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We have a great guest post from JT of Just Making Cents today on a very relevant topic, paying off your mortgage. Enjoy the read!
Hi everyone, I’m JT, and I’m so excited to be a guest on MSM, a site I’ve been a fan of for some time! I’ve spent over 15 years on Wall Street and try to apply what I know about money to personal finance, faith, and parenting my 3 kids. I hit my retirement number in my 30s and helped my children make, save, and invest hundreds of dollars of their own money. And if you can’t tell, I also love super hero movies. If you like what you read here, check out my site Just Making Cents!
Should You Keep Your Mortgage or Pay It Off?
We sat down. He pulled up his laptop. His expenses filled the screen.
My heart sank.
The numbers before me told a story of debt grown unchecked, like a many-tentacled monster. We came up with a plan to fix it, but the next scene in his movie was going to involve a lot of sacrifice for him and his family. When debt ensnares you, it leaves casualties.
Help! Help! My finances!
I hear this cry of distress a lot. And it usually means “I’m being strangled by debt!”
Many of you know, or know someone who knows, this panic. Because of this experience, we think of D-E-B-T as a four letter word. We struggle to think of any situation where debt can be good.
So then why am I keeping my biggest piece of debt – my mortgage – even though I can pay it off? And why does it make sense for some of you to do the same?
First, let’s start with understanding the two types of debt.
Villain vs. Hero, or: Bad Debt vs. Good Debt
Debt is like what Vince Vaughn’s character, Trent, describes in the movie Swingers:
“[T]he guy you’re not sure whether or not you like yet. You’re not sure where he’s coming from.”
Debt, like the best characters (and Trent himself), is nuanced. As someone who has lived through the financial stories of hundreds of companies, friends, family, and people who ask me for help, let me show you how to identify when debt is a hero and when it’s a villain.
- Bad Debt (Villain): This is meant to be short term and is structured that way. How do you know? The high interest rates and high penalties for not paying off your debt soon or on time should tell you that this type of debt should be paid off within a month. The most popular short-term debt is, of course, credit cards. Credit cards are fine if they’re treated like short term debt. It’s when short-term debt mutates into long-term debt that it turns bad. Personally, I use my credit cards to buy just about everything to get cash back rewards. But, I make sure I never spend more than I’m able to pay off completely when the bill comes…or else bad things will happen.
- Good Debt (Hero): This debt is meant to be long term and structured to help you improve your cash flow. This kind of debt has allowed millions and millions of people to advance in life, either in the form of student loans or mortgages. They’re heroes if used correctly. And, if this debt is secured by assets, like a house is for a mortgage, they’re also cheap. They’re cheap because, unlike credit cards, the bank can seize your home if you stop paying for long enough. This means that it’s not super risky to the bank. When long-term debt mutates into short term, it doesn’t go bad, but you might be missing out on some amazing feats of heroism which I’ll show you below.
(Mr. MSM himself has already done an excellent job of discussing debt with this post.)
Next, there are two things I’d like to show you that can really give you a framework for thinking about your mortgage.
Your 2 Financial Super Powers
Lucky for you, you have two financial super powers you can access to really boost your money when you harness them correctly.
- Fungibility (Shape Shifting): It sounds like fungi, but they’re completely different. Fungibility basically means that one dollar can be substituted for another. So if you get $1 from a friend or pick up 4 quarters off the street, it doesn’t matter the shape or from where. They are basically the same when in your wallet. Either can buy you that protein bar equally well.
- Leverage (Super Strength): Ever wonder why many companies borrow money even when they don’t have to? They use debt to buy an asset to improve shareholder value. This is called “leverage.” And it can help you lift much larger financial boulders than you’re capable of now. In the example I’ll show you below, you’ll see why so many companies use leverage.
If you have any sort of debt now, you are using leverage whether you know it or not because of the fungibility of money. However, you might not realize that leverage has not been working you. Let’s change that. I’ll show you how to harness your super powers to your advantage.
(Want to give your child financial super powers? Download the FREE Guide to Helping Your Child Start Their First Business right here. You’ll also get access to a FREE course on how to get your finances in shape for early retirement!)
How Can You Use Your Mortgage to Boost Your Finances?
Here your story takes an interesting twist.
You somehow stumble upon this amazing machine. This machine can make you $7 for every $100 you feed into it. On the other side of the machine pops out your $100 along with the $7 it made. Sometimes it makes you more. Sometimes that machine breaks down and swallows part of your money. But over time, it all averages out to $7. Would you try it?
Just as you pull out your only $100 to feed into the machine, out of the shadows emerges the character DEBT. He wants to get in on the action. He offers to lend you $80 of every $100 you put into the machine in return for a cut of your $7. Should you take him up on his offer?
You need to find the rate he’s charging you to borrow that $80. So if DEBT wanted 16% in return for letting you borrow his money, you would need to pay him back $12.80 in addition to his $80. Basically, that’s all of the $7 the machine makes and $5.80 from your pocket. (Not coincidentally, 16% is the average credit card APR) Don’t fall for his evil plot.
But, say DEBT wanted to lend you the money for 3.5%. What happens?
If you don’t borrow from DEBT, then you’re limited to putting in that single $100 to get $7. But, with his loan, you can feed $500 into the machine. Here’s how: If DEBT offers you $80, then you only need to add $20 to make $100. And since you have $100 (the equivalent of five $20s), you can put in $100 five times, or $500. So you take his deal. Nervously, you feed the $500 into the machine. It creaks and sputters, but on the other side spits the $500 you put in and $35 extra dollars.
Before you can even count it, DEBT has his hand out. Because you expertly chose the 3.5% rate, you give DEBT back his $400 and $14 ($400 x 3.5% = $14). You’re left with your $100 and $21 extra dollars.
So without DEBT, you made 7% ($7 for every $100). But with DEBT, you made 21%, tripling your return! That’s the super power of leverage and in this case, DEBT was a hero.
You might be wondering how you get DEBT to give you the 3.5% option. Pretty easy: it’s your mortgage. Ok, you have a follow-up question. Will real estate give you 7% returns like this magic machine does? With some exceptions (like in housing bubbles and certain high demand areas), it has not.
So is this story pure fiction?
It would be if you didn’t have that other super power: the fungibility of money. Here’s how it works:
Let’s say you have $35,000 burning a hole in your pocket and $28,000 left on your mortgage. Should you keep your mortgage or pay it off? If you pay it off, it will be a fantastic accomplishment. You are no longer held down by this debt. The day you pay it off is when you discover you can fly.
But, if you keep your mortgage and invest the $28,000 in the S&P 500 and it makes its historical inflation-adjusted return of 7%, you’ve basically used your cheap mortgage to leverage your investment to get that 21% return. (Did you catch that fungible shape shift?) And that 21% return doesn’t take into consideration the tax deduction you get from your mortgage.
Now, it’s important to remind you that the S&P 500 could have a down year, in which case you could end up with less than your mortgage balance. For many of you, this possibility is so scary that you’d rather go for the sure thing. There is nothing wrong with that, but it’s important to understand your choices.
So…Should You Keep Your Mortgage or Pay it Off?
Look, if you’re fortunate enough to have the money to pay off your mortgage now, you’re doing very, very well. Paying off your mortgage now would be a great decision. But there are reasons to keep it anyway, and the reasons might resonate with you. So, when you come to that moment where you’re fortunate enough to ask yourself if you should keep your mortgage or pay it off, here are some thoughts to consider:
- When Should You Consider Paying Off Your Mortgage? If you’re planning to retire soon and have enough assets afterward that can still generate a return for your living expenses, it might make sense for you to pay off your mortgage now. Paying off your mortgage will have the most dramatic impact on your expenses, and reducing your expenses is the most powerful factor in helping you retire early. Also, if you can’t stomach the risk of your investments losing money when you’ve used your mortgage as leverage, then pay it off.
- When Should You Consider Keeping Your Mortgage? If you want to use leverage with cheap debt to continue maximizing your asset growth, then keep your mortgage. But make sure you’re actually investing that money rather than spending it. If you’re not investing it you’re not benefitting from leverage, and in many ways are hurting yourself. The ability to get debt cheaply is one of the cornerstones in getting wealthy.
So it really comes down to whether you plan to play the short game or long game, and your risk tolerance.
How Your Story Ends:
How do you want your money movie to end? In this choose your own adventure, what you do with your mortgage can dramatically affect your outcome. Regardless of which you would choose, however, your true aim is to get yourself in position so that you have the option of paying it off or keeping it. How do you get there? That, dear readers, is a different story for a different day.
Now roll the credits!