is about more than the math. It’s about what will actually work. So, send the extra money to your mortgage company, but do yourself a favor and see if you can’t work on building the financial savvy and discipline that would help you in the long run. Maybe send $400 to the mortgage company and save $100. Put the $100 someplace it’s harder to get to like at a bank a four-hour drive away. Don’t setup online access and cut up the ATM card the second you get it. Then, that $100 will build up and you won’t be able to spend it on a whim. With the extra time to think about it, you might just find that you have the discipline after all.

Good Luck

If you do manage to pay off your house, congratulations. It is a noble goal and I am not speaking against it. In fact, the best retirement planning I do is for people with their house paid off. But, it has to be that they have their house paid off AND they have significant savings. Planning for someone with no mortgage and $700,000 is a joy. Trying to squeeze a budget out of $250,000 even with no mortgage is an exercise in bargain shopping and cutting down to the bare necessities.

Just understand that there are many factors to be taken into consideration. Once you have looked at all the factors, then pay the darn thing off. I’ll be the first to shake your hand.

Related posts:

1. Money Psychology
2. Get Rich Not So Quick in Real Estate
3. Buy Real Estate?