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Mortgages: Is Bigger Better?


Mortgage Repayment Calculation for Smart Decision Making

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Many people believe intuitively it is good to have a small mortgage, and that paying off your mortgage early is a sensible objective. There are those who disagree with this, however. For example, Ric Edelman, who wrote the book The Truth about Money, argues it is shrewd to have the largest mortgage you possibly can. Is he correct?
 

The Best Use of $100,000

 
Suppose you had a $100,000 mortgage, and one day you woke up to find $100,000 lying under your pillow. Should you pay off your mortgage? If not, what should you do with the $100,000?
 
The first thing you should do with your new-found $100,000 is pay off your non-mortgage liabilities, such as credit card balances. Typically, these carry a higher interest rate than a mortgage. Moreover, interest on these loans is not tax-deductible. Thus, it is very likely that compared to other liabilities your mortgage represents a lower net cost to you.
 
The next thing you should do with your new-found money is to make sure you are maximizing your contributions to tax-advantaged retirement accounts, such as a 401(K) plan. If you are in the 25 percent tax bracket and have a 7 percent mortgage, then the after-tax cost of your mortgage is 5.25 percent. If you can earn more than that in a retirement account, you are ahead of the game. If you work for an employer who matches some of your contributions to a 401(K) plan, you are ahead even more.
 
However, once we get past paying off other liabilities and investing in tax-advantaged retirement accounts, there is not much to be said for keeping a mortgage. For example, if we invest in taxable bonds earning 6 percent, then we come out behind no matter how you look at it. Before taxes, we lose 1 percent (6 percent on our assets minus 7 percent on our mortgage). After taxes, we lose 0.75 percent (we earn 4.5 percent after taxes on our assets and we pay 5.25 percent after taxes on our mortgage).
 
We could invest our $100,000 in stocks and hope that they earn more than the cost of our mortgage. However, there are less expensive ways to finance a purchase of stock. Margin credit often is less expensive, particularly when you consider other costs of a mortgage, such as private mortgage insurance (PMI), and the fact mortgage lenders keep some of your money tied up in escrow accounts.
 
Moreover, one can use futures or option contracts to place large bets on stocks. This point is often is overlooked by financial writers. Using futures and options, it is as easy to take a large position in the stock market without a mortgage as it is with a mortgage. We can use our hypothetical $100,000 to pay off our mortgage without in any way inhibiting our ability to invest in stocks.
 
To put this another way: if you are afraid to buy stock using a margin loan from your broker, then why should you feel comfortable about buying stock using a mortgage loan from someone else? On close examination, the case for using a large mortgage to fund one's investment in financial assets does not stand up.
 

Forced Saving

 
A completely different argument for a large mortgage is the following:
 
If I did not have a large mortgage payment to meet every month, I would throw away all my money.
 
The idea here is that a mortgage represents a form of forced saving. The theory is that you will not save any extra income that you get, unless you force yourself to invest in equity in your house by making regular mortgage payments.
 
Unfortunately, this form of forced saving does not necessarily work. Many people who adopt this strategy then proceed to refinance their mortgages, taking out larger loans. This defeats the purpose, because refinancing in this manner undoes any equity you have built up.
 

Conclusion

 
Having a large mortgage is not nearly as shrewd as Ric Edelman and other experts would have you believe. If your intuition tells you it would be healthier to pay off your mortgage as soon as possible, that is probably best for you.
 
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