Ask Money

Pay off mortgage

Chris Farrell May 26, 2010

Question: My wife and I owe $55,000 on our home which is currently valued at around $150,000. The mortgage interest rate is 5.65%. We have enough savings to pay off the mortgage, and since interest on savings accounts and CDs is so low right now, it is tempting to consider paying it all off. Other than the dent this would put in our savings, is there some other disadvantage to doing this right now that we are not seeing? Thank you for considering our question. Donald, Albany, NY

Answer: Listener questions tend to come in waves. For instance, toward the end of the last year many folks wrote in with queries about Roth-IRA conversions for 2010. Earlier this year, a constant refrain was the search for safe investments that still paid a decent yield. (Alas, there’s no way around the trade-off between keeping money safe and earning a low return and creating the chance for a higher gain but for the price of greater risk.) Lately, the focus has shifted on the wisdom of getting rid of the mortgage or aggressively paying it down, say, over a four to five year period.

There’s no doubt that saying goodbye to mortgage payments is a wonderful moment. Living debt free is liberating. I also believe that in almost all circumstances it’s a smart move to enter retirement with the mortgage paid off.

That said, you asked what are the main tradeoffs to consider. Let’s go through a few of the main ones for you to consider.

For one thing, you’re putting most of your financial eggs into one asset–a home. Your overall financial health will be more dependent than before on how that asset performs in coming years. You’re already highly exposed to the local economy through your jobs. In a sense you’re doubling down that bet on local conditions. You need to know that you’re committed to staying in the home and area.

For another, there are other important savings goals to strive for in an uncertain economy. Are you carrying any credit card debt or an auto loan? Get rid of those debts. Are you putting the maximum into retirement savings plans? If not, I’d do so now. Is there enough money in savings accounts and money market funds to get you through a spell of unemployment or a medical emergency? How about the kid’s college fund?

Of course, some to none of these issues may apply to you. But we all struggle to meet various savings goals. That’s why I recommend people focus on paying down their consumer debts and concentrate on building up a well-diversified portfolio of cash, stocks and bonds first–and not just in retirement savings accounts.

A related concern is what economists call “opportunity cost.” Whenever you make a decision to do something–like pay off the mortgage with savings–you foreclose using the money for other purposes. Economists call the value of the goods and services you sacrificed in making a choice an opportunity cost. It’s a measure (a very imprecise one) of what you’ve given up. It helps us better understand the return we expect from our choices.

The late Robert Eisner, an economist at Northwestern University, somewhat tongue-in-cheek illustrated opportunity cost this way. The cost of buying and reading his book–The Misunderstood Economy–was not only the dollars spent on it, but also the value of the time spent reading it and the alternative use of that time. In other words, his book should only be read if you believe your return, both in enlightenment and enjoyment exceeds its opportunity cost, that is, money spent on the book and the time required to read it.

The same goes with the mortgage payoff strategy. Your savings could go toward an investment opportunity opened up by the Great Recession or to fund a career change some time in the near future. Or it could go to paying off the mortgage.

So, if at the end of all this you still feel getting rid of the mortgage is right for you then by all means eliminate the debt. Congratulations.

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