In the real world there are three things you’re not supposed to talk about: politics, money, and religion. In the personal finance blogosphere, it’s whether or not you should pay down your mortgage or invest the cash instead. There are a million differing viewpoints on the matter, and I truly don’t care which you choose. However, I do wish that you include every possible contingency in your decision.
The fact of the matter is that there are millions of articles about paying off your mortgage vs. investing, but none of them—at least none that I’ve found—have bothered to talk about bankruptcy. Maybe it’s because bankruptcy is somehow impossible if you’re perfect with your personal finances. Not true. Personal finance is too safe that it’s dangerous. I mentioned this in my post “Screw the Emergency Fund, Buy a Home.”
Most people say you should pay down your home mortgage because you’re getting a risk-free return. This is also not true. The only risk-free returns are found in US Treasuries, and only because the Treasury can, at any time, come up with the dollars they need to make good on your Treasury securities. Both home mortgages and US Treasuries are US dollar denominated, assuming you live in the United States, so the risk of a compete dollar collapse is irrelevant.
Why mortgage debt isn’t a risk-free investment
Homes are cheap where I live. They’re horrendously cheap (like, Midwest cheap!) to the point where a newer home in the best areas with one-acre lawns and with great schools don’t top $100 per square foot.
Even still, laws in my state provide for a homestead exemption in chapter 7 and chapter 13 bankruptcy of only $15,000. On a $150,000 home, for example, that means you’re allowed only 10% of it it should you go broke. If you own a $45,000 home, then you’re allowed to keep 33% of the equity, assuming its all paid off. Homes, then, are not risk-free. You can lose by paying off your home because each time you make a payment you:
- Own more of the home, and thus have more equity on the line should it fall in value.
- Own more of the home beyond bankruptcy shelters.
(For a overview of the economic dynamics of the US real estate market, see the post on home price trends.)
If the price of real estate falls and you own the majority of your home, then the loss is all yours. If the price of real estate rises and you own the minority of your home, you have as much upside as the same person who owns a majority, or all, of their home equity.
Put it simply: the more you own of your home, the more downside risk you take on for virtually zero gain.
More importantly, if you cannot pay for any reason–injury, serious long-term disability, financial hardship–you can walk away from a home and no one can force you to use your retirement assets to pay for it. It’s the way the law works.
Why you should invest the money
You should be investing the cash because the laws are telling you to do it. Whereas I get to keep $15,000 of my home equity in bankruptcy, I get to keep 100% of my 401k and IRA assets in bankruptcy.
This completely erases the argument that securities are riskier than your own mortgage because it ignores absolute failure in your life while including the possibility for absolute failure of the financial markets. If your home plummets, whatever you have in it minus the bankruptcy exemption is gone…immediately. It isn’t protected.
And hey, I know I’ll hear plenty about this but home mortgages are a two way street. You can either pay back the money, or give up the home. The Fed’s monetary policy is mostly centered around keeping rates low for this reason. They don’t want any more people walking away from a mortgage.
If you’re underwater significantly, give up the home.
Comparing and contrasting
How to make the most of a mortgage:
Never own more than 20% of my home – If I’m protected only to $15,000, and PMI is gone after 20%, it doesn’t make sense to own more of it. Every time rates plummet, you can extract on the equity you’ve built up for further investment elsewhere, preferably one that is a bankruptcy shelter.
Never complain about bailouts – I wasn’t keen on bailout out Wall Street, but hey, their money is worth more than my vote—I can’t do anything about it. That said, I can’t really complain, since I’m getting a fat bailout in the form of retirement asset protection and cheap money from a home loan.
Always max out, if possible – If you aren’t yet maxing out on a 401k and IRA, then you shouldn’t be paying down your home mortgage, plain and simple. Again, Treasury ETFs through a 401k or IRA are risk-free, your home mortgage isn’t. Not that I’d advocate buying Treasury ETFs, but the reality is that there is a safehaven for you to put your cash in a 401k/IRA.
Always understand basic risk management – The spread between a 30-year fixed mortgage and a 30-year Treasury bond is roughly .3% for credit-worthy borrowers. That’s a small loss, one easily erased by the tax benefits of paying mortgage interest, and even if not erased it basically means that Wall Street thinks an individual borrower is .3% per year more risky than the US Treasury. That’s silly, really.
Readers: Am I wrong? Notice any errors in my thinking? Do you pay off your mortgage early, or do you instead invest the money? Both? I’d like your input!