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Weighing in on paying off mortgages

Advisers are split on whether it's wise to end burden early

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By Janet Morrissey

August 11, 2008 6:01 am ET

It used to be the American dream to crack open a bottle of champagne and burn the mortgage the moment a homeowner paid off their house in full before settling into retirement.

However, that mind-set may be more fantasy than reality as many financial planners are now cautioning homeowners not to rush to pay down their mortgage, and to scrutinize carefully their personal finances and retirement investments first.

"I would encourage them not to [prepay their mortgage] especially in a liquidity crunch," said Gibran Nicholas, chairman and chief executive of the CMPS Institute in Ann Arbor, Mich., and a certified mortgage planning specialist.

"In a liquidity crunch, cash is king," he said. "And if you've got all your cash tied up in your home and home values decline," lenders will tighten the purse strings, making it tough for homeowners to pull equity out of their homes, Mr. Nicholas said.

Even if there isn't a credit crisis, experts said, it's still not always smart to pay off a mortgage early.

A key factor is total return, said Brett Hammond, chief investment strategist with TIAA-CREF in New York. In many cases, homeowners will get a smaller return by paying down a mortgage than they would by investing those dollars elsewhere, he said.

"The long-term [annual] return on houses is 1% above inflation, and the long-term return on stocks is about 5% above inflation," Mr. Hammond said.

Still, there's no one-size-fits-all answer to the question. It all comes down to an individual's personal situation, advisers said. The person's mortgage rate, age, spending habits, liquidity, health and tax ramifications are among the issues that must be assessed.

"If their mortgage rate approaches or goes above 7% or 7.5%, then I tell them to start considering prepaying their mortgages," said Tony Proctor, a certified financial planner at Proctor Financial in Wellesley, Mass.

Even personality and spending habits play a role.

"If that person is going to toss and turn every night because they're naturally predisposed to being nervous about having a large debt, then that has to be taken into consideration," said Brian Larrabee, a mortgage banker at Americorp Funding in Rye Brook, N.Y.

However, most financial advisers agree that the homeowner, first and foremost, must be fully funding a retirement plan before thinking about prepaying a mortgage.

"Their retirement plan at work should be fully funded as well as their personal [individual retirement account] — whether that be a Roth or a traditional IRA," Mr. Larrabee said.

Mr. Hammond concurs. "In real estate, it's location, location, location. But in long-term investing, it's diversify, diversify, diversify."

Age is also a factor. If the homeowner is 30 years or younger, Mr. Larrabee encourages him or her not to prepay.

"If that money is going to fully fund a tax-deferred or [tax-]advantaged retirement account [that has a compounding rate of return] rather than paying off the mortgage, then that will be infinitely greater over a 30-year period for somebody who is young," he said.

Then there are the tax ramifications. Under federal tax laws, homeowners can deduct the mortgage interest on their federal income tax returns if they use the itemized-deductions form.

"People tell me that they keep a mortgage because it's deductible — and so I tell them, 'Well, go have your bank double your [mortgage] rate, and you'll get twice as much deduction,'" quipped Larry Botzman, an independent certified financial planner in Somerset, Ky., with about $70 million in assets under management.

Even for those who do qualify, the deduction isn't hugely bigger than the standard deduction people receive without a mortgage, Mr. Proctor said.

"Without having a mortgage, you could deduct $10,000 right off the top," he said. "If you paid $15,000 of mortgage interest and itemized, it may allow you to deduct an extra $10,000 [above the standard deduction], but you paid $15,000 worth of interest," Mr. Proctor said. "It's something, but it's not as big as people think of it in their heads.

"I just think the whole tax deduction aspect is somewhat overblown," Mr. Proctor said.

Also, middle- to upper-income earners, whose salary falls roughly between $100,000 and $500,000, are subject to the alternative minimum tax, which effectively wipes out the mortgage deduction, he said.

However, there are also tax issues to consider when paying off a mortgage.

If a homeowner uses a retirement account to pay off the mortgage, the decision could trigger a hefty income tax burden that would offset the benefit of paying it off at that point," Mr. Botzman said.

Next is whether the house itself is a home. Experts said paying off a mortgage early can be a good strategy if the person plans to live in the house during retirement.

This way, the homeowner won't have to worry about making monthly mortgage payments if the broader market suddenly crashes and the person is left struggling with a decline in the cash flowing from his investment portfolio, Mr. Botzman said.

"For many people, there's just a sense of comfort in having the house paid off in retirement," he said.

However, if a homeowner ex-pects to downsize to a smaller home or relocate within the next five years, or if poor health could force a person into an assisted-living facility in the near term, Mr. Botzman recommends that the homeowner not try to pay off the mortgage early.

In 2004, about 36% of homeowners between 50 and 54 owned their homes outright, with the number climbing to 65% for those between 60 and 64, according to the Washington-based Research Institute for Housing America.

E-mail Janet Morrissey at jmorrissey@investmentnews.com.

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