As I’ve written elsewhere, Dave Ramsey was my early influence in the personal finance world. Prior to encountering Dave, despite real success in growing my income, I was wandering around “like Gomer Pyle on Valium” when it came to planning our family’s financial life. We didn’t do everything wrong. We paid our bills on time, got the employer match, and put money in IRAs. But we had no overarching plan for our money, and we spent way too much. I had no idea that savings rates in excess of 15% were a thing. I didn’t even know what a savings rate was!
Around 2014, my brother introduced me to Mr. Money Mustache and the scales began to fall from my eyes. From Triple M, I wandered over to the Mad Fientists’s site, where, in a podcast interview, I first heard the fabulous Mr. and Mrs. 1500 Days. They were discussing early retirement and beer at FinCon 2015 in Charlotte. By then we had caught the FI vision, and these days our family of five clocks in with a savings rate in the 45% – 60% of gross income range. And I just booked travel and got signed up for FinCon 2017; needless to say, I’m super stoked.
Given our roots with Dave Ramsey, it’s unsurprising that one of our current goals is the elimination of our mortgage. We have about 40% of the balance left.
Over the last six months or so, though, I’ve modified the way we’re planning to pay off our home. Rather than chipping away at it month-by-month, we are piling up cash in a savings account and plan to kill the mortgage all at once. But before I dissect the specific repayment tactic we’re using, I’d like to talk about why we’re paying it off at all.
Why pay it off at all?
First and foremost, I agree wholeheartedly with anyone who argues their wealth will be higher, in expected value terms, if they keep their mortgage and invest additional money in good index funds or rental real estate. And I won’t argue with anyone who wants to be a perpetual renter, as long as they’re clear on the implications of that choice - your rent will rise with inflation and you’ll always have a rent payment. My rationale for paying off our home is based on something other than expected value or convenience. My reasons can be grouped as practical, emotional, and financial.
A home is a uniquely practical asset; you can’t live in your index fund. Your home and land provide you with opportunities not afforded by paper assets. Although a home is only one of many ways to get the job done, meeting the “shelter” requirement of your life is a biggie. In addition, if you have even a little bit of land you can raise some of your own food, and change your land to suit your needs. As a tenant, you can negotiate the use of a house and land, but you have less control. That’s why you sign a multi-page contract with the landlord. I also think that in the United States context, a government will be slightly more reluctant to deprive me of my home, or to directly tax my home equity, than they would be to find a way to tax my e.g. Roth IRA assets.
Emotionally, I think it would just feel good to own my home. Formulated more precisely, I think it will feel great not to have a mortgage. Twice in my adult life I have been a renter. I enjoyed the fact that I was not in debt for a pile of money to the bank. My wife will enjoy having a paid-for house (yes, we know we still pay property tax, demonstrating our perpetual servitude to the county).
Financially, the benefits of repaying our home come in two varieties. First, the less interest we pay the bank, the more money we have to invest or to consume. Even a taxpayer with a 50% combined tax rate is still $0.50 behind for every $1.00 in interest. The more important benefit though, is the flexibility afforded our budget by eliminating a big payment.
For example, to pay a $1200 principal and interest payment requires $1925 per month in gross wage income ($1200 / 0.6235 = $1925 based on an all-in tax rate of 37.65% derived as 25% federal + 5% state + 7.65% Payroll Tax). $1925 x 12 months is $23,100 in gross income per year that is no longer needed if this debt is paid. Based on a 4% withdrawal rate, that’s $577,500 in assets that are no longer needed to support a principal and interest payment. And the reduced cash-flow need is not tied to stock market performance or even real estate market performance. The underlying value of the asset may fluctuate, but the monthly payment stays $0!
I’m not arguing that your home is “your most important asset”. I don’t believe your home is where you should do the bulk of your savings. No question, your house is a consumption item. Rather I am arguing that, for the reasons above, having some of your wealth tied up in your house is not a terrible idea. Based on Tom Stanley’s data, having 20% to 30% of your total net worth in your home is in line with the Millionaire Next Door’s balance sheet. That’s good enough for me.
Why call mortgage repayment “buying a bond”?
Reducing your mortgage principal reduces the amount of future interest you will pay and buying a bond allows you to collect interest from someone else. Collecting interest and not paying interest amount to the same thing. At the end of the bond’s duration, you stop getting payments and receive your principal back. At the end of your mortgage’s duration, you stop making payments and own your house!
One reason I want no mortgage is that I am the best credit the bank will ever underwrite. My mortgage interest rate should be no more than the cost of servicing my mortgage + the risk-free rate. Instead, my mortgage rate reflects the average risk of a borrowing cohort. Since I know I’m lower risk than the cohort, I know I’m overpaying. There’s no one I’d rather invest in than me - I pick a winner every time!
There are tax ramifications to all this – the deductibility of mortgage interest lowers the real cost of the debt. As far as debt goes, mortgage debt is the cheapest. But I still want it gone (in the smartest way possible). Here’s the tactic we’re employing.
We are using automatic transfers to sweep the amount of extra money that we want to put toward the mortgage into a savings account at 1% interest. Then, when the savings account balance reaches the mortgage balance, we'll pay the whole thing off at once.
By accumulating savings, rather than sending the extra to the bank as additional principal payments, we give ourselves the most flexibility leading up to the time we can clear the debt completely. For example, if an investment opportunity came up, or if our income was interrupted, or we had a large emergency expense, we would be in the best possible position. I like a big cash cushion.
The wealth implications? For a hypothetical mortgage balance of ~$145,000 at 3%, and additional principal payments of $2500 per month, this approach paid off the note in 44 months versus 43 months, and cost $2763 in after-tax wealth.
Since a big part of the reason we want the mortgage gone is that we value flexibility, taking this route, even with the slightly greater cost, suits our family just fine.