Esoteric Finance Corner: Never Pay Off Your Mortgage

Oh husbant... you take unlicensed financial advice... now we are homeress

For most people, their mortgage is both their largest debt and their largest month-to-month expense. There is a temptation to try to reduce this, through the obvious mechanism of paying it off early, so one can be “debt free”.

Do not do this. Under the American tax and debt regime, it is almost always a bad idea to pay off your mortgage early. If you wish to reduce the net monthly cashflow burden of your mortgage, the way to do this is via offsetting assets.

As debts, mortgages are a bit odd. Most bonds are structured with a fixed principal, the face value of the bond, and periodic, identical interest payments called coupons. If you buy a 10 year, $10,000 bond at 5%, each year you will receive $500 in interest, and a lump sum of $10,000 after 10 years. You might also buy a zero coupon bond, where one buys it at a discount and receives the face value at maturity - $6140 up front for a $10,000, 10 year bond, also works out to approximately 5% interest.

However, mortgages are structured to have the same payments each month, with fluctuating balance between interest and principal. When one considers that one is paying a different amount of principal each month, it becomes easy to model a mortgage as borrowing a certain amount for one month, a slightly larger amount for two months, and so on, up to the final amount one borrows for the full 30 years.

Furthermore, paying down one’s mortgage happens in reverse. The monthly payments are fixed, so an extra payment on the mortgage does not reduce the amount we pay going forward; instead it eliminates payments at the end of the mortgage. In cashflow terms, this is economically equivalent to buying a zero-coupon bond with a maturity of the current payoff time of the mortgage. In other words, if you have a 30-year, 5% mortgage, and you make an extra $1000 payment, this is equivalent to buying $1000 worth of 30-year zero-coupon bonds.

This matters because we want to offset our mortgage rather than paying it off, and the assets required to offset a 30 year mortgage as of Year 1 are different than the assets required as of Year 10.

Why do we want offsetting assets? Liquidity, optionality, and taxes. Let’s start with liquidity.