To Pay Down your House or Not?

To Pay Down your House or Not? 03/14/2010

Often I will be asked this question as to wither someone should pay-down the house (often said as invest in my home), or invest in other ideas. The real key to this question is the definition of an Asset or a Liability as discussed in the book, The Wealth Code.

In general you want to invest in Assets, or financial vehicles which at the end of each month put money into your pocket. A liability is something that pulls money from your pocket each month.

Is your house an Asset or a Liability? It is a liability. You have your mortgage expense, property taxes, insurance, and miscellaneous expenses each month. It is draining your pockets of valuable dollars which could be put into Assets which would be putting money into your pocket.

Is a house an investment? Yes and No. It is real estate and that will appreciate in value as our dollars are devalued by the government. But the equity in a home effectively earns 0% interest. The more money you put into the house, the more money you have earning 0%.

Don’t believe this. Imagine your house right next to my house. Both exactly the same. The difference is your house is paid off and mine is 100% leveraged. Let’s say that both houses have a market value of $100,000. Therefore you have $100,000 of equity inside your home and I have $0, since I have a $100,000 loan on my house.

The next year the real estate market appreciates by 5%. Your house is worth $105,000, and incidentally my house is worth $105,000. I earned exactly what you earned! It is the house which appreciates not the equity inside. Thus the equity in a home earns ZERO %. Paying down a house is working with the concept of Lost Opportunity cost, and I explore it in great detail in the book.

What you ARE doing by paying extra into the home? You are creating a situation that the mortgage holder salivates for. Each time you pay extra, you place more money in their hands for them to invest for THEIR well-being, and also you lower THEIR risk. Let me repeat again. As you put more equity into the home, the mortgage gets smaller, and there is more equity protecting the lien holder in case you can't make your mortgage payment for whatever reason. Death, disability, and divorce are common unforeseen reasons. If their risk is lowering, what is happening to your risk? It is going up. You have more to lose if you can't pay your mortgage, and they take your home to auction and only cover what is owed to them, the mortgage balance. Auctions are not meant to protect the seller; they are meant to protect the lien holders.

Here is what I call unconventional or uncommon knowledge. Instead of paying extra into your home, make the exact same payment into a side account. Something that can earn 5–6% each year and compound on itself, and is fairly liquid. Even something with surrender charges will work. In the same time you would have paid off your house, in actuality faster, the side account will have grown to equal your remaining mortgage balance. At that point, you can take your side account and pay off your mortgage all at one time and own your home outright.

The advantage to this financial strategy is many fold.

First, you have an emergency reserve of immediate cash. Is equity in your home more liquid than a side account? No way. Unless you have a line of credit already established and it hasn't been taken away, like so many are today, then your equity in your home is stuck. Without a pre-existing line of credit, you could apply for a line of credit, refinance your mortgage, or sell your home to unlock the equity to pay for your emergency. Today, all three choices are exceptionally difficult and time consuming. In an emergency, time is not a luxury we usually have.

Second, by not paying down your mortgage, you will retain more mortgage interest to deduct, which will give you greater tax rebates from Uncle Sam. If you really wanted to be aggressive with your saving, take the rebate generated due to the interest deduction and apply it toward your side account.

Paying down a house is a two sided question and needs to be viewed from both sides to see which one is better for your personal situation..

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