Should I pay off my mortgage?

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The conventional wisdom used to be: Pay off your mortgage as soon as you can. Retire with a paid for home. Some personal finance writers still believe that. I used to believe it too, but not any more.

No debt is as bad as too much debt. I used to be a zero-debt advocate, but now I make a distinction between bad debt and better debt.

Better debt is debt you use to buy an appreciating asset. The mortgage on your primary residence is better debt and I don't believe in paying it off or paying extra unless you just have so much money you have nothing better to do with it. Here is why:

If you have too much of your net worth tied up in home equity, your money isn't working hard enough, you are very sensitive to falling real estate prices, and you are going to find it very difficult to tap your home equity if you need it.

Let's start with the the most obvious problem with home equity. It is that you are tying your money up in an asset that, as a general rule, doesn't earn enough. You can do a back-of-the-napkin calculation on your required rate of return using the formula:

(w + i) / (1 - t)

This is your withdrawal rate in retirement (typically use 4 or 5%) plus the rate of inflation (historically 3.5%) divided by one minus your marginal tax bracket. So an example would look like this:

5% + 3.5% / 1 - 33% = 8.5% / .66 = 12.88% required rate of return

This is the amount your money needs to earn to pay yourself, pay Uncle Sam, and not lose purchasing power.

The problem with locking a large portion of your net worth up in non-cash flow producing real estate, like your home, is that most of the time, that money just doesn't work hard enough. You need that money and, if you are typical, you need it to produce at a much higher rate than residential real estate typically does.

Most people have been brought up believing a paid for home is security. They can't kick you out of a paid for home. That safety is an illusion. It is something we tell ourselves but it just isn't true.

Another thing we used to tell ourselves is that at least we can't lose money in a home like we can in the stock market. Well, we know that is just not true either!

Another critical problem with home equity is that the more you need it, the harder it is to get to. What lender, for instance, is going to give you a home equity loan when you have just lost your job? What kind of bargaining power do you have in the sale of your home if a loved one is sick and needs hugely expensive out-of-pocket medical treatment?

One possible solution is to take out a home equity line of credit and let it sit there unused in case you ever need it. However, as we discovered during the mortgage crisis, that is not the foolproof solution many people thought.

In 2008, lenders across the country froze home equity lines of credit, even for borrowers with perfect credit scores. Lenders sent hundreds of thousands of letters to consumers telling them those home equity lines of credit they paid money to secure, could no longer be tapped.

Most of us think of diversification in terms of asset classes. You also have to think in terms of diversifying liquidity. On the liquidity continuum, cash is obviously most liquid. Businesses and limited partnerships are probably least liquid. In between you have a broad range.

Having an emergency fund is key. I believe in at least twelve months of expense, in cash, on hand. Next comes cash flow. Interest, dividends, option premium, rent, and royalty payments are all forms of short term liquidity. After that are items that can be readily bought and sold in efficient markets. This would include stocks, bonds, options and futures. From there, liquidity becomes murkier.

Some investments have lock-up periods in which you cannot sell them or you will pay a big penalty to sell them. Others, like real estate, can be easy to sell at times, but almost impossible to sell at others. The more complex the asset, likely the less liquid it will be.

It is helpful to consider that most companies don't go bankrupt because they lose money. A company with investors pouring in cash can survive for a very long time. Companies only go bankrupt when they don't have sufficient liquidity to meet their daily obligations.

The same is true of individuals. Most individuals who file for bankruptcy have jobs and assets. It is just that their cash inflows don't properly match up to their cash outflows. When this happens, you have a liquidity problem.

Your job, as Family CFO, is to structure your assets so that no matter what happens, your cash inflows match up to your cash outflows. In other words, liquidity has to be a primary consideration.

As a general rule, I like to think of liquidity as being inverse to assets. The less resources you have, the more liquid you need to be. As your assets increase, you can afford to put more and more of them in less liquid assets.

The same is true for variability of income. The more variable it is, the more liquidity you need. For example, if you are a commissioned salesperson, a business owner, or work for a company with shaky prospects, you need more liquidity than someone who lives comfortably on a government paycheck.

If you haven't already, sit down and list out your assets. The free, My Financial Plan web app on SniderAdvisors.com, is an excellent way to keep track of assets and liabilities.

Stack rank your assets from most liquid to least liquid. Then ask my favorite question … "What if?"

Ask yourself, "What if I had no income coming in for two months? Where would the money come from?"

What about six months? A year? Two years? What if you were permanently disabled? What if you were sued or someone in your family became ill?

Asking these questions forces you to examine your resources in terms of liquidity. If you don't like the answers you come up with, it might be time to restructure your assets or get going on augmenting your savings.

No statement in this article should be construed as a recommendation to buy or sell a security or to provide investment advice unless specifically stated as such. All investments involve risk including possible loss of principal.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Personal Finance , Credit and Debt

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