Should you pay off your mortgage? Maybe not

John Waggoner - USA Today

Your great-Uncle Jack, inventor of the left-handed monkey wrench, left you $250,000. You can either invest it or pay off your mortgage. Which is better?
If you have a low mortgage rate and a long investment horizon, then it's better to invest it. And, no, property isn't where you should put Jack's jack.

Let's start with the basic question: Should you pay off the mortgage early? Your best assumption is that the return on paying off your mortgage is the same as your mortgage rate. If you are paying 5.91% on your mortgage, the current national average, then you're saving 5.91% interest on your principal over the term of the loan. This basic rule comes with many caveats.

•Taxes. If you pay off your mortgage, you'll lose the mortgage deduction on your federal income taxes. That lowers your overall return from repaying the mortgage. (Taxes also lower the return from most other investments.)

More important, the mortgage interest deduction, either by itself or with other deductions, is typically more than the standard deduction on your federal income taxes. Of all the people who itemized in 2003, 82% claimed mortgage interest as a deduction. Unless you're a real saint, it's probably your mortgage that allows you to itemize deductions and pay less in taxes.

•Leverage. If you pay off your mortgage, you'll also lose the advantage of using someone else's money to invest. Let's say that your mortgage is paid off, and your home gains 5% in price this year, to $210,000 from $200,000. You've gained $10,000.

But let's say you had $20,000 in equity in your home and a $180,000 mortgage. If you were to sell your home for $210,000, you'd repay the $180,000 loan, keep the $20,000 in equity and pocket $10,000 — without tying up $200,000 of your own money.

•Liquidity. If you suddenly need money, you may not be able to sell your house quickly. You'll also have to pay a broker's commission to do so. True, you can tap a home equity line of credit — but then you're back where you started before you paid off your mortgage.

But to really make the decision, you have to compare your return with another investment. Over long periods of time, you could probably beat 5.91% by investing in stocks. The stock market has averaged a 10.4% gain since 1926, according to Ibbotson Associates, a Chicago research firm.

And there's the rub. Investing in this kidney stone of a market would make most people balk. When people talk about paying off their mortgage, they're often considering investing the money they save in real estate. Stocks have gone nowhere since 1999, but home prices are going wild in many parts of the country. "I talk to one or two people a week who ask about buying another house and just flipping it," says Malcolm Makin, a financial planner in Westerly, R.I.

That's not the time to load up on real estate. Although the word "bubble" is batted around too frequently — true bubbles are rare — you can make a strong argument that housing gains will ease:

•Rising rates. Every quarter-point increase in mortgage rates eliminates potential buyers from the market. The Mortgage Bankers Association thinks the rate on 30-year fixed-rate mortgages will rise to 6.6% by the end of 2005, and 7.3% by the start of 2007.

•Cooling prices. Home prices, like stock prices, don't normally double in a year or two. Typically, home prices rise 1 or 2 percentage points above inflation, currently running at 3.1%.

•Soaring expectations. In 1999, people would talk about how much they made from their tech stocks. These days, the topic is usually how much they have made from their houses. That's not a good sign. People who buy now are "doing the same thing they did with tech stocks," says Tim McIntosh, a financial planner in St. Petersburg, Fla. Should home prices actually fall, the magic of leverage will work in reverse. If you buy a $200,000 house with $20,000, you'll be in trouble if your home price falls 10% to $180,000.

And just as some people don't have the temperament to be investors, some don't have the psychological makeup to be landlords. There's nothing quite like tenants who view paying rent as optional, or discovering a renter's spouse planted in the zinnias.

When should you pay off your mortgage? If you're close to retirement, the mortgage is near its end, and your alternatives are low-yielding bonds or bank CDs. For a retiree on a fixed income, losing a major expense means a big boost in lifestyle.